29 Oct 2020
Death and Income Taxes: Private Company Shares
In this blog, we will focus specifically on post mortem planning for private company shares on death.
On death, a Canadian-resident individual will pay income taxes as if all assets were sold or liquidated that day, except for assets that are bequeathed to a spouse.1
- Accrued gains on capital assets are currently subject to 50% taxation
- The values of an RRSP or RRIF are fully taxed
The same tax treatment applies to life interest trusts (LIT), the more common of which include alter ego trusts (AET) and joint partner or spousal trusts (JPT), when the settlor of an AET or the surviving spouse of a JPT dies.
This tax event is not a concern where a person or LIT owns assets with little to no accrued gains (such as GICs or bank accounts) or assets that are not taxable (such as a home that qualifies fully for the principal residence exemption).
It may not even be a concern where a person owns publicly traded securities with significant accrued gains, since these assets can generally be liquidated quickly to fund the taxes payable.
A significant concern arises with private company shares on death. This is where a person owns assets such as rental properties or private company shares with significant accrued gains, and there are insufficient funds or life insurance coverage to fund the taxes payable.
It is often not practical, feasible or even possible to liquidate these assets quickly. This can create undue financial hardships on the estate or LIT, which adds to the emotional turmoil experienced by family members who are often executor(s) or trustee(s).
Private Company Shares
Below, we’ll discuss tax planning that is available when a person dies owning private company shares, which can cause double or triple taxation if the shares are not sold to an arm’s length party.
Double Taxation - The value on which the deceased’s estate or LIT has paid tax may be subject to a second layer of tax (when funds are withdrawn).
Triple Taxation – Funds may also be subject to a third level of tax (when assets held by the private company are sold).
To illustrate, let’s take a look at Catalina, a widow, and what happens to her private company shares on death.
Let’s say Catalina dies owning all of the shares of DoggoneCo with a fair market value (FMV) of $1 million. She paid a nominal amount for the shares, so we will consider the adjusted cost base (ACB) and paid-up capital (PUC) as $nil. She bequeaths all of her shares of DoggoneCo to her only adult son, Ratcliffe.
At the time of her passing, she will have a capital gain of $1 million (FMV of $1 million less ACB of $nil), half of which is currently taxable. This will increase or “bump” the ACB of the shares to $1 million, so that if and when the shares are sold in the future, no tax is payable on the first $1 million.
Let’s assume that 2 years later, the FMV of the shares has not changed and Ratcliffe decides to liquidate the underlying assets of DoggoneCo and wind it up.
The $1 million cash remaining in DoggoneCo will be paid to him as a taxable dividend (or deemed dividend, if his shares are redeemed) and he will have paid tax on the same value that Catalina already paid tax on when she passed away.
The distribution received by Ratcliffe is essentially taxed as a dividend rather than a capital gain. Specifically, the dividend that will arise is equal to the share redemption proceeds in excess of the PUC of the shares (which as noted above, is nominal) as opposed to the ACB (which has been “bumped” up).
The worst-case scenario for Catalina’s private company shares on death, using top 2020 tax rates, will generate an aggregate tax bill of 75.64% on the $1 million value at the time of death:
Ratcliffe or Catalina's estate
Capital gain = FMV $1m - ACB $nil
Deemed dividend = FMV $1m - PUC $nil
There are two main post-mortem strategies available to mitigate these additional levels of taxation of private company shares on death:
1. Windup and Loss Carryback
This simpler method removes one layer of tax at capital gains rates but must be completed within the first year of death if the assets are held by a Graduated Rate Estate (GRE)3 or within 3 taxation years if assets are held in an AET or JPT.
This plan involves liquidating DoggoneCo and winding it up within the first year of Catalina’s death, while the shares are still held by her GRE.
The distribution to Catalina’s GRE would generate a deemed dividend of $1 million and also a capital loss of $1 million (FMV $1m less deemed dividend $1m less ACB $1 million). The capital loss is only beneficial in reducing taxes payable on capital gains that are realized in the current, three previous, or any future, taxation year(s).
Often, a GRE does not have sufficient capital gains to utilize significant capital losses. A specific tax provision4, however, allows the GRE’s capital loss to be applied against the capital gain realized by Catalina on her death.
