Upon death, a taxpayer is deemed under paragraph 70(5)(a) of the Income Tax Act to have disposed of all property for proceeds equal to their fair market value at the time of death. Any resulting capital gain must be reported in the taxpayer’s income tax return for the year of death (terminal return). Included in income at death is the net capital gain recognized under the deemed disposition rules.
The deemed disposition rules treat capital property owned by the deceased as if it was sold immediately prior to death. Thus, all unrecognized capital gains and losses are triggered at that point with the net capital gain (gains less losses) included in income. The Income Tax Act does contain provisions to defer the tax owing under the deemed disposition rules if the asset is left to a surviving spouse or to a special trust for a spouse (spousal trust) created by the deceased’s Will. This provision allows the spouse or the spousal trust to take ownership of the asset at the deceased’s original cost. Hence, no tax is payable until either the spouse or the spousal trust sells the asset or until the surviving spouse dies. The tax is then payable based on the asset’s increase in value at that point in time.
If you are an incorporated professional, what about the shares of your corporation?
In the case of shares of your corporation, this is covered under the deemed disposition rules. Corporations do not die when a business owner dies. Corporate bylaws or a shareholders’ agreement dictate what happens with a deceased shareholder’s shares. If there is no shareholder agreement, the shares pass according to your estate plan. Generally, when the owner of the corporation dies (you) and is survived by their spouse, the shares can be transferred to a spouse or spousal trust tax-free. When you and your spouse both pass, there are several areas of taxation that apply.
- Capital gain on the disposition of shares of the corporation. The corporation was setup with a share value of $1. The deemed value of the corporation at the time of death is at least the fair market value of these investments. This value will be taxed as a capital gain as the shares are deemed to have been disposed.
- Capital gains on the sale of investments owned by the corporation. This is where you are looking at the gains on the investments. This gain will be taxed only when the investments are sold. If the investments are not sold, there is no tax.
- Dividend tax on distribution of assets to the next generation. When the investments are sold and assets distributed, the distribution of these assets to the next generation will done so as a taxable dividend.
As a part of your estate plan, the corporation may be instructed to redeem the deceased shares or pass them through to the estate. It may be better to redeem the shares then simply pass them through the estate from a tax perspective so long as this is done within the first year. This redemption causes a disposition of the shares by the estate which may result in a capital loss. If the redemption takes place in the first year, any capital loss can be used to offset capital gains on the terminal return (section 164-(6) of the Income Tax Act) which may result in lower taxation. This strategy is called Redemption and Loss Carry Back Planning as per subsection 164(6) of the income tax act and is designed to stop double taxation.
When we add life insurance privately held corporations, taxes may be significantly reduced and the benefit to your heirs is further enhanced due to the preferred treatment of life insurance and the capital dividend account in the income tax act.