Dealing with Private Company Shares at Death: Post-Mortem and Insurance Planning (Part I)

CALU Report

October 2009

This issue of CALU Report contains part I of a two-part article dealing with the post-mortem tax planning for an individual who owns private company shares at death. In the article Carol Brubacher of Manulife's Tax and Estate Planning Group discusses and provides detailed analysis regarding the overall goal of post-mortem planning to minimize the tax burden arising at death and on distribution of a deceased person's assets to his or her chosen beneficiaries.

In Part I, Carol looks at an individual who owns common shares of an investment corporation at death. In Part II, which will be published in the October 2009 CALU Report, Carol will look at an individual who owns fixed value preference shares of an operating company.

This article was originally published in Manulife's Tax and Estate Planning Groups Tax Topics. CALU thanks Carol and Manulife for sharing this excellent discussion with our members.

Regards, Paul McKay, CAE

Table Of Contents

• Ownership of Common Shares at Death
• Part I Summary: Ownership of Common Shares at Death
• About the Author

Ownership of Common Shares at Death

This article will review the planning opportunities for an individual who owns common shares of an investment corporation at death. Investment corporations are corporations like any other corporation. They are referred to as investment corporations because the assets they hold are primarily investment assets (as opposed to an active business). Some investment corporations were at one time operating companies or holding companies that owned the shares of an operating company. If the business assets or shares of an operating company are sold, and the after-tax proceeds are retained in the corporation and invested, then the company becomes what is often referred to as an investment company or investment holding company. If the individual continues to hold onto the investment corporation until his or her death, he or she will have a deemed disposition at death equal to the fair market value (FMV) of the shares of the corporation. Often the next step is to distribute the assets out of the corporation to the intended beneficiaries. This is where post-mortem planning is done in order to minimize the overall tax burden.

Fact Situation

Post-mortem planning for an individual who owns common shares of an investment corporation at death will be illustrated using the following facts:

• Mr. A (age 70) and Mrs. A (age 65) are equal shareholders in Investco. 
• Their Investco shares have nominal paid-up capital (PUC) and adjusted cost base (ACB).
• Investco was originally an operating company that sold its business for $3 million after tax. The corporation used the proceeds from the sale to acquire an investment portfolio that included $2 million fixed income (5%) investments and $1 million equity growth (7%) investments.
• Dividends were paid annually to distribute fixed income earnings and recoup refundable dividend tax on hand (RDTOH). Equity growth investments were held to defer the capital gains.
• Mr. A and Mrs. A die 25 years later at age 95 and 90 respectively. 
• Mrs. A died first and on her death she transferred the shares of Investco to Mr. A at cost pursuant to subsection 70(6) of the Income Tax Act ("the Act").
• At the time of death the portfolio inside Investco has grown to a fair market value (FMV) of $7.4 million with an ACB of $3 million. Consequently the shares of Investco also have a FMV of $7.4 million (but nominal ACB). 
• No estate freeze has been done.
• The corporate tax rate on investment income is 48%, and the personal tax rate on dividends is 31% and on other income is 46%.

At the time Mr. A dies, a number of different scenarios may arise. The following sections will look at what happens if no planning is done and compare that to what happens if various post-mortem planning tools are utilized. (Note: Detailed calculations of the following scenarios are found in the Appendix.)

a) Do Nothing - Double Tax Issue

Upon Mr. A's death, there will be a deemed disposition of his Investco shares at their FMV immediately before death (paragraph 70(5)(a) of the Act). If no planning is done, this will result in a capital gain to Mr. A of $7.4 million. One-half of this capital gain would be included in income and reported on Mr. A's terminal return. Income tax of approximately $1.702 million would be assessed on the capital gain.

If Mr. A's beneficiaries wish to receive their proportion of the corporation's investments, Investco would have to dispose of the investment portfolio (either by an actual sale, or by a distribution of the assets as a dividend in kind). This would result in a capital gain inside the corporation of $4.4 million and corporate tax payable of approximately $1.056 million. The disposition would also generate RDTOH equal to 26.67% of the taxable capital gain ($586,667) and a capital dividend account (CDA) credit equal to the untaxed portion of the capital gain ($2.2 million).

