When an owner passes away, much of the company’s value will be eliminated by taxes. A proper estate plan can reduce unnecessary taxes.
By Jerry Gedir
One of the most valuable assets business owners have is their private company shares. When an owner passes away, much of the company’s value will be eliminated by taxes. A proper estate plan can reduce unnecessary taxes.
Let’s examine a situation in which a business owner dies and the fair market value (FMV) of their shares is $5 million.
There is a deemed disposition on death of these shares at FMV. The capital gain on the shares is their current value minus their original value (the adjusted cost base). If we assume the adjusted cost base is zero, this results in a capital gain of $5 million to be reported on the deceased’s final tax return. Capital gains are taxed at roughly 25%. The business owner’s estate must come up with $1.25 million in cash for the CRA.
If the estate doesn’t have the cash, the executor of the estate could choose to wind up the company and pay a taxable dividend to the estate of $5 million (the company’s full value). Assuming dividend income is taxed at 40%, which would amount to another $2 million tax bill. That’s an example of double taxation – the value flowing to the beneficiaries of the estate has been taxed twice. In fact, this $5 million asset has paid 65% in tax! The beneficiaries of the estate will receive only $1.75 million of the original $5 million company value.
What will your legacy be?
Without proper planning, double taxation can be a huge problem. The legacy the business owner was hoping to leave may be significantly reduced. But it doesn’t have to be this way. Certain post-mortem arrangements can be completed to avoid double taxation after death.
The two most common post-mortem alternatives are pipeline planning and capital loss planning. The method used will depend on the facts of the situation. Note that the two methods can be used in combination. The key aspects of these methods are outlined below.
This arrangement involves corporate restructuring after a shareholder’s death to avoid double taxation. Pipeline planning may also reduce or eliminate a third layer of tax that can arise if the company sells assets to generate cash. This planning approach preserves the capital gains tax rate, which is lower than the tax rate on taxable dividends. The executor should work closely with the business’s professional advisors to execute this strategy.
As a notional tax account that tracks tax-free amounts received by Canadian resident private corporations, the capital dividend account (CDA) includes proceeds received as a death benefit from a life insurance policy.
Download the white paper The Capital Dividend Account and Life Insurance and learn the specific rules, issues, and interpretations relating to life insurance and the CDA.
Capital loss planning
This approach eliminates the capital gain on death by creating a capital loss in the estate through redeeming shares or winding up the company in the first year after death. The executor can elect to carry back the loss from the estate to offset the capital gain on death. In capital loss planning, you effectively trade the capital gains tax rate for the dividend rate.
Even though the current dividend tax rate is higher than the capital gains rate, that problem is mitigated if the dividend can be a tax-free capital dividend. A capital dividend account (CDA) comes into existence when the company receives certain tax-free income, such as life insurance proceeds. The CDA enables tax-free proceeds to flow to shareholders tax-free. The following are capital loss planning alternatives:
Before April 27, 1995, it was possible to use a life insured corporate redemption strategy to eliminate the tax arising on deemed disposition of private company shares at death. Stop-Loss rules were put into place to reduce the amount of capital loss available to be carried back against capital gain to only 50%. The stop-loss rules do not apply if the shares were subject to a shareholders’ agreement made before April 27, 1995, or if the corporation was a beneficiary of an insurance policy on April 26, 1995. If either of these conditions apply, the deceased’s shares are grandfathered and not affected by the stop-loss rules. Grandfathering provides the best result for the estate.
But in most cases today, grandfathering doesn’t apply because most agreements or insurance are post April 1995. We are, however, left with other alternatives.
With this approach, the full amount of the CDA is paid to the estate and the stop-loss rules apply. This results in no tax to the estate and a 50% reduction in capital gains realized in the year of death. This can be a tax-effective result for the estate but wastes 50% of the available CDA credit.
This approach avoids the stop-loss rules so the capital gain on death is eliminated, but there is a taxable dividend in the estate. Since dividends are taxed at a higher rate than capital gains, the 50% solution results in more tax than the 100% solution, but leaves 50% of the CDA available for future use.
The chart uses the example of private company shares with an inherent capital gain of $5 million, showing the differences between the alternatives, as well as the pipeline planning strategy with the CDA. Note that the cost of insurance has not been factored into these calculations.
The chart assumes $5 million in corporate-owned life insurance, a CDA of $5 million equal to the shares owned at death, and nominal adjusted cost base for the shares. Top tax rate assumptions in the chart are 50% for regular income and 40% for dividend income.
Each scenario in the chart can be valuable in certain circumstances.
- It’s best if grandfathering applies because it provides the most tax-efficient solution, with no tax payable, but this may not be available in most situations.
- The 100% solution provides the next best tax result for the estate but effectively wastes the CDA that could have been used by the surviving shareholders. This approach might be an option if parties are not related, or where in a family situation, the beneficiaries of the estate and future shareholders are not the same people.
- If the beneficiaries of the estate and future shareholders are the same people, the 50% solution is likely more efficient because it results in the CDA being available for future use.
- Pipeline and insurance planning can be combined, resulting in the capital gains tax rate being preserved and all of the CDA being available for use by the shareholders, producing future tax savings with the CDA that are greater than the tax paid on death.
This is an important reminder that estate planning requires collaboration among all your professional advisors – legal, tax, insurance, and financial. This article is for general information purposes only. Please seek advice from your professional advisors to let them help you leave the legacy you want to leave, under your terms, not the government’s. Remember – the value of your business is probably the largest part of your legacy. Let’s do this right.
First published in the June 2020 edition of The Business Advisor.