What Happens on Death?
For illustrative purposes, we will assume that a taxpayer dies (with no surviving spouse) owning shares of a private company with a $1M capital gain. On death, there is a capital gain of $1M on the deemed disposition of the shares owned by the deceased, half of which is taxable. This would result in approximately $260,000 of taxes owing. The deceased’s Estate would then acquire the shares at Fair Market Value (FMV) with Adjusted Cost Base (ACB) equal to FMV. In other words, there is an ACB bump on the shares owned by the deceased’s Estate since there has been tax paid on the $1M gain. However, since there is no ACB bump on the corporately owned assets (for example, real estate), there is then a second capital gain realized on a sale of the real estate owned by the corporation.
If we assume that the real estate had a $1M capital gain (ignoring any recapture for simplicity), this would result in another $250,000 of taxes owing. Effectively, the same $1M capital gain has been taxed twice. Once at the individual level (on the shares owed by the deceased) and once at the corporate level (on the real estate owned by the corporation). This is known as “double tax”. To make matters even worse, there is potentially a third layer of tax when the corporate proceeds received from the sale of the real estate are paid out to deceased’s Estate in the form of a dividend, some of which would be a taxable dividend and some of which would be a tax-free capital dividend.
This basic example described above illustrates the effects that our tiered (corporate and personal) tax system can have on an unsuspecting corporate owner.
What Planning is Available?
Although post-mortem planning is unique to each deceased, there are a few common planning techniques that are often used. The specific mechanics of each plan will of course be driven by the individual facts of each case.
1. Sell corporate shares not the underlying assets.
Since the Estate receives the shares with high Adjusted Cost Base (ACB), there is no double taxation where shares of the private company owned by the Estate are sold (instead of the underlying assets). Generally, selling the shares is not practical where the company owned by the Estate owns passive investments or was used as a personal consulting company. Practically, this type of planning is only available where the company owned by the Estate is a sellable operating company.
2. 164(6) loss carry-back election.
Where the appropriate election (known as the 164(6) election) is filed, net capital losses realized within first taxation year of the Estate are deemed to be capital losses of the deceased.
The capital losses deemed to have been realized by the deceased are used to offset the capital gain realized on death. The net effect of the 164(6) election is that tax is paid by the Estate on a dividend and not a capital gain. Given current tax rates (dividends are taxed a higher rate than capital gains), this type of planning is an effective strategy where a corporation has a Capital Dividend Account (CDA) or Refundable Dividend Tax on Hand (RDTOH), which are used to reduce the overall tax rate on the dividend received by the Estate.
Corporately owned life insurance is often use to create CDA in anticipation of this type planning, however, certain loss restrictions can apply.
There are several conditions that must be met in order to file a 164(6) election, which include:
- The Estate must be a Graduated Rate Estate (GRE);
- Disposition of property to create the capital loss must occur within first taxation year of the Estate;
- The election must be in prescribed manner and within prescribed time; and
- The Estate must have an overall capital loss.
3. Use of high ACB created on death (pipeline planning).
On death, the deemed disposition by the deceased results in high Adjusted Cost Base (ACB) in the assets transferred to the Estate. Essentially, the high ACB represents the tax paid value on death. The pipeline technique is used to repatriate the high ACB (note that the capital gains exemption cannot be claimed on death) to the Estate without incurring additional dividend tax. Generally, this type of planning requires the Estate to transfer its shares (the high ACB shares received on death), typically using to subsection 85(1) of the Act, to a newly incorporated holding company (Holdco). On the transfer, the Estate will usually receive a promissory note, equal to the ACB of the shares transferred. The promissory note is then repaid to the Estate over time.
In other words, corporate funds are used to repay the promissory note (tax-free) to the Estate over time, thereby avoiding a taxable dividend that otherwise would have been paid. The CRA will generally not challenge this type of planning, provided that the following conditions are met:
1.The transferee corporation and Holdco must remain separate and distinct for one year from the date the shares were transferred to Holdco.
2.The transferee corporation must continue to carry on business in the same manner as before for at least one year.
3.Following the one-year period in 2 above, the promissory note can be gradually repaid over time (2 to 5 years).
4.Use of high ACB created on death (88(1)(d) bump planning).
Unlike the 164(6) loss carryback, this type of planning is not required to be done within the first year of death. The bump planning is designed to avoid double taxation on non-depreciable capital property by increasing the adjusted cost base (ACB) of corporate property up to Fair Market Value (FMV) at date of death. An 88(1)(d) bump is an alternative to subsection 164(6) planning.
This type of planning can be used for non-depreciable capital property such as:
- Land (not building)
- Shares (private or public)
- Partnership interest
Where a bump is used, the Estate may be able to reduce or eliminate tax in the corporation on liquidation of its assets. The net effect is a capital gain paid by deceased and no tax in the corporation on liquidation of its capital assets. If used in combination with pipeline planning, the proceeds received on liquidation of corporate assets can be paid out tax-free to the Estate via the promissory note.