In order to get the cash from the sale of the investments into the estate and ultimately into the hands of the beneficiaries, Investco must distribute either cash or the investments from the corporation to the estate (or heirs) in the form of dividends. Investco will have $6.344 million left after paying corporate taxes, plus it will recover $586,667 in refundable tax on the payment of the taxable dividend. As a result Investco can pay out a total dividend of approximately $6.931 million. Part of the dividend could be characterized as a non-taxable capital dividend and the remainder will be a taxable dividend to the estate. The taxable dividend will give rise to a further $1.467 million in taxes.

In summary, if no planning is done, the total tax burden on the death of Mr. A includes:

1. Personal tax payable on the deemed disposition of the Investco shares owned by Mr. A at death ($1.702 million), 
2. Corporate tax payable on the disposition of the investment portfolio held inside Investco ($1,056,000 - $586,667 of refundable tax recovered = $469,333), and 
3. Personal income tax payable by the estate on the assets being distributed as a taxable dividend from the corporation to the estate ($1.467 million).

The total tax payable is $3.638 million or 49% of the value of the investments ($7.4 million). Considering capital gains tax rates are around 23%, double tax is the result. Some of the tax planning techniques that could be put in place to mitigate this tax result are outlined in the next two sections.

b) Wind up the Investment Company and Loss Carryback

One planning strategy commonly used to avoid double taxation is called a "Windup and Loss Carryback" strategy. This strategy involves winding up Investco on Mr. A's death to give rise to a capital loss that can be used to reduce the capital gain at death using a loss carryback provision in the Act (subsection 164(6)).

As above, Mr. A is deemed to dispose of his shares of the corporation at FMV at his death and a capital gain is reported on his terminal tax return.

The next step is liquidation of Investco's investment portfolio and distribution of the net proceeds to the beneficiaries. The disposition of the corporate held investments results in the same capital gain and taxes as the previous scenario: a capital gain of $4.4 million; corporate income tax payable of $1.056 million; an RDTOH balance of $586,667; and a CDA balance of $2.2 million.

However, in this strategy, instead of distributing the investments as a dividend, Investco is wound up. On wind up, the assets distributed in excess of the PUC of the Investco shares, will be deemed to be a dividend for tax purposes. In our example the cash available for distribution is $6.931 million. Since the PUC in this situation is nominal, the deemed dividend would be $6.931 million. A portion of the dividend could be characterized as a tax-free capital dividend and the remainder would be a taxable dividend. So far this result is very similar to what occurred when no planning was done.

However, the windup also causes a disposition of the shares by the estate, resulting in a capital gain or loss. The adjusted proceeds for determining the gain or loss is the amount distributed on wind up less the deemed dividend. Since the amount distributed equals the deemed dividend in this example, the adjusted proceeds are nil. The capital loss is then calculated as the adjusted proceeds less the ACB of the shares. Note that the ACB of the shares is $7.4 million because of the deemed disposition at death. As a result there is a capital loss of $7.4 million. If Investco is wound up within the first year of the estate, the capital loss of $7.4 million can be carried back to offset the capital gain of $7.4 million triggered on the deemed disposition at death pursuant to subsection 164(6) the Act.

Thus, the total tax burden on the death of Mr. A in this scenario includes:

1. Corporate tax payable on the disposition of the investment portfolio held in Investco ($1,056,000 - $586,667 of refundable tax recovered = $469,333), and 
2. Personal income tax payable by the estate on the taxable deemed dividend on the redemption of the shares ($1.467 million).

In this scenario the total tax payable is $1.936 million (or 26%) compared to the no planning option above with taxes payable of approximately $3.638 million. By winding up the company within the first year of death and utilizing subsection 164(6) to carry back the loss to the terminal return, taxes have been reduced by $1.702 million.

