Owners of private companies are often unaware of the potential for double taxation on death. The following case study will demonstrate how critical careful estate planning is for avoiding this punitive outcome.
Trevor, a widower, has two adult children, Emily and Brett. Many years ago, at the time of retirement, Trevor’s operating company sold its business assets for $2 million and used the proceeds to invest in marketable securities (stocks, bonds and mutual funds) within his corporation. Throughout retirement, Trevor supplemented his income with dividends from the company.
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His will names Emily and Brett as beneficiaries. It provides for them to receive shares of his company via his estate. But Trevor didn’t put much thought into what his death would mean from a tax perspective.
Trevor passed away several months ago. At the time of death, the adjusted cost base (ACB) and paid-up capital (PUC) of his company shares were nil. The fair market value (FMV) of the shares was $5 million. Also, the company’s investments had an ACB of $2 million (the price originally paid for the investments on sale of the company’s business assets) and a FMV of $5 million.
According to section 70(5) of the federal Income Tax Act (ITA), when an person dies he/she is deemed to have sold his/her capital property just before death. Because Trevor’s company shares were considered capital property, he was deemed to have sold them just before death, resulting in a capital gain of $5 million (FMV minus ACB) reportable on his terminal tax return for the year.
Since Trevor’s marginal tax rate was 45% at the time of death, capital gains tax of approximately $1.1 million resulted (as shown below). Note that the corporation’s investment assets were not impacted by the deemed disposition that occurred on Trevor’s death.
| Personal tax – Trevor’s terminal return | |
|---|---|
| FMV of shares | $5,000,000 |
| Less: ACB of shares | $0 |
| Capital gain | $5,000,000 |
| Taxable capital gain (50% of gain) | $2,500,000 |
| Personal tax payable (@45%) | $1,125,000 |
Trevor’s estate then received the company shares with an ACB of $5 million, the amount Trevor was deemed to have sold the shares for. Thereafter, as per his will, Trevor’s executor transferred the shares to Emily and Brett (with an ACB of $5 million), who then sold the corporate investments and paid dividends to themselves.
With a 45% corporate tax rate and a 34% personal tax rate on dividends, tax payable by the corporation and Emily and Brett was approximately $1.4 million ($275,000 + $1,096,500), calculated as follows:
| Corporate tax – Sale of investments | |
|---|---|
| FMV of investments | $5,000,000 |
| Less: ACB of investments | $2,000,000 |
| Capital gain | $3,000,000 |
| Taxable capital gain (50% of gain) | $1,500,000 |
| Corporate tax (@45%) | $675,000 |
| Less: Refundable tax when dividends paid1 | $400,000 |
| Tax payable | $275,000 |
1 Corporation receives a partial refund of tax paid when dividends are paid to shareholders.
| Personal tax – Emily and Brett | |
|---|---|
| FMV of investments | $5,000,000 |
| Less: Corporate tax | $275,000 |
| Dividend available to Emily and Brett | $4,725,000 |
| Less: Capital dividend2 | $1,500,000 |
| Taxable dividend | $3,225,000 |
| Dividend tax (@34%) | $1,096,500 |
2 A capital divided is a tax-free amount paid to shareholders from a corporation’s capital dividend account; it is often the result of capital gains realized within the company.
The deemed disposition that occurred on Trevor’s death required tax to be paid on the increase in value of the company. Then, once the shares were transferred to Emily and Brett, the sale of the investments within the company resulted in tax again, resulting in double tax of the same economic gain. In the absence of a proper estate plan, total tax payable was $2.5 million or half (50%) of the value of the children’s inheritance.
| Summary – No Post-Mortem Planning | |
|---|---|
| Personal tax – Trevor’s terminal return | $1,125,000 |
| Corporate tax – Sale of investments | $275,000 |
| Personal tax – Emily and Brett | $1,096,500 |
| Total tax payable | $2,496,500 |
| Tax as a percentage of FMV | 50% |
Given that capital gains tax rates across Canada are approximately 24%, this double tax problem is difficult to accept. Fortunately, proper planning can minimize tax payable.
An Alternative
Instead of leaving his company shares to Emily and Brett, let’s assume that, with guidance from his financial, legal and tax advisors, Trevor instructs his executor to wind up his company in his estate before distributing the proceeds to Emily and Brett. Provided the wind up occurs within a year of Trevor’s death, section 164(6) of the ITA allows a capital loss triggered in Trevor’s estate to be carried back to his terminal return, where it can be applied against the capital gain realized on Trevor’s death.
