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In Canada, when we pass away, we are deemed to dispose of all of our assets right before our death at their fair market value (FMV). While there are a few exceptions to this rule, such as assets left to our spouse and farming / fishing assets left to children and grandchildren, the general rule is we pay tax on death. If the assets are worth more today than what was paid for them, a capital gain will result. This will result in taxes owing on the final return, which is the tax return required to be filed from January 1 of the year of death up until the date of death.
Many Canadians pass away holding shares of private companies. If the company is a qualified small business corporation, it will be possible to use your capital gain deduction on the resulting capital gain. Each person has a lifetime capital gain deduction which can be used to shelter specific types of capital gains from tax. This blog does not deal with the details surrounding the capital gain deduction, but instead focuses on planning when the deceased owned shares of a company that cannot be sheltered by the capital gain deduction.
Imagine the following scenario: Mrs. A, a widow living in Alberta, has passed away holding shares of a private company. Like many Canadians, Mr. and Mrs. A were entrepreneurs that built a successful business which has previously been sold. During their lives, their investments were made through a separate private company, called Nest Egg Ltd. When Mr. A passed away, the shares of Nest Egg Ltd. were transferred to Mrs. A without any tax. On Mrs. A’s death, this company has a FMV of $3 Million, consisting of cash, GICs and marketable securities. Mrs. A has two adult children and her estate is left to them equally.
On Mrs. A’s final return, a capital gain of $3 Million will be reported resulting in total tax of $585,000 in Alberta.
Absent any planning, the executor of the Estate then causes the shares to be transferred to the beneficiaries. When the Estate disposes of these shares of Nest Egg Ltd., there will not be any tax consequences as the shares have a cost and FMV equal to $3 Million. The company is then wound up. It will be deemed to pay a dividend of $3 Million to the beneficiaries, and taxes of $831,300 will be payable by the beneficiaries. This is in addition to the taxes already paid on the terminal return. Essentially, the same value of $3 Million is being taxed twice – once as a capital gain on Mrs. A’s death, and second as a dividend on the wind-up of the company. The end result is that total taxes of $1,416,300 will be paid by Mrs. A and her children, leaving them only $1,583,700 after tax. This is the worst case scenario and has a total tax rate of 47% on the gain.
If the shares of Nest Egg Ltd. are not transferred to the beneficiaries, but instead the company is wound up by the Estate within one year from the date of death, the taxes can effectively be reduced by $585,000 over the worst case scenario. The net result is total taxes of $831,300 are paid, leaving $2,168,700 after tax to distribute to the beneficiaries. The effective tax rate is 27.7% on the gain.
Another possibility is to have the shares of Nest Egg Ltd. sold to a newly incorporated company for a promissory note. Since the shares have a cost equal to their FMV of $3 Million, no tax will arise on this sale. As funds are paid to the two adult children over time, they are paid as repayment of the promissory note, and are not taxable. The CRA has previously issued advance tax rulings that this was an acceptable transaction as long as the structure remains intact for one year and the operations continue in Nest Egg Ltd. as they did before the transaction. This type of planning can save $831,300 in taxes, and results in a net amount to distribute to the beneficiaries of $2,415,000. The result is a tax rate of 19.5% on the gain, which is the expected rate on a capital gain in Alberta.
If you are planning your Will or are the executor of an Estate, be sure to know what kinds of planning options are available to you. If you have questions, please consult your local MNP advisor or contact me and we would be happy to assist.
Related Topics:Estate Planning; Capital Gains
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