Life Insurance Opportunities

Corporate-owned life insurance can be used in conjunction with windup and loss carryback planning to improve the outcome. Let's continue with our example and assume the following additional facts:

• When Mr. A and Mrs. A sold the business they had Investco purchase a joint-last-to-die term-to-100 life insurance policy on their lives with a face amount of $1.6 million to cover the estimated future tax liability which would arise on their death.
• The premiums on the policy are approximately $25,000 per year, and are funded by liquidating a portion of the interest-bearing investments each year.
• The same dividends are paid yearly to Mr. A and Mrs. A as in the above scenario.
• Due to the utilization of some of the capital to pay the insurance premiums, the FMV of the investment portfolio is less. At the time of death the portfolio inside Investco has grown to a fair market value (FMV) of $6.4 million with an ACB of $2.0 million. Consequently the shares of Investco also have a FMV of $6.4 million (but nominal ACB). 
• At the time of Mr. A's death, the ACB of the life insurance policy is nil and the cash surrender value (CSV) is also nil.

As was the case without insurance, there is a deemed disposition of the Investco shares at Mr. A's death; however, the gain is $6.4 million (instead of $7.4 million) because a portion of the corporation's assets have been used to fund the life insurance policy premiums. Since the FMV for deemed disposition purposes is the FMV immediately before death, the life insurance proceeds are not included in FMV. (Note that if the life insurance policy had cash value, the cash value immediately before death would be included in calculating the FMV of Investco's shares for purposes of the deemed disposition at death.)

The death benefit proceeds of $1.6 million will be received tax-free by Investco, and Investco will receive a credit to its CDA equal to the excess of the life insurance proceeds ($1.6 million) over the ACB of the policy ($0). The CDA can be used to pay a tax-free capital dividend to the shareholders of the corporation (the estate).

If the beneficiaries of Mr. A's estate wish to receive their portion of the value of Investco, the corporation could liquidate its investments and wind up the corporation. The liquidation of the assets held by Investco will result in a taxable capital gain of $4.4 million and corporate tax payable of $1.056 million inside the corporation. The disposition would also generate RDTOH equal to 26.67% of the taxable capital gain ($586,667) and a CDA credit equal to the untaxed portion of the capital gain ($2.2 million).

The windup dividend will be larger than in the non-insurance scenario due to the addition of the life insurance proceeds. The windup dividend will be $7.531 million. Part will be characterized as a capital dividend and the remainder is a taxable dividend. The CDA includes the $2.2 million resulting from the liquidation of the investments and $1.6 million from the life insurance proceeds, for an available capital dividend of $3.8 million. The remaining deemed dividend on wind up would be a taxable dividend resulting in personal tax payable of $1.157 million.

The wind up also creates a capital loss of $6.4 million on the disposition of the Investco shares by the estate. Provided Investco is wound up within the first year after death, subsection 164(6) allows the loss on wind up to be carried back to offset the gain reported on Mr. A's terminal return.

The stop-loss rule in section 112 of the Act can limit the amount of losses that can be carried back using subsection 164(6) of the Act when a capital dividend has been paid (or is deemed to be paid) on the shares. If the PUC and ACB of the shares are equal then the loss carryback available for carryback will be reduced if the taxable dividend on redemption is less than half of the capital gains on death. In our example, the PUC and ACB are equal; the taxable dividend is approximately $3.731 million which is greater than half of the loss carryback of $6.4 million, therefore, the stop-loss rules do not reduce the loss available. (The detailed stop loss calculation is shown in the Appendix.) Stop-loss rules will not apply if the shares of the corporation are grandfathered. A detailed analysis of the grandfathering rules is beyond the scope of this article, however, the detailed rules should be consulted to determine the grandfathered status of any particular shares. It is also possible to avoid the stop-loss rules through what is often referred to as a "roll and redeem" strategy. We will look at this strategy in the second part of this article.

Thus, the total tax burden on the death of Mr. A when the windup and loss carryback strategy with life insurance is used includes:

a) Corporate tax payable on the disposition of the investment portfolio held inside Investco ($1,056,000 - $586,667 of refundable tax recovered = $469,333), and
b) Personal income tax payable by the estate on the assets being distributed on the wind up of Investco ($1.157 million).

