Double taxation on death poses a critical challenge for business owners with private corporations, particularly given liquidity to pay the tax balance can be an issue for the Estate. Careful planning is required to minimize the tax burden and well thought out planning can make a big difference. While there are various options available, we will examine a few select planning options and see how they might fit into the overall planning.
Understanding Double Taxation on Death
When someone passes away, all assess are deemed to be disposed of at fair market value on their terminal tax return with CRA. This is despite the fact that no actual sale occurs and is no different for a shareholder in a private company. When the shareholder passes away, their shares in the corporation are deemed to be sold at fair market value, triggering immediate tax consequences. Further, when the corporation’s assets are eventually distributed, a second layer of personal taxation can apply. This compounding tax effect can significantly diminish the wealth intended for heirs, often reaching effective tax rates as high as 75%. Proper estate planning is essential to navigate these challenges and preserving wealth for the next generation.
Consider the following scenario: A corporation owned by the deceased holds investments/ value worth $1,000,000. Assume the shareholder has no cost basis in these shares. On death, the shares are deemed to have been sold, resulting in a $1,000,000 capital gain. In Ontario at the highest rate, this gain incurs approximately $268,000 in taxes, assuming a capital gains tax rate of 26.8%. When the retained earnings of the company are eventually distributed as dividends, another $477,000 in dividend tax (at an effective rate of 47.7%) is applied. This double taxation reduces the wealth transferred to beneficiaries to just $255,000, or 25.5% of the original $1,000,000.
These figures illustrate the stark consequences of double taxation and highlight the importance of implementing proactive tax strategies to mitigate this burden.
Avoiding Double Taxation – Strategies
Pipeline Planning Strategy
A pipeline planning strategy offers a practical solution to the problem of double taxation by restructuring the flow of assets to convert surplus income taxed as dividends into capital gains, which are taxed at a lower rate. This approach involves several key steps and is fairly complicated to implement. Often a tax ruling from CRA is requested as part of this planning to ensure CRA is satisfied with the planning. There are also some strict rules around when the money can be extracted from the company to stay onside with this planning.
The pipeline strategy reduces the overall tax burden on corporate surplus to the capital gains tax rate of 26.8%, which is significantly lower than the combined tax rate of 75% seen without planning. Additionally, it can provide opportunities for further flexibility for the estate. Just be sure to talk to a tax specialist to ensure everything goes as planned.
164(6) Loss Carry Back Strategy
The loss carry-back strategy under section 164(6) of the Income Tax Act provides another avenue for addressing double taxation. This approach allows the estate to redeem the deceased’s shares, which generates a capital loss in the estate. This loss can then be carried back to offset the capital gain reported on the deceased’s final tax return. The redemption of shares would be treated as a deemed dividend and taxed at the 47.7% tax rate we saw earlier. Note this rate could be reduced to 39.34%, depending on certain tax balances the company may have.
For example, if the estate redeems $1,000,000 worth of shares, resulting in a $1,000,000 capital loss, this loss can negate the $1,000,000 capital gain from the deemed disposition on death. As a result, the double taxation problem is effectively eliminated, leaving only one layer of tax to address. This strategy is particularly valuable for estates seeking immediate tax relief and has the added advantage of allowing flexibility in its application, as it can be executed within the estate’s first taxation year (this has recently been expanded beyond the first year). However, precise execution and adherence to timing requirements are critical for its success.
While this option results in a higher tax rate than the first option, it is much easier to implement and there are less guidelines to implement so it can make sense when the share value is lower.
Utilizing Life Insurance Proceeds
Corporate-owned life insurance is a versatile tool for addressing liquidity challenges and mitigating double taxation. A properly structured life insurance policy can provide the funds needed to cover tax liabilities triggered by death, reducing the financial strain on the estate. Additionally, life insurance proceeds can increase the corporation’s Capital Dividend Account (CDA), enabling tax-free distributions to heirs.
To maximize these tax benefits, careful attention must be paid to policy ownership and beneficiary designations.
Leveraging the Capital Dividend Account (CDA)
CDA is an essential component of corporate tax planning for estates (and everyone else for that matter). CDA builds over time in the company from sources such as the non-taxable portion of capital gains realized, CDA paid to it by other companies and a portion of life insurance proceeds received on the passing of an insured. This balance can then be used to pay tax-free dividends to shareholders or their estates, providing a mechanism for transferring corporate wealth with a much better tax outcome.
Timing is critical when using the CDA. Elections to pay capital dividends must be carefully scheduled to ensure the balance is maximized and the proper paperwork is filed with CRA. By strategically leveraging the CDA, estates can reduce the overall tax burden and increase the amount available for beneficiaries.
Comparison of Strategies
Each of these strategies—pipeline planning, the 164(6) loss carry-back, the use of life insurance and CDA planning —has unique advantages and is suited to different circumstances. The pipeline strategy is particularly effective for estates with substantial corporate surplus and a long-term planning horizon. The 164(6) loss carry-back is ideal for estates requiring immediate tax relief, while corporate-owned life insurance provides a valuable safety net for liquidity and tax efficiency and can be used in a number of scenarios. Careful consideration of the deceased’s business structure, financial goals, asset distribution planning and family needs is crucial in selecting the most appropriate approach.
Conclusion
The key to minimizing double taxation lies in proactive, pre-death planning. Business owners should work closely with a team of professional advisors—including tax experts, lawyers, insurance agents and financial planners—to design and implement a tailored strategy. Regular reviews of the estate plan are essential to account for changes in tax laws, financial circumstances, and personal objectives.
