The importance of post-mortem planning

Tax and estate planning usually takes place during a client’s lifetime. That said, there are post-mortem planning opportunities that you should discuss with clients.

The goal of post-mortem planning is to reduce the overall tax liability for the estate and its beneficiaries. So create a customized plan to deal with the specific tax issues that may arise.

Depending on the circumstances, an executor may be entitled to file certain elective tax returns. For instance, if the deceased had earned income from what are known as “rights or things,” the executor can choose to report this income on separate returns. Rights or things include items such as:

• payments for work in progress by professionals;
• dividends declared, but not paid, before the taxpayer’s death; and
• unpaid salary for a pay period completed prior to death.

Partnership stub returns (reporting income from a partnership), and trust stub returns (reporting trust income paid to a beneficiary) may also be available, depending on the deceased’s situation. By filing these additional returns, the deceased can access another set of credits (e.g., personal tax credit or age credit), and a second set of graduated tax rates. That reduces her overall tax liability. Other post-mortem planning techniques include: taking advantage of available exemptions (e.g., if the deceased owned more than one property at death, you would apply the principal residence exemption to the property with the greatest apital gain); and making appropriate elections (e.g., taking advantage of the preferred beneficiary, where applicable).

One of the most common and potentially valuable examples of post-mortem planning relates to the treatment of private company shares when the shareholder dies.

The double tax issue

When someone dies, there is a deemed disposition of all her assets at fair market value (FMV). If she dies owning private company shares, there will be a capital gain realized at death, unless the shares pass to a surviving spouse or a qualifying spousal trust. When this occurs, the capital gains tax is deferred until the death of the second spouse.

When the shares are deemed disposed, there is no increase in the tax cost of the underlying assets held inside in the corporation. As a result, when the corporation disposes of these underlying assets in future, another layer of corporate tax will be triggered, giving rise to double taxation.

But you can take steps to avoid this outcome. Double tax planning, often referred to as post-mortem planning, is recommended when there is a deemed disposition of the deceased’s private company shares as a result of death. The technique is often used when the person’s estate, or its beneficiaries, are unable to sell the shares to a third party.

This may be the case for investment holding companies, as third-party purchasers are often unwilling to purchase a holding company that only contains real estate or a securities portfolio. Another common corporate structure is where an operating company is indirectly owned through a holding company. It also lends itself to double tax planning. In these types of situations, unless the shares of the holding company can be sold directly, post-mortem planning is necessary to eliminate double taxation.

Post-mortem tax planning

One of the most common planning alternatives to alleviate double taxation is often referred to as a loss carry-back under Section 164(6) of the Income Tax Act. Under this option, the private company is wound up during the estate’s first taxation year, often creating a capital loss in the hands of the estate. The estate would then file a special election under Section 164(6) to carry back this capital loss and offset the capital gain in the deceased’s terminal tax return. As a result, the estate will only be taxed once—on the deemed dividend.

Here’s an example. Mr. Smith, a widower, dies owning shares of a private investment holding company (holding public securities and real estate), Holdco. At his death, Holdco is worth $5 million and its shares have a tax cost base and paid-up capital of $nil. The deemed disposition of the Holdco shares triggers a gain of $5 million, of which $2.5 million is a taxable capital gain in Mr. Smith’s terminal tax return, resulting in taxes payable of $1.25 million.

When Holdco subsequently disposes of the underlying public securities and real estate assets that it owns, corporate tax will be payable on the gains realized, along with a layer of personal tax on the distribution of any dividends. This additional tax could reasonably be about 30% of the total gain, or $1.5 million in taxes. This would bring the total tax bill to $2.75 million. If, however, the Section 164(6) loss-carry-back planning option had been implemented, Holdco would have been wound-up in the first taxation year of the estate, triggering a capital loss of approximately $2.5 million. This capital loss would have been carried back to offset the $2.5-million capital gain reported in Mr. Smith’s terminal tax return, essentially taking his tax liability to zero.

Taxes (of about $1.5 million) will apply when Holdco eventually disposes of the underlying public securities and real estate assets. In this example, by making use of the Section 164(6) election, the estate is able to achieve a total tax savings of approximately $1.25 million.

Impact of testamentary trusts

The 2014 federal budget included measures that will change the taxation regime for testamentary trusts, beginning in 2016. And, recently passed legislation included some additional measures that will adversely impact post-mortem planning involving spousal and other life interest trusts (see “Ottawa overhauls trust rules,” page 4).

Summary

The term “post-mortem tax planning” can be misleading, since it suggests nothing can be or needs to be done during someone’s lifetime.

But that’s not the case. While execution of the scheme or structure must occur post-mortem, the actual plans are put in place before death.

All clients should ensure their wills provide broad authority to executors. [Tweet that phrase] Otherwise, an executor may not be able to take advantage of all available post-mortem planning opportunities. And if a client dies intestate, all post-mortem planning opportunities are forfeited.

Also, post-mortem planning can be very complex, so clients should work with experts who have a deep understanding of the Income Tax Act.

by Elaine Blades, director of Fiduciary Services, Scotia Private Client Group & Kevin Tran, director, Tax Advisory Services, Financial Planning & Advisory Services.