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This is often referred to as the “Loss Carryback Strategy.” Trevor needs to include a provision in his will allowing his executor to claim beneficial tax elections on his behalf (a standard provision included in many lawyer-drafted wills). Assuming ACB, PUC and FMV amounts are the same as above, tax implications on Trevor’s death would be as follows:
| Personal tax – Trevor’s terminal return | |
|---|---|
| FMV of shares | $5,000,000 |
| Less: ACB of shares | $0 |
| Capital gain | $5,000,000 |
| Less: Capital loss carryback (see details below) | $5,000,000 |
| Taxable capital gain | $0 |
| Personal tax payable (@45%) | $0 |
Following his deemed disposition at death, Trevor’s estate would receive his company shares with an ACB of $5 million, the amount Trevor is deemed to have sold the shares for. At that point, as per his will, Trevor’s executor would wind up the company, resulting in the company’s buy back or redemption of shares from Trevor’s estate.
This would provide cash to Trevor’s estate for distribution to Emily and Brett. The redemption would require the sale of the company’s investments, so corporate tax would still be payable as would personal tax by Trevor’s estate on the redemption of the shares. However, a capital loss to Trevor’s estate would result, allowing for a carryback of the loss to Trevor’s terminal return and a reduction of total tax payable.
Similar to the case where little-to-no planning was done, the sale of the company’s investments would create corporate tax of $275,000:
| Corporate tax – Sale of investments | |
|---|---|
| FMV of investments | $5,000,000 |
| Less: ACB of investments | $2,000,000 |
| Capital gain | $3,000,000 |
| Taxable capital gain | $1,500,000 |
| Corporate tax (@45%) | $675,000 |
| Less: Refundable tax when dividends paid | $400,000 |
| Tax payable | $275,000 |
Following corporate tax, a “deemed dividend” would be paid to Trevor’s estate. This generally refers to a dividend paid to a person or estate when corporate shares are redeemed, provided the payment exceeds the company’s paid-up capital (PUC). The dividend may be taxable or non-taxable depending on the characteristics of the company and credits to its capital dividend account (CDA). In this example, the result would be as follows:
| Personal tax – Trevor’s estate | |
|---|---|
| FMV of investments | $5,000,000 |
| Less: Corporate tax | $275,000 |
| Dividend available to Trevor’s estate | $4,725,000 |
| Less: Paid up capital (PUC) | $0 |
| Deemed dividend | $4,725,000 |
| Less: Capital dividend | $1,500,000 |
| Taxable dividend | $3,225,000 |
| Dividend tax (@34%) | $1,096,500 |
So far, it’s not much different from the above scenario where little-to-no planning was done. However, in this scenario the wind up causes a disposition of the shares by Trevor’s estate resulting in a capital loss:
| Capital loss on wind-up – Trevor’s estate | |
|---|---|
| Amount received on redemption of shares | $4,725,000 |
| Less: Deemed dividend | $4,725,000 |
| Adjusted proceeds of disposition | $0 |
| ACB of shares (estate) | $5,000,000 |
| Capital loss on wind-up/loss carryback | $5,000,000 |
While Trevor’s estate receives $4.725 million on redemption of his company shares, for capital gain/loss reporting purposes, this amount is reduced to nil (“adjusted proceeds of disposition”). When the ACB of the shares, $5 million, is subtracted from the adjusted proceeds, the result is a $5 million capital loss to the estate.
Subsection 164(6) of the ITA then allows for the capital loss to be carried back to Trevor’s terminal return, offsetting tax from his deemed disposition at death. Trevor’s executor can request a 164(6) election by filing a letter with the estate’s tax return for the year.
Using the loss carryback strategy, Emily and Brett can receive the post-wind-up, after-tax value of Trevor’s company from his estate. Total tax payable for the family would be $1.4 million. This represents a $1.1 million tax savings when compared to the above alternative.
| Summary – With Post-Mortem Planning | |
|---|---|
| Personal tax – Trevor’s terminal return | $0 |
| Corporate tax – Sale of investments | $275,000 |
| Personal tax – Trevor’s estate | $1,096,500 |
| Total tax payable | $1,371,500 |
| Tax as a percentage of FMV | 27% |
Estate planning can ensure inheritances are maximized and assets are distributed as intended. Planning for a 164(6) tax election can be a key part of this process. In the case of privately held corporations insurance can also be used to enhance benefits. And, other tax minimization strategies, such as “bump” or “pipeline,” can also be used.
Advisors familiar with these strategies can assist clients in indentifying suitable solutions to the double-tax problem many business owners face.