Most people are familiar with basic estate planning steps such as drafting a will or enduring power of attorney. However, in certain circumstances, it is wise to involve a competent tax lawyer in the estate planning process, particularly when a person owns one or multiple businesses. In situations where an individual:
- owns shares of a private corporation;
- is a business owner looking to transition the business to the next generation;
- is a business owner planning a future sale of the business;
- is a high net worth individual; or
- has a business with a complicated ownership structure (e.g. partnerships, trusts, foreign holdings etc.),
we recommend that the individual obtain tax advice as part of their larger estate plan.
Taxation on death in Canada
In contrast to some other jurisdictions, including the United States, there is no estate or inheritance tax in Canada. Rather, when a person dies in Canada, that person is considered to have disposed of all of their capital property immediately before death at its fair market value – this is a “deemed disposition”. The tax payable on this deemed disposition of capital property will be 24% (assuming the top marginal tax rate in Alberta) of the amount of any gain on such property (i.e. any increase in value from the individual’s cost amount of the property). Unfortunately, a typical result from a deemed disposition can be taxation without the realization of any cash proceeds to pay the resulting tax.
In addition to the liquidity problem that can arise as a result of the deemed disposition of capital property on death, many other common tax pitfalls can arise in the estate context, including:
- double and triple tax situations – e.g. where the individual was the shareholder of a private corporation at the time of death;
- attribution rules;
- kiddie tax; and
- deemed capital gains/dividends.
Opportunities for tax planning for business owners
Tax lawyers can help business owners to build an estate plan to provide for the next generation and ensure the successful transition of the family business. Common planning opportunities include:
- tax-deferred transfers to a spouse, common law partner or spousal trust;
- tax-deferred inter-generational transfers of farming or fishing property; and
- use of the capital gains deduction for certain shares or property, such as:
- approximately $212,000 tax savings for “qualified small business corporation shares”, and
- approximately $240,000 tax savings for “qualified farm or fishing property”.
Potential ways to minimize taxation on death
Because the value of a business can fluctuate over time, it is difficult to predict the amount of a shareholder’s future tax liability on death. Without proper planning, assets may need to be sold to pay the tax owing on death, which can be problematic for family businesses that intend to continue beyond the founder’s death.
There are numerous tax planning solutions to address this issue, including:
- an estate freeze;
- income splitting;
- proper use of Graduated Rate Estate status;
- life insurance planning;
- charitable donations;
- the use of the capital gains exemption; and
- tax-free rollovers;
Highlighted below in more detail are a few select tax planning solutions that may be useful for a business owner when considering their estate plan. In a future blog post, we will cover the other tax planning opportunities in more detail.
An estate freeze is an estate and tax planning tool that “freezes” or “fixes” the value of assets and consequently, the tax liability associated with that asset (subject to tax rate increases). For example, a parent who owns shares of a private corporation can “freeze” the value of their shares by exchanging their common shares for fixed value preferred shares. Such a transaction causes the value of the corporation to be fixed in the redemption amount of the preferred shares, thereby causing the common shares of the corporation to have nominal value. This permits the children or a family trust to subscribe for common shares of the corporation for nominal consideration. As the value of the corporation increases beyond the fixed value of the preferred shares over time, the common shares increase in value while the value of the preferred shares remains fixed.
Some of the benefits of implementing an estate freeze include:
- certainty: the amount of the tax liability on death of the business owner is fixed;
- reduced tax liability: the business owner is not taxed on the growth of the business; and
- flexibility: the business owner can continue to control, and/or participate in the growth of the business; the business owner can implement a succession plan at a nominal cost; an estate freeze can also be combined with other planning techniques.
Estate freezes are most advantageous when business values are low (e.g. during recessionary time).
Income splitting is an estate and tax planning tool that generally involves transferring income from a high-income family member to a lower-income family member in order to reduce the family’s overall tax burden. Although recent changes to the Income Tax Act have reduced access to income splitting opportunities, it can still be used in certain situations. Among other things, the new rules include a “reasonableness” test, which requires that the lower income family member’s contribution must be sufficient to justify the amounts paid to him or her (e.g. by way of dividends).
Another means of managing a family’s overall tax burden is the proper use of prescribed rate loan plans. Prescribed rate loan planning involves a high-income parent lending money to a family member or a trust established for the benefit of family members:
- interest on the loan equals the prescribed rate (currently 1%);
- borrowed funds are invested and earn investment income, which is allocated to lower income family members;
- tax savings depend on marginal tax rates, the amount invested and rates of return; and
- it may be possible to earn up to $12,298 tax-free if the individual earns no other income.
Although a prescribed rate loan plan is not necessarily a tool for the minimization of tax on death, it can be a valuable opportunity to lower the overall tax burden to a family as a whole. This tool is particularly useful when an individual has significant capital to invest and several lower income family members.
Graduated Rate Estate status
A Graduated Rate Estate (“GRE”) of an individual is an estate that arose on and as a consequence of the individual’s death, if that time is no more than 36 months after the death of the individual.
In order to be an individual’s GRE, the following conditions must be met:
- the estate must designate itself, in its T3 return of income for its first taxation year (or if the estate arose before 2016, for its first taxation year after 2015), as the individual’s GRE;
- no other estate can have designated itself as the GRE of the individual; and
- the estate must include the individual’s Social Insurance Number in its return of income for each taxation year of the estate that ends after 2015 during the 36 month period after the death of the individual.
There are numerous reasons why it is important to consider GRE status as part of your estate plan, including the availability of certain post-mortem tax planning solutions such as subsection 164(6) loss carryback planning.
Other benefits of GRE status include:
- the income of the GRE is subject to graduated tax rates (as opposed to tax at the top marginal rate);
- the flexibility to use charitable donations in the deceased individual’s terminal return or year preceding death, or by the GRE; and
- the taxable capital gain on a charitable gift of publicly traded securities by the estate is deemed to be nil.
CARSCALLEN LLP’S TAX LAW EXPERTISE
Carscallen LLP offers tax advice to both individual and business clients on a wide range of matters, including corporate and commercial transactions; estate planning; and tax dispute resolution and litigation. Our lawyers can help you or your business navigate the complexities of the Canadian tax system. We advise individuals, businesses and other entities with respect to a broad range of tax matters. We understand the ever-changing tax environment can present many challenges to taxpayers. Our legal team’s experience and expertise enable us to provide tailored and practical solutions to your Canadian tax issues.*This update is intended for general information only on the subject matter and is not to be taken as legal advice.