In this scenario the total tax payable is $1.626 million or 20.32% of the value of the investments plus the life insurance proceeds.

The following table summarizes the "No Planning" option compared the "Windup and Loss Carryback" strategy both with and without insurance.

Based on the above analysis the windup and loss carryback strategy is much better than no planning, and if life insurance is incorporated into the planning, the net estate value is increased by approximately $900,000. The life insurance is advantageous for two reasons. First, it increases the windup proceeds; the life insurance proceeds received on death are greater than the decrease in the investment portfolio caused by utilizing investments to fund the life insurance premiums. Secondly, the life insurance death benefit increases the CDA and reduces the tax payable on the windup dividend. If Mr. and Mrs. A were to die prematurely, the insurance scenario would look even better because it would generate higher values and a larger CDA credit in the corporation relative to the taxable investment.

c)  ACB Pipeline and Bump

The second planning strategy to avoid double taxation is the "ACB Pipeline and 88(1)(d) Bump". The ACB pipeline is a method of turning the ACB that arose on the deemed disposition at death into a loan from the corporation that can be repaid without incurring further tax. The 88(1)(d) bump is a tax planning strategy that uses paragraph 88(1)(d) of the Act to increase or "bump up" the cost base of assets inside a corporation in order to reduce the tax payable on the disposition of those assets. We will use the same example as above to illustrate the sequence of transactions to implement this strategy.

As above, Mr. A is deemed to dispose of his Investco shares at FMV on his death. The resulting capital gain of $7.4 million is reported on Mr. A's final personal income tax return, resulting in income tax of approximately $1.702 million. Following the deemed disposition, Mr. A's estate will hold the Investco shares, which have ACB equal to FMV of $7.4 million.

To create the "ACB pipeline," a new company (Newco) is incorporated and the estate sells the Investco shares to Newco in exchange for two things: a promissory note receivable equal to the value of the Investco shares ($7.4 million); and common shares of Newco with nominal value.  There should be no gain or loss on the sale of shares by the estate to Newco because the FMV of the Investco shares should equal the ACB (due to the deemed disposition at death). (See Diagram for illustration of structure.)

After the share transfer, Investco is wound up into Newco. The windup results in the Investco's assets being transferred to Newco and in the process paragraph 88(1)(d) of the Act allows the ACB of the underlying investments to be "bumped up" to FMV, assuming the assets are "eligible" for the bump. The bump is to reflect the higher cost base inherent in the ACB of the Investco shares. Generally, the ACB bump cannot exceed an amount equal to the ACB of the shares of the subsidiary (Investco - $7.4 million) less the ACB of the assets of the subsidiary (Investment portfolio - $3 million). Therefore in our example, the ACB of the investments owned by Investco could be bumped from $3 million to $7.4 million.

Newco can now liquidate the investment portfolio and since the FMV and the ACB of the investments are equal or close to equal; there should be little or no income tax in Newco on the disposition of the investment portfolio. Newco can then flow the proceeds up to the estate by repaying the promissory note and no further tax is payable by the estate on the distribution.

In summary, the ACB pipeline and bump planning strategy limits the tax liability on the death of Mr. A to the personal tax arising on the deemed disposition of the Investco shares at death ($1.702 million). This works out to a tax rate of 23% based on the value of the investment portfolio of $7.4 million. Compared to the no planning option the tax payable is reduced by both the net corporate tax payable on the disposition of the investment portfolio ($469,333) and the tax payable by the estate on the taxable dividend arising on the distribution of the assets from Investco to the estate ($1.467 million). The tax rate has been cut from 49% down to 23% capital gains rate by utilizing the pipeline and 88(1)(d) bump strategy.

Life Insurance Opportunities

Corporate-owned life insurance can also be used in conjunction with ACB pipeline and bump planning. Assuming the same facts as in the windup and loss carryback with life insurance scenario, the tax implications of utilizing corporate-owned life insurance in conjunction with the ACB pipeline and bump planning would be as follows.

