Death and Taxes

Canadian income tax rules deem a person to have disposed of all his or her property at time of death

by Chris Ireland, Dec 21, 2011

Canadian income tax rules deem a person to have disposed of all his or her property at time of death for fair market value.

For the family business owner, or for someone with substantial real estate holdings, the final tax bill can be huge. And if it's not covered by liquid assets, it can force heirs to sell their inheritance. In most cases, life insurance can efficiently raise the cash to pay the taxes.

Case Study

A client from Kitchener, Ont., we'll call John Stafford, is a 65-year-old widower with three adult children. He founded Softco, a software company, worth $17 million. He hasn't implemented an estate freeze and has little wealth outside of the business.

If he dies tomorrow, his final tax return would show a $17 million capital gain (assuming his shares in Softco had a nominal cost base, typical for a business founder).

Ignoring the potential use of the capital gains exemption (and using the highest marginal rate in Ontario of approximately 46%), the tax on this capital gain would be about $3.9 million. If there isn't much available cash in John's estate, the heirs may either have to sell the business or borrow money to pay that tax bill.

If John had taken out life insurance several years ago, the rate of return would range from 5% to 7%.

If John had completed an estate freeze and owned fixed-value shares on death (retaining the same $17 million value), and one of his children was involved in the business, the dynamics could shift:

  • Common or participating shares could be owned by the child working in the business (likely owned in a discretionary family trust, and later distributed to that child).
  • John could pass his fixed value shares to his two other children. While the $3.9 million tax bill hasn't gone away, the child working in the business could have the company buy back the fixed value shares so the siblings can't meddle as shareholders.
  • Fixed value shares usually have a retraction right, which means the siblings can demand Softco buy back their shares. To cover this issue, the life insurance funding shouldn't be $3.9 million but rather the full $17 million so there's enough cash.
  • If the insurance is purchased by Softco, as opposed to its owner, the $3.9 million tax bill can be reduced with specific post-death planning.
  • The taxes owed by John's estate could be paid by the siblings inheriting the fixed value shares.

If John has philanthropic objectives, he could take out an $8.5 million insurance policy equal to the taxable capital gain arising on death (assuming he fixes the share value). The taxes on the deemed capital gain on death (50% of which is taxable) could be off set by the credit from the charitable donation on death.

Chris Ireland is a senior vice-president, planning services, PPI Advisory.

This article originally appeared in Canadian Capital. It is reprinted with permission.

These resources are provided for reference only and do not necessarily represent the opinions of Guilfoyle Financial Inc. Please consult your own tax and legal advisors.