Tax for Estate Planners: The Triple Tax Problem

Your client might soon face a triple tax problem. This issue can arise when a client dies holding shares of a private corporation. Without planning, the effective tax rate can exceed 70%.

This note outlines in broad strokes three strategies to mitigate this problem: loss carrybacks, pipelines, and bumps.

The problem, part 1: double tax

When a client passes away, there is a deemed disposition of all their assets, including shares in private corporations.

For example, assume a client originally subscribed for shares at $10, and at the time of death, here shares were worth $2 million. This results in a $1,999,990 capital gain and corresponding tax liability.

The estate will receive the shares with cost at their fair market value ($2 million). If the estate sells the shares to an external investor for $2 million, no additional tax arises.

The problem arises if the company will either be retained by beneficiaries or wound up. Sooner or later, beneficiaries will want cash from the corporation. Without further planning, despite the capital gains tax already paid by the estate, distributions from the corporation will be taxed as dividends, leading to double taxation.

Fortunately, there are two ways around this.

Solution 1: loss carrybacks

This is a solution if the corporation will be wound up.

Upon winding up, the assets will be distributed to the estate in the form of a dividend. Simultaneously, the shares will be deemed to have been sold, in this case, for $10, creating a capital loss.

This loss can be “carried back” (hence the name) to the tax year in which the client died, eliminating the capital gain and leaving just one tax (a dividend).

Assuming the estate is a graduated rate estate (see my earlier post) and the wind-up is within the first year of the estate, then this plan should work.

However, this plan is not viable if the company can’t be wound up or otherwise sell the its assets. Additionally, the tax rate on dividends is typically higher than on capital gains, meaning this approach may increase the overall tax liability as compared to the alternative: a pipeline.

Solution 2: pipelines

A pipeline strategy is useful when beneficiaries intend to continue operating the business or hold corporate assets, such as real estate.

A pipeline allows the $2 million that would otherwise be taxed as a dividend to be extracted tax-free.

There are different ways to accomplish this. Typically the estate will incorporate a holding company, and then sell the shares of the operating company to the holding company in exchange for a promissory note. If properly planned, that promissory note may be paid down over a period of time, tax free.

There are requirements for the company. For example, it needs to continue to operate over a period of time. Also, it can’t be a cash company, and the CRA has commentary on the nature of the underlying business that must be followed.

The problem, part 2: triple tax

A third layer of tax may arise if the corporation holds appreciated assets, such as real estate.

To illustrate, say the corporation bought a piece of real estate for $500,000 and it’s now worth $2 million. In order to obtain the cash necessary to fund the payment under a loss carryback or pipeline (without going into debt), the corporation will have to sell the asset, resulting in a $1.5 million capital gain.

This is a third layer of tax—hence, the triple tax problem.

Solution 3: bump

A bump allows the estate to increase the tax cost of the corporation’s assets, reducing or eliminating the additional tax burden.

Typically, to implement, you create a new holding company, transfer the shares of the real estate company to the new corporation, and then wind up (or amalgamate) the real estate company into the holding company.

This process, in essence, pushes the increased cost base from the shares (i.e., $2 million) down to the real estate, reducing future capital gains tax.

Questions

To determine the best course of action for your client, consider the following:

Is there a corporation in the estate?

If so, do the executor or beneficiaries want to continue operating the business, or do they intend to liquidate it?

• If the former, explain the double tax problem. Suggest to the client that they could consider a pipeline.

• If the latter, explain the problem and suggest that they could consider a loss carryback (assuming that the estate is less than a year old).

Does the corporation own appreciated assets?

• If so, explain the potential for triple tax and the solution (the bump).

If you have any further questions about corporate tax (or tax questions related to estate planning), you can feel free to reach out to us. The author can be contacted directly at jonathan@rkwlaw.ca or 604.425.1123.