This removes one layer of tax on Catalina’s private company shares on death and continuing from the same facts above, the aggregate tax bill goes down from 75.64% to 48.89%:
Capital gain = FMV $1m - ACB $nil - capital loss
Deemed dividend = FMV $1m - PUC $nil
2. Pipeline Restructuring Plan
A more complex plan that is not as limited by the windup and loss carryback plan (to time or to GREs) is commonly known as a “pipeline” restructuring plan. The purpose of the pipeline is to remove at least one layer of tax at dividend rates, and potentially remove another layer of tax paid by the company.
The pipeline involves restructuring that usually includes the incorporation of a new company.
In DoggoneCo’s case, it will be required to maintain the same business activities for a period of time (usually 1 year). There are limits to when and how much can be paid out of DoggoneCo to the estate, or to Ratcliffe when he becomes the shareholder (there is usually a waiting period of at least 1 year, followed by a precise scheduled repayment over a period of 1 or more years).
A pipeline brings the overall tax cost on Catalina’s private company shares on death down from 75.64% to 26.75%, producing an overall savings of 48.89% (or 22.14% relative to the windup and loss carryback plan):
Catalina's estate, or Ratcliffe
Capital gain = FMV $1m - ACB $nil
Deemed dividend - FMV $1m - PUC $1m
“Bump planning” allows the ACB of DoggoneCo’s non-depreciable capital assets, if any, to be increased up to the value on which tax was paid on death. Specific planning must be considered prior to death to avail an AET or JPT of this plan. Where the bump is available to an estate or AET/JPT, the tax savings (not illustrated above) are even more significant.
For Catalina’s private company shares on death, this plan must be structured carefully to ensure that the intended tax savings are available. Obtaining a favourable Advanced Tax Ruling (Ruling) from the Canada Revenue Agency (CRA) will provide certainty, so long as the transactions are implemented exactly as proposed to the CRA.
Absent a Ruling specific to a taxpayer’s facts, a pipeline should be planned as closely as possible to the most recent Rulings that are publicly available (usually with significant portions of information redacted for privacy purposes), otherwise, a tax provision5 may apply to negate the tax savings of this plan and revert back to a double or triple taxation situation.
The tax benefits of this plan are significant, as noted above. They must however be weighed against the costs of the plan, such as:
- Additional administrative and compliance complexities
- Significant professional fees, and
- Delays in accessing funds
For the unsophisticated executor or trustee, this plan is usually difficult to understand, navigate, and comply with.
These post-mortem strategies for private company shares on death will assist in funding the taxes payable on death. The timing in which funds can be withdrawn in a pipeline plan must be considered with respect to:
- When the taxes are payable, or
- Where funds are borrowed from the company, when it must be repaid in order to prevent an income inclusion under shareholder loan provisions6
Other Considerations for Private Company Shares on Death
Several other matters that were not considered above, but bear a brief mention, include:
Probate Fees - In addition to income taxes, probate fees also apply to the value (rather than the accrued gains) of an estate’s assets where grant of probate is required. AETs and JPTs are not subject to probate, since assets are held by the trust rather than an estate.
Charitable Donations - There are different rules relating to charitable donations which have not been considered here. Where effective planning has been considered, donations may be useful in reducing the amount of income taxes payable on death.
We Are Here to Help
It would be prudent, particularly for high net-worth individuals, to consider post-mortem planning for private company shares on death during their lifetime. This will allow them to plan for funding the taxes that will become payable on death and easing the transition of wealth to the next generation.
Please contact Wendy Seet of the Manning Elliott Tax Team with any questions you may have about private company shares on death by submitting a contact form inquiry.
1 All references to a spouse herein will include a common-law partner.
2 Assumes that the dividends are taxed as non-eligible dividends.
3 Generally means an estate where a person died not more than 36 months ago and other specific criteria is met (such as not having a contributor other than the deceased, not having received a loan from a beneficiary or non-arm’s length person unless certain exceptions are met, and certain information is included or designation criteria is met in the trust income tax return).
4 Subsection 164(6) of the Income Tax Act (ITA).
5 Subsection 84(2) of the ITA.
6 Subsection 15(2) of the ITA.
The above content is believed to be accurate as of the date of posting. Canadian tax laws are complex and are subject to frequent changes. Professional tax advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained herein.