LLQP practice question 13 of 35

Jeremy, aged 35 and Emily, aged 40, are common law spouses and have 3 children, Jack, Maddie, and Grace. They are reviewing their life insurance…

Jeremy, aged 35 and Emily, aged 40, are common law spouses and have 3 children, Jack, Maddie, and Grace. They are reviewing their life insurance coverage with Mark, a local life insurance agent, to ensure they have adequate coverage. Currently, Jeremy and Emily both have term life insurance in the amount of $200,000. Jeremy recently inherited a family cottage valued at $400,000 (ACB of $200,000), which him and Emily hope to pass on to their children one day. Mark informs Jeremy & Emily of the potential tax liability of passing the cottage to their children and advises them that they should consider purchasing additional life insurance. How much life insurance should they purchase to cover the future tax liability of the children taking into account a tax rate of 50%?

Answer options

A: $400,000

B: $200,000

C: $100,000

D: $50,000 Correct answer

Correct Answer:

D. $50,000

Explanation

The life insurance is intended to cover the tax liability from the deemed disposition of the cottage upon the owner's death. The capital gain is calculated as the Fair Market Value (FMV) minus the Adjusted Cost Base (ACB), which is $400,000 - $200,000 = $200,000. In Canada, 50% of the capital gain is taxable. Therefore, the taxable capital gain is $200,000 x 50% = $100,000. The final tax liability is this taxable amount multiplied by the given tax rate: $100,000 x 50% = $50,000. This is the amount of life insurance needed to provide liquidity to the estate to pay the taxes.

Why Incorrect

A. $400,000 is the cottage's fair market value, not the tax liability.
B. $200,000 is the total capital gain before the 50% inclusion rate is applied.
C. $100,000 is the taxable portion of the capital gain, not the final tax payable.

References

1. IFSE Institute, Life Insurance (LLQP) Common Law Study Manual, 2023, Module 6: Estate Planning, Section 3.1 "Taxation at Death". This section explains that upon death, there is a deemed disposition of capital property at its Fair Market Value, which triggers a capital gain subject to tax. Life insurance is identified as a primary tool to provide the necessary liquidity to pay this tax.

2. IFSE Institute, Life Insurance (LLQP) Common Law Study Manual, 2023, Module 5: Taxation, Section 2.3 "Capital Gains and Losses". This section details the formula for calculating a capital gain (Proceeds of Disposition - Adjusted Cost Base) and specifies that the taxable capital gain is 50% of the total capital gain.

3. Canada Revenue Agency, Guide T4037, Capital Gains, 2023, Chapter 2 "Calculating your capital gain or loss". This official guide confirms that only 50% of a capital gain is taxable (the inclusion rate) and must be reported on the income tax return.

4. Canada Revenue Agency, Guide T4011, Preparing Returns for Deceased Persons, 2023, Chapter 3 "Final Return", Section "Deemed disposition of property". This document states, "When a person dies, we consider that the person has disposed of all capital property right before death... at its fair market value (FMV)." This establishes the event that triggers the capital gains tax.

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