Owners of private companies are often unaware of the potential for double taxation on death. The following case study will demonstrate how critical careful estate planning is for avoiding this punitive outcome.

Trevor, a widower, has two adult children, Emily and Brett. Many years ago, at the time of retirement, Trevor’s operating company sold its business assets for $2 million and used the proceeds to invest in marketable securities (stocks, bonds and mutual funds) within his corporation. Throughout retirement, Trevor supplemented his income with dividends from the company.

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His will names Emily and Brett as beneficiaries. It provides for them to receive shares of his company via his estate. But Trevor didn’t put much thought into what his death would mean from a tax perspective.

Trevor passed away several months ago. At the time of death, the adjusted cost base (ACB) and paid-up capital (PUC) of his company shares were nil. The fair market value (FMV) of the shares was $5 million. Also, the company’s investments had an ACB of $2 million (the price originally paid for the investments on sale of the company’s business assets) and a FMV of $5 million.

According to section 70(5) of the federal Income Tax Act (ITA), when an person dies he/she is deemed to have sold his/her capital property just before death. Because Trevor’s company shares were considered capital property, he was deemed to have sold them just before death, resulting in a capital gain of $5 million (FMV minus ACB) reportable on his terminal tax return for the year.

Since Trevor’s marginal tax rate was 45% at the time of death, capital gains tax of approximately $1.1 million resulted (as shown below). Note that the corporation’s investment assets were not impacted by the deemed disposition that occurred on Trevor’s death.

Personal tax – Trevor’s terminal return
FMV of shares $5,000,000
Less: ACB of shares $0
Capital gain $5,000,000
Taxable capital gain (50% of gain) $2,500,000
Personal tax payable (@45%) $1,125,000

Trevor’s estate then received the company shares with an ACB of $5 million, the amount Trevor was deemed to have sold the shares for. Thereafter, as per his will, Trevor’s executor transferred the shares to Emily and Brett (with an ACB of $5 million), who then sold the corporate investments and paid dividends to themselves.

With a 45% corporate tax rate and a 34% personal tax rate on dividends, tax payable by the corporation and Emily and Brett was approximately $1.4 million ($275,000 + $1,096,500), calculated as follows:

Corporate tax – Sale of investments
FMV of investments $5,000,000
Less: ACB of investments $2,000,000
Capital gain $3,000,000
Taxable capital gain (50% of gain) $1,500,000
Corporate tax (@45%) $675,000
Less: Refundable tax when dividends paid1 $400,000
Tax payable $275,000

1 Corporation receives a partial refund of tax paid when dividends are paid to shareholders.

Personal tax – Emily and Brett
FMV of investments $5,000,000
Less: Corporate tax $275,000
Dividend available to Emily and Brett $4,725,000
Less: Capital dividend2 $1,500,000
Taxable dividend $3,225,000
Dividend tax (@34%) $1,096,500

2 A capital divided is a tax-free amount paid to shareholders from a corporation’s capital dividend account; it is often the result of capital gains realized within the company.

The deemed disposition that occurred on Trevor’s death required tax to be paid on the increase in value of the company. Then, once the shares were transferred to Emily and Brett, the sale of the investments within the company resulted in tax again, resulting in double tax of the same economic gain. In the absence of a proper estate plan, total tax payable was $2.5 million or half (50%) of the value of the children’s inheritance.

Summary – No Post-Mortem Planning
Personal tax – Trevor’s terminal return $1,125,000
Corporate tax – Sale of investments $275,000
Personal tax – Emily and Brett $1,096,500
Total tax payable $2,496,500
Tax as a percentage of FMV 50%

Given that capital gains tax rates across Canada are approximately 24%, this double tax problem is difficult to accept. Fortunately, proper planning can minimize tax payable.

An Alternative

Instead of leaving his company shares to Emily and Brett, let’s assume that, with guidance from his financial, legal and tax advisors, Trevor instructs his executor to wind up his company in his estate before distributing the proceeds to Emily and Brett. Provided the wind up occurs within a year of Trevor’s death, section 164(6) of the ITA allows a capital loss triggered in Trevor’s estate to be carried back to his terminal return, where it can be applied against the capital gain realized on Trevor’s death.

Read: How to destroy an inheritance

This is often referred to as the “Loss Carryback Strategy.”  Trevor needs to include a provision in his will allowing his executor to claim beneficial tax elections on his behalf (a standard provision included in many lawyer-drafted wills). Assuming ACB, PUC and FMV amounts are the same as above, tax implications on Trevor’s death would be as follows:

Personal tax – Trevor’s terminal return
FMV of shares $5,000,000
Less: ACB of shares $0
Capital gain $5,000,000
Less: Capital loss carryback (see details below) $5,000,000
Taxable capital gain $0
Personal tax payable (@45%) $0

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