Many owners of private companies are un-aware of the potential for double taxation that can arise after they die. However, there are some strategies that make it possible for beneficiaries to reduce the amount of the taxes payable in these common situations.
Many clients are taking unnecessary risks by not addressing the potential for this \u201cdouble dip,\u201d according to tax professionals. \u201cIt\u2019s an extremely widespread problem,\u201d says Mike Stubbing, a tax partner with Grant Thornton LLP<\/b> in Victoria, \u201cand has the potential to apply in just about every scenario in which someone dies while owning shares in a private company.\u201d
The most likely double-taxation scenario arises when someone dies while owning shares in a company that, in turn, owns significant assets.
In such a case, the owner\u2019s death would trigger a deemed disposition of the shares at fair market value, says Kathy Munro, leader of the national high net-worth group at PricewaterhouseCoopers LLP<\/b> in Toronto.
As the adjusted cost base of the shares could well be nil if the owner also started the company, the entire value of the shares could be subject to capital gains taxes. Although many beneficiaries are aware of this situation, they may not also realize that the assets held by the owner\u2019s corporation (usually a holding company; small Canadian-controlled operating companies receive some tax breaks on capital gains) will also be subject to capital gains taxes if and when they are sold. In addition, dividends paid out to heirs that represent this value may also be taxable.
For example, assume an Ontario resident owns $10 million worth of shares in a holding company that was established by the resident; the shares have an adjusted cost base of nil. Capital gains would be imposed on 50% of the gains. At the highest marginal rate, the taxes on the $10-million gain would be $2.3 million, or 23%.
The double taxation arises when underlying assets of the same company then have to be sold, generating further capital gains on the same value. For instance, the shares of a private company may not be marketable. Value has to be realized by liquidating its individual assets: investments or real estate, for example. Or corporate assets may have to be sold to pay the taxes generated by the deemed disposition. (For more on holding companies, see B5.)
If the company owner has a spouse, many of these issues can be dealt with by using other methods, such as a tax-free rollover to the spouse. However, the double taxation issue may still arise when the spouse dies.
Stubbing says that the double-taxation scenario is surprisingly common and can cause problems for a wide range of businesses, including small concerns such as a medical practice, a garage or a corner store. When the owners of small businesses of this type die, their businesses may have been inactive for some time, exposing them to relatively high rates of taxes.
One strategy to mitigate this type of double taxation is to use Section 164(6) of the Income Tax Act. That section allows losses generated in the first tax year of an estate to be carried backward to the business owner\u2019s terminal return.
To use the ITA section, a number of steps must be taken within a year of death. Following the deemed disposition of shares triggered by the death, the corporation redeems or repurchases the shares at fair market value. The cost of repurchasing the shares can, effectively, be applied against the proceeds of the deemed disposition, thus eliminating the exposure to capital gains taxes on the deemed disposition.
At this point, options arise in terms of distributing the underlying value in the estate to the beneficiaries: in each case, additional planning by a tax professional is required to increase the paid-up capital of the company and, if necessary, to increase the tax costs of assets that may be sold. This is usually accomplished through a reorganization.
Where there is a surplus in the company\u2019s refundable tax account (a common situation for companies that mainly hold investments), it may make sense to wind up the company. The proceeds of the liquidation would be paid out as a dividend and would receive favourable treatment.
In addition, if capital dividends are available (the untaxed 50% of any capital gain), they can be paid out, tax-free. These transactions must take place in the year following the company owner\u2019s death, due to deadlines imposed by the provisions of Sec. 164(6).
@page_break@But if a winding up is likely to generate a significant taxable dividend on distribution, there are other options. One alternative uses what is known as \u201cbump\u201d planning. In very simple terms, this involves transferring the company\u2019s shares to a new company and winding up the first corporation.
The bump plan can be carried out outside the one-year window, but it is more complex than the liquidation option. Bumping is generally useful only when the only assets are investments. The strategy results in the tax costs of a corporation\u2019s capital assets being increased to their fair market value as of the date of death. Thus, they can be sold without triggering a large capital gain. Taxable dividends are avoided by using another transaction that relies on a promissory note: the note is payable by the merged company to the estate, tax-free.
Options like this that turn on reduced capital gains are becoming more popular, as the effective tax rate on capital gains has fallen over the past decade and is now 23%, a more advantageous rate than the 31% rate imposed on taxable corporate dividends.
It\u2019s also crucial to ensure that estate documents are properly drafted to avoid errors, such as directing that shares be transferred directly to beneficiaries; this could prevent the trustee dealing with the shares in the strategies outlined above.
Stubbing tells his clients who are private shareholders to get their tax advisors and their lawyers on the same page: \u201cThey should have someone with experience in tax planning take a look and be involved in the estate-planing process.\u201d Regardless of which strategy is chosen, it pays to act quickly and with thorough knowledge of the taxpayer\u2019s situation.\tIE<\/b>
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