As was the case without insurance, there is a deemed disposition of the Investco shares at Mr. A's death; however, the gain is $6.4 million (instead of $7.4 million) because a portion of the corporation's assets have been used to fund the life insurance policy premiums. Since the FMV for deemed disposition purposes is the FMV immediately before death, the life insurance proceeds are not included in FMV. (Note that if the life insurance policy had cash value, the cash value immediately before death would be included in calculating the FMV of Investco's shares for purposes of the deemed disposition at death.)

The death benefit proceeds of $1.6 million will be received tax-free by Investco, and Investco will receive a credit to its CDA equal to the excess of the life insurance proceeds ($1.6 million) over the ACB of the policy ($0). The CDA can be used to pay a tax-free capital dividend to the shareholders of the corporation (the estate).

The additional cash in the company from the life insurance proceeds could be a problem in 88(1)(d) bump planning because the additional cash increases the cost basis of the assets in Investco and thereby reduces the amount of the available bump. To get around this problem, the death benefit proceeds could be paid to the estate as a capital dividend before the reorganization. The stop loss rules will not apply because there is no loss being carried back.

Now the restructuring can take place as described above: the estate sells the shares of Investco to Newco for FMV of $6.4 million. The only difference from the scenario without insurance is that the value of Investco is lower because the insurance premiums paid have reduced the value of the investment portfolio. In exchange for the shares of Investco, Newco issues common shares to the estate for nominal value and a $6.4 million promissory note. There should be no gain or loss on the sale of shares by the estate, because FMV should equal ACB.

Investco is then wound up into Newco and as part of the windup the ACB of the underlying investments can be "bumped up." Since there is no cash from the life insurance sitting in Investco which would have limited the available bump, the investment portfolio may be bumped up to its FMV (from $2 million to $6.4 million) to reflect the higher cost base inherent in the shares of the corporation. (The maximum bump equals $4.4 million calculated as the share ACB of $6.4 million less the $2 million ACB of the investment portfolio.) Newco can liquidate the investment portfolio and since the FMV and the ACB of the investments are equal, there should be no tax in Newco on the disposition. Newco would than flow the proceeds up to the estate by repaying the promissory note and there would be no tax payable by the estate on the distribution.

The following table summarizes the results of the "No Planning" option compared the "ACB Pipeline and Bump" strategy both with and without insurance.

The advantage of adding life insurance to ACB pipeline and bump planning is that net estate value has increased to $6.5 million compared to $5.7 million with no insurance. Although the values of Investco's investments are reduced due to the payment of life insurance premiums, the life insurance proceeds have more than offset the premium costs.

Copyright the Conference for Advanced Life Underwriting, October 2009

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Part I Summary: Ownership of Common Shares at Death

If you compare post-mortem estate planning strategies, the analysis is affected by tax rates, particularly, the relative tax rates on dividends as compared to capital gains. The ACB pipeline and bump strategy results in tax at the personal capital gains rate, and the windup and loss carryback strategy results in corporate tax on the liquidation of the investment portfolio and personal tax on the taxable dividend on wind up. The analysis is affected by the tax rates and in particular the relative tax rates on dividends as compared to capital gains. Currently in most provinces capital gains treatment results in a lower tax burden than dividend treatment, and therefore ACB pipeline planning may be preferred over windup and loss carryback planning. Both strategies should be reviewed to determine which provides the best overall tax result. Wills and other agreements affecting estate planning should be flexible enough to allow whichever structure will minimize the tax under the rules which exist at the time the death occurs. The above analysis also confirms that life insurance can improve the overall estate value regardless of the post-mortem strategy chosen.

In the October issue of CALU Report we will consider the post-mortem planning opportunities for an individual who owns fixed value preference shares of an operating company at death.

Copyright the Conference for Advanced Life Underwriting, October 2009

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About the Author

Carol Brubacher is a consultant with Manulife's Tax and Estate Planning Group in Kitchener, ON. You can e-mail her at carol_brubacher@manulife.com. The original article was published in Tax Topics, a publication of Manulife's Tax and Estate Planning Group. This article may not be reproduced without the written permission of either Manulife or CALU.

Copyright the Conference for Advanced Life Underwriting, October 2009

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