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By Nizam Shajani, CPA, CA, MBA
October 23, 2020
“Life is really simple, but we insist on making it complicated.” Confucius.
The estate of business owners often encounters the implacable reality of double taxation. This may occur when the shareholders of an owner managed business pass on without a tax effective estate plan. On death, there is a deemed disposition of all the assets of the deceased and this includes the share holdings within a corporation (which would continue to exist). As such, the value of the business is determined and tax on the sale of those shares would be due, even if the business is not sold. Thereafter the corporation may wish to extract funds to provide to the estate and to pay for the taxes due, often done via dividends. This results in a second tax to the estate (or the beneficiaries) as the dividends are also taxable.
To illustrate this, consider the sole shareholder of a corporation in Alberta passes away while holding those shares valued at $1,000,000. The capital gains tax on the shares would amount to approximately $240,000. If the business were to subsequently liquidate its assets or pay out a dividend in the amount of the $1,000,000 to the estate, an additional dividend tax would range from $317,100 to $412,400 (depending on the dividend being eligible or other than eligible). This double taxation would result in an overall tax burden of up to 65.24% or $652,400 on the business valued at $1,000,000, leaving just $347,600 for the estate.
A properly instated and tax effective estate plan completed in conjunction with a will would eliminate the double taxation. A tax specialist would be familiar with plans that include pipelines, 164(6) planning, bumps or a hybrid of these. Additional considerations include the use of trusts such as alter ego or joint spousal trusts.
An example of how one of these plans would work can be seen in the pipeline plan. This is effective where the assets held by the corporation have a high cost base or make up the fair market value of the corporation. The result would be that only the lower capital gains tax would be due by the estate and the dividend could be reclaimed tax free and over a period.
Using the example above, the deemed disposition on death resulted in the cost base of the shares to the estate to be $1,000,000 (as the $240,000 capital gains tax was based on this amount). If the assets of the company also equal $1,000,000 – those shares could be transferred to a new corporation (owned by the estate or its beneficiaries) for a promissory note payable to the estate of $1,000,000. The operating company would then pay tax free dividends to the new company and the new company would repay the loan to the estate. The result would be only the $240,000 or 24% capital gains tax was paid.
The pipeline plan would have farther benefits where the lifetime capital gains exemption (LCGE) of the deceased had not yet been used. The LCGE allows for about $835,000 in capital gains to be distributed to the shareholder tax free. If this was available to the deceased, the result would be only $39,600 in tax due by the estate or less than 4% in tax.
Although simplified in the above example – estate planning is an important tool for business owners and those with considerable estates and should be implemented with the consultation of a tax professional as the tax rules on estate planning do get complicated. A well purposed estate plan prepared by a tax specialist should go hand in hand with a will.
This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action. © 2020 Shajani LLP