Death taxes are assessed by the government on your estate. Without proper planning, your heirs may lose up to 70% of your assets. When you pass away, your estate needs to file a terminal return (final tax return). This will tax your income and the gains on your investments. Below is an overview to help you understand how tax works when you pass away and what you can do about reducing the potentially massive tax bill.
At the time of death, you are assessed for tax on the income earned that year.
Upon death, a taxpayer is deemed under paragraph 70(5)(a) of the Income Tax Act to have disposed of all capital property, subject to certain exceptions, for proceeds equal to their fair market value at the time of death. Resulting capital gains must be reported in the taxpayer’s 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 and unless you have liquid assets such as life insurance (which flows through your corporation tax-free), the result may be a cash crunch.
What if I am survived by my spouse?
The Income Tax Act contains 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 adjusted cost base. Hence, no tax is payable until either the spouse or the spousal trust sells the asset or until the surviving spouse dies and the assets flow to your heirs or to whoever is specified in the trust documentation.
What about my Corporation (i.e. Medicine Professional Corporation or Holding Company)?
As an incorporated doctor, there are issues you may not be aware of with respect to the taxation of the assets of your corporation. Generally, when the shareholder 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 and the assets are distributed to your heirs, there are up to 3 levels of taxation that may occur.
- TAX ON YOUR CORPORATE SHARES
The corporation was setup with a value of $1. The deemed value of the corporation’s shares at the time of death is the fair market value of the corporate investments (less the $1 adjusted cost base for the shares) which will be taxed as a capital gain as the shares are deemed to have been disposed. Assuming there are $3,000,000 in investments; this will result in a capital gain tax on the shares of $802,950. ($3,000,000*50%*53.53%).
- TAX ON THE CORPORATIONS’ INVESTMENT GAINS
Once the investments owned by the corporation (stocks, bonds, mutual funds) are sold, there is capital gains tax due on these investments. Assuming the cost base of the corporation’s investments is $2,000,000, there will be a capital gain of $1,000,000.
- Passive investment income for Canadian Private Corporations is taxed at 50.17%.
- 50% is subject to capital gains tax of 25.09% or $250,900.
- $153,350 will be added to the corporation’s refundable dividend tax account (RDTOH). The net corporate capital gain tax on investments is $97,550 ($250,900-$153,350)
- TAX ON THE ASSET DISTRIBUTION TO YOUR HEIRS
When the investments are sold and assets are ultimately distributed to your heirs (i.e. your children), the distribution of these assets will likely be done at least in-part as a taxable dividend at the heirs' personal tax rate on dividend income. If so, the payment of taxable dividends will trigger a dividend refund from the Corporation's RDTOH account.
- The highest tax rate on dividend income is 47.4% which would result in tax of approximately $1,066,073
- $3,000,000 in proceeds incurs $250,900 of corporate capital gains tax and $153,350 in RDTOH, leaving $2,595,750 after tax
- A tax-free CDA dividend of $500,000 can be paid, leaving $2,095,750 to be paid-out as a taxable dividend.
- Once the $2,095,750 is paid-out as taxable dividends, the corporation receives an RDTOH dividend-refund of $153,350 which can then itself also be paid out as a taxable dividend.
- When these taxable dividends are paid-out, the tax incurred at the 47.4% personal tax rate is $1,066,073
|Less capital gain tax on corporate shares||$ 802,950|
|Less corporate capital gain tax||$ 250,900|
|Less heirs personal tax on dividends:||$1,066,073|
|Equals total tax paid||$2,119,923|
|Net after tax for your children||$ 880,077|
|% Estate lost to tax||71%|
On a $3M portfolio, this estate lost $2,1M to tax!
There has to be a better way...
3. Life Insurance
Life insurance can be owned and paid for by your corporation. An advantage of corporate owned life insurance is that the corporate tax rate is usually lower than the shareholder’s marginal tax rate; therefore, there is typically a cost advantage to having the corporation own the policy and pay the insurance premium where the corporation owns a policy on the life of a business owner.
At the time of death, the receipt of insurance proceeds by a corporation creates a capital dividend account credit which creates significant tax planning opportunities. Upon your death, the corporation receives the proceeds of the life insurance and it can credit its “capital dividend account” by an amount equal to the proceeds less the policy’s adjusted cost base. The corporation is then able to declare a capital dividend, which will allow the proceeds in the corporation’s capital dividend account to flow to the corporation’s shareholders. The shareholders, who may be your estate, your spouse and/or your children, are not taxed on the receipt of a capital dividend. Corporate owned life insurance is not creditor proof and the insurance premiums are usually a non-deductible expense. As part of your overall planning, we would encourage you to revisit your Articles of Incorporation and corporate will on a regular basis with your lawyer to make sure that they are up to date and consistent with your wishes. With tax efficient cash available, there is no need to close out any stock positions or liquidate any other assets to cover your terminal tax liability.
4. Other Assets
Upon the second death of the surviving spouse, all other things being equal, your other assets are your home, vacation property and RSPs.
- House – Gains on your principle residences are not subject to tax.
- Vacation property. Gains on a secondary property are subject to capital gains tax of 26.77%.
- RSPs/RRIFs are taxed as income at your marginal tax rate or up to 53.53%.
Physicians often think that the only tax owing is on the gain of the investments in their corporation. Often, they do not realize that the shares of their corporation are taxable. In addition, the distribution of the assets to their heirs is also taxed. If you have life insurance as a corporate asset, this flow tax free through to your estate and provides liquidity to the heirs.
The amount of tax ultimately payable will depend on the type of post-mortem planning that is done and whether or not there are planning tools available at the time you and your spouse pass away. For example, loss carry back planning, pipeline planning, a transfer of shares and then liquidation of assets or a combination of these strategies may be useful if they are available at the time you and your spouse pass away.
One asset that your corporation can own that is guaranteed, not subject to tax and flows through your corporation tax-free is life insurance.
Elliott Levine is the President of Levine Financial Group in Toronto
416-222-1311 I firstname.lastname@example.org
The above is an overview of incorporation and is not to be relied upon for definitive legal, tax or financial planning advice. Professionals interested in exploring the opportunities of incorporation of their practice should consult with experienced corporate law, tax and financial planning advisors to discuss their specific needs and circumstances. E&OE.