Over the last four weeks, I have explained simple tax strategies for business owners and incorporated professionals to learn about and consider.
In each case, I have reminded you that the Canada Revenue Agency is a silent partner in your life’s journey from employment to retirement and beyond—however you define retirement (you know me—I’m in the Never Retire camp!).
In Part 1, I explained the tax problems associated with the strategy of accumulating surplus cash in a corporate account and offered easily implemented strategies that may reduce the corporation’s passive income, hence preserving the small business deduction limit.
In Part 2, I offered effective ways to split income from the higher income spouse to the lower income spouse, sharing strategies that were easy to comprehend and apply (if/when appropriate).
In Part 3, I clarified Individual Pension Plans and explained how an IPP could be expanded by adding three individual plans within one account. Both options allow business owners to accumulate a bigger pension plan (compared to the typical RRSP), minimize passive income earned in the corporation, and provide an opportunity to implement the generational transfer of pension assets at death (if children are employed by the corporation).
This week I’m going to talk about how you can avoid double taxation upon the death of a loved one.
If you’re still confused about where to start, I would suggest booking a tax planning appointment with your advisors to discuss the ideas and strategies. If needed, bring my four blogs with you and start with my simple strategies.
Or give me a call, and I’ll come to the meeting with you and help translate all of the information into understandable options and action items.
After the meeting, take some additional time to reflect on how the recommended strategies may reduce and defer your corporate and personal taxes.
As with all my blogs, please don’t assume the strategies presented automatically apply to your individual situation. Seek out competent advisors and, together, discuss whether any of them fit your unique situation.
So this, my fourth and final blog in the series “Your silent partner—the CRA,” discusses strategies to minimize the tax effects on death.
Before diving into the topic, let me say that minimizing taxes due on death has been a very divisive subject in my practice. About half of business owner clients feel that they have no responsibility to forgo present cashflow in order to minimize taxes on death and increase cashflow for the estate. This group believes that the estate will inherit whatever is left and not a penny more. They feel that they have already given their children enough in providing a loving home, food, tuition, and so on, and they don’t need to do any more.
The other camp feels that they have worked their whole life to build a successful business and can’t sleep at night knowing that their death may cause double taxation of business assets. This group believes that they have a responsibility to take the necessary steps to structure a tax efficient exit plan.
Regardless of where you pitch your tent, this blog will present some strategies I think you will find interesting.
First, let’s set up the problem…
Mr. Electric owns a successful corporation that manufactures parts for Tesla cars. He is the sole shareholder and is married with teenaged children.
On a business trip to sign a big contract with Elon Musk, Mr. Electric suffers a massive heart attack and ultimately dies. After the funeral, Mrs. Electric begins the painful work of settling her husband’s estate. (For simplicity, I will keep this example focused solely on one issue arising from Mr. Electric’s death.)
In Canada, when taxpayers die, they are deemed to have sold all their assets on the date of death at fair market value. This rule applies to Mr. Electric.
Since he started the company from scratch, his shares have an adjusted cost base of zero and have a current value of $10. This creates a deemed taxable capital gain of $5 per share and taxes of $2.50 per share (assuming a 50% tax rate).
Mrs. Electric inherits the shares at the same fair market value. This is the first level of taxation.
Assuming Mrs. Electric who is the beneficiary of the estate and becomes shareholder of the corporation decides to withdraw $1M from the corporation to buy a cottage in Muskoka, and the corporation issues her a taxable dividend for this amount.
Since she receives a dividend, it is taxable in her hands and she is required to report the dividend and pay the appropriate taxes. This is the second level of taxation.
Consequently, the value of the assets of the private corporation may be taxed twice, the first time as a capital gain on the deemed disposition at death, and the second time as a dividend on the distribution of the assets (or substituted property) of the private company to its shareholder (i.e., the deceased’s estate).
Now let’s assume that the corporation doesn’t have the cash to make the dividend payment, so it sells and leases back the building that holds it operations. The building was bought for $500,000 and is now sold for $1M.
The sale creates a capital gain of $500,000 for the corporation and a $250,000 capital gain tax, adding a third level of taxation.
Potentially, three layers of taxation arise from the death of Mr. Electric. That’s why you should consider the CRA as a silent partner in the Electric family’s life—both before and after death.
Now, let’s look at some solutions to this problem.
1) An estate freeze
This is a somewhat complicated corporate reorganization that usually leads to freezing the value of the corporate assets on a designated date and transferring any future growth to the next generation.
If the freeze works properly, the tax on the future growth of the company is reflected in an increase in the value of the shares owned by the children and in the tax paid by the children on their passing.
This establishes a multi-year tax deferral.
In addition, the freeze allows the shareholder (Mr. Electric ) to calculate the amount of tax that is due on his passing, and he can take appropriate actions to fund the liability (assuming the shareholder is enjoying life in the second camp as outlined above).
2) Tax exempt life insurance
During an estate freeze, the amount of tax due on the shareholder’s death is calculated, providing the shareholder an opportunity to create a cost-effective method to fund the tax liability.
One effective method is for the corporation to purchase life insurance equal to the amount of the tax liability due on the shareholder’s death—and designating the shareholder as the life insured. The corporation would be designated as the beneficiary and policy owner
On the death of the shareholder, the death benefit less the adjusted cost base of the policy is added to the Capital Dividend Account and can be distributed to the new shareholders (the beneficiaries of the shares) free of tax.
The death benefit can make the estate whole, which means it replaces the portion of the estate that was lost by taxes arising from the deemed disposition.
3) Post- Mortem Tax Planning
Usually the solution to double or triple taxation is:
a) A loss carryback.
This approach carries losses realized in the first taxation year of the deceased’s estate back to the year of death and applied any capital gains caused by the deemed disposition.
b) Pipeline transaction.
If you’re not clear what a pipeline transaction is, let me share an excellent explanation with you.
“The pipeline structure is intended to permit the estate of the deceased taxpayer to extract the assets (or substituted property) from the private corporation without triggering any additional tax.
A typical pipeline transaction, for example, is implemented after the taxpayer’s death (i.e., after the deemed disposition at fair market value) and involves the estate incorporating a new corporation (“Pipelineco”) that will acquire the shares of the private corporation held by the estate. As consideration for the shares, Pipelineco will issue a noninterest bearing promissory note in an amount equal to the fair market value of the shares of the private corporation.
The private corporation is subsequently wound-up into Pipelineco and all of its assets are transferred to Pipelineco. Pipelineco uses the assets received on the wind up of the private corporation to repay the promissory note to the estate.”
The benefits here are evident. But if you want to hear more or have any questions about how this could work in your particular situation, give me a call and I’ll take you through the details.
c) A combined approach.
Of course, one could also use both approaches in combination.
Here are my final thoughts on this entire topic.
Be deliberate with your tax planning and include the voices of a competent group of advisors: accountants, lawyers, bankers, and wealth advisors.
Be comprehensive in your tax planning and ensure that the tax plans complement your financial and wealth plans.
Be transparent in your tax planning by discussing and obtaining feedback from everyone connected to the business (such as your spouse, children, employees, and so on).
This wraps up my four-part series on your close and personal relationship with the CRA. I hope I have provided much food for thought.
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