Death and Taxes

Alfred Harris and his partner Brian Brown own a consulting engineering firm with nine employees. Alfred seemed to be walking carefully as he came into our boardroom.

“How are you feeling?” I said. “I heard you were in hospital.”

“I needed a triple bypass, and it has put the fear of God into me. I’m only 59 and in reasonably good health, or so I thought. I really wasn’t expecting this.”

“It’s a scary business,” I said.

“It’s certainly that. I wanted an appointment with you to discuss some questions I had about life insurance and death taxes. First of all, from a tax viewpoint, what happens when I die?”

“There’s a deemed disposition of all of your assets at fair market value,” I said. “That normally means that a capital gain is triggered at death reflecting the increase in the value of your assets. Fair market value is easy to determine for public company shares, so we won’t have difficulty in valuing your stock portfolio held outside your registered savings plan (RSP). The entire value of your RSP becomes taxable, not as a capital gain but as income. The shares in your private company must be valued, and any increase in their value would be taxed as a capital gain.”

“Isn’t there an exemption for these taxes?”

“There are a couple of important exemptions,” I said. “The first is the spousal rollover. The second is the small business capital gains exemption which has a lifetime limit of $500,000.”

“We don’t have to talk about the small business exemption. My partner and I used that fully several years ago.”

“Then let’s concentrate on the spousal rollover. To defer taxes at your death, you can transfer any of your assets including your RSP to your wife. No taxes are payable on the transferred assets at the time of your death. Taxes will be paid at the time of your wife’s death.”

“Okay, I understand that,” Alfred said. “The spousal exemption will be useful for my portfolio investments and RSP. I’m not so sure about my Harris Brown shares. Our shareholder agreement states that when one shareholder dies, his shares must be tendered to the other shareholder. I don’t think Brian would want my wife as a partner if I passed away, so I’m sure he’ll purchase her shares, although he’s not required to do so.”

“That’s a typical objective of shareholder agreements — and it usually makes both parties happy. But I’m surprised that your agreement calls for a buyout by the partner. Usually the arrangement is that the company is required to buy back the shares from the deceased’s estate with the proceeds of a life insurance policy on the life of the deceased.”

“We just figured whoever was left would go to the bank and borrow to buy the shares,” Alfred said.

“That’s not a great idea. With one partner gone, the bank may choose not to lend in order to facilitate a share purchase. Second, if the partner chooses not to buy the shares, it may be difficult to entice him to — at a minimum you could expect a dispute on their value. Certainly the value of the 50% of the shares of a private company are worth less than half the value of 100% of the shares, due to a discount for lack of control. Finally the tax treatment for the seller is better if the company purchases her shares as a share redemption.”

“So what do you suggest?”

“I think the shareholder agreement should be immediately reviewed. I think the buyout should be mandatory, it should be funded by life insurance, the buyout proceeds should be tax-free, and the company should pay for the insurance.”

“Why should the company pay for it?”

“As you know, life insurance proceeds are generally tax free. When an insured dies and a company receives its insurance proceeds, it not only receives those proceeds without tax, it can pass its tax savings onto the ultimate recipient of the money — the surviving spouse. That’s due to a special mechanism for companies in the Income Tax Act. An individual doesn’t have that flexibility. It makes more sense for the company to own the policy.

There’s another reason as well. For you and Brown to pay personally for the premiums, you’d have to pull money from the company, and that means you’d pay personal taxes on the amount spent on insurance. For example, you would have to earn $10,000 from the corporation to have $5,000 left after taxes for insurance premiums. The company, on the other hand, paying tax at the small business rate, would only have to earn about $6,700 to have $5,000 left after taxes for insurance premiums.” CCE

Hank T. Bulmash, C.A., MBA is a principal in Bulmash Cullemore chartered accountants of Toronto