What to do when a taxpayer dies

Why read this?

› If your client or client’s relative has died and owned a private company

› If your client has a private company and needs an estate plan

The situation

A client put $100,000 in an investment-holding corporation, Company A, 10 years ago and it’s since grown to a fair market value of $500,000.

She died, and was deemed to have disposed of her share in the holding company. Her estate has to put the $400,000 capital gain on her T1 terminal return.

Now, her estate owns the corporation, which still exists. The estate received the share at fair market value (FMV), $500,000, but there is no provision in the Income Tax Act to increase the paid-up capital ($100,000).

If the estate wants to wind up Company A, it will trigger a deemed dividend equal to the FMV less the paid-up capital, or $400,000. That dividend will reduce the proceeds of the corporation by $400,000, and the estate will have a capital loss of $400,000.

The problem

The $400,000 gain on the T1 terminal return can’t be offset by the estate’s capital loss of $400,000 because the estate and the client are different taxpayers. If the estate does not have capital gains of at least $400,000, the loss won’t be used and the client will face double taxation.

How to avoid this

There are three options for the company:

1.

164 (6) election

“Generally, as long as you wind up the company within the first taxation year of the estate, you can take the capital loss and put it in the terminal return. But if you miss that year, you can’t do it anymore.”

– Marina Panourgias, Deloitte

The estate doesn’t want to maintain the company. A provision in the Tax Act, Section 164 (6), provides a solution. The trustee will have to file an amended terminal T1 return. If the year lapses, the estate trustee can ask CRA for an extension.

2.

Section 85 rollover

If the estate doesn’t want to wind up Company A, it could incorporate Company B and transfer the shares on a rollover basis, thanks to Section 85 of the Tax Act.

The estate would transfer its $500,000 of shares to Company B in exchange for a promissory note for $499,000 and $1,000 in shares of Company B. (The value of the shares plus the note must equal the amount received in exchange. You may use any combination of note and shares.)

“The note you’ve gotten back is your pipeline to the cash,” says Panourgias.

To make sure this is on-side with CRA, Company B cannot pay back the note all at once. CRA has “never admitted to a timeline,” but Company A should stick around for at least a year after Company B is incorporated and makes the exchange. This solution means beneficiaries can’t get the proceeds of Company A right away without potential challenge from CRA, and should have other ways to pay the taxes on the estate and terminal T1.

Says Panourgias, “Winding up the old company into the new and immediately shoving cash over is seen as offensive”—CRA case law suggests that would trigger a deemed dividend, which is what the estate was trying to avoid.

After the note is paid back in full, the estate can wind up Company A.

3.

Paragraph 88(1)(d) bump: The most complicated!

“When the new company acquires the old one, you can choose to increase the adjusted cost base of some of those assets in the old company because of the deemed acquisition of control due to the death.”

– Marina Panourgias

Upon winding up Company A into B, Paragraph 88(1)(d) lets Company B “bump up” the cost base of any non-depreciable capital property transferred from A to B, since the taxpayer’s death triggered a transfer of control of the company. The bump must be between the adjusted cost base ($100,000) and the FMV ($500,000).

If Company B doesn’t use the bump and sells eligible assets, it will realize gains above the $100,000 cost base—which may result in double taxation. If Company B is able to use the bump strategy to its full extent ($500,000), it will only realize gains accrued subsequent to the taxpayer’s death when it sells the eligible assets.

Our sources: Marina Panourgias, senior manager, Deloitte and John Campbell, tax group leader, Hilborn.

CRA is reviewing the bump strategy, so use with caution. Also, “the bump is a formula, so you won’t get up to the full $500,000,” says John Campbell of Hilborn.

Why would an estate wind up a corporation?

› To use proceeds for the terminal T1 tax bill

› To use the 164(6) election

› To distribute cash to beneficiaries

› No one wants to manage the corporation’s affairs

Questions to ask

› What did the deceased want?

› Do the beneficiaries need cash right away? If yes, consider 1

› Is there enough cash to pay tax bills without winding up the corporation? If no, consider 1

› Is it ultimately better for the estate to pay tax on dividends 1 or capital gains 2?

› Is the estate trustee competent enough to handle the more complicated strategies? If no, consider 1

› Can the estate trustee wind up the corporation within the first taxation year of the trust? Do shareholder agreements permit the estate to wind up the company? If no, consider 2 or 3

› Does the company have ongoing business? If no, consider 2 or 3

› Are there tax balances in the company that would generate dividend refunds? If yes, consider1

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.