Ownership of Private Corporations by an Estate

Introduction

Many of our clients own shares of private corporations which will become part of their estate.  The ownership and eventual disposition those shares raise many interesting and challenging income tax and legal issues.

The executors may have dual roles:  as shareholders of the corporation and also as directors and officers of the corporation.  The executors’ roles and responsibilities include income tax planning (especially in the first year of the estate), management of the corporation, its assets and business, the sale or transfer of the corporation to the beneficiaries or to a third party purchaser and possibly the wind-up of the corporation.

These roles and responsibilities, and the liabilities that come with them, will have an impact on the choice of executors, the drafting of the Will and on the performance by the executors of their duties.

The Double Tax Problem

We all know about the deemed disposition of capital property which occurs at the time of death.  In general, the deceased is deemed to dispose of all of his or her capital property for proceeds of disposition equal to the fair market value of the property as of the date of death.

In the case of private company shares, this deemed disposition can result in the capital gain.  The capital gain may be deferred if the shares are left to a spouse or spousal trust and may be reduced or eliminated if the capital gains deduction is available.

The executors must estimate the fair market value of the shares at the time of death.  Many valuation issues arise[1].  These include the following:

(a)    Should the shares be valued on a going concern or breakup-value basis?

(b)   Should the share value be discounted for income taxes payable on a wind-up of the corporation?

(c)    Do fixed value preference shares have a value equal to their redemption price?

(d)   Should a premium be added to voting shares which have a nominal redemption value?

(e)    Should non-voting dividend sprinkling shares have a discounted value?

(f)     What value should be given to life insurance policies on the lives of individuals other than the deceased shareholder?

The deemed disposition results in an increase of the adjusted cost-base (“ACB”) of the shares but does not increase either the paid-up capital (“PUC”) of the shares or the ACB of the assets owned by the corporation.  This means that additional “double” tax will be payable when the funds are removed from the corporation.

It is best to demonstrate this with an example.

The estate own shares with a fair market value of $100 and a nominal ACB and PUC.  At the time of death, the deceased will realize a capital gain of $100.  The tax on the capital gain is $23.20 (assuming the top marginal rate of 23.2% on capital gains applies).  The ACB of the shares is increased to $100 but the PUC is still a nominal amount.  If the $100 value is then paid to the estate as a dividend, the estate will pay tax of $32.57 (assuming the deemed dividend is not an “eligible” dividend and is taxed at the top rate of 32.57% applicable to dividends in 2010).  In result, the total tax is $55.57, which is almost 56%. 

The double tax problem might not arise if the shares are immediately sold to a third-party purchaser and if it is not necessary to remove assets from the corporation before the sale.  However, in many cases, tax planning will be needed to avoid the double tax.

There are many tax planning strategies to avoid the double tax.  A review of the strategies and technical rules is beyond the scope of this paper[2].  Two strategies will, however, be briefly summarized as illustrations.

              a.       Share Redemption

One strategy involves the redemption of the shares in the first year of the estate.  Using the example from above, the shares will be redeemed for $100.  The redemption results in a $100 deemed dividend to the estate and a $100 capital loss.  The deemed dividend equals the redemption proceeds ($100) minus the PUC of the shares (nominal).  In calculating the capital loss, the proceeds of disposition are reduced by the amount of the deemed dividend.  Hence, the capital loss equals the proceeds of disposition ($0) minus the ACB of the shares ($100).

The capital loss may be reduced in some cases by the stop-loss rules contained in sections 40(3.6) and 112(3.2) of the Income Tax Act.  These rules are quite technical and need to be carefully considered. Tax planning may be available to avoid or minimize the impact of those rules.  For example, those rules will not apply if all of the shares of the corporation are redeemed, or if the corporation is wound-up, and no portion of the redemption or wind-up proceeds is paid with tax-free dividends[3]. 

Under section 164(6), if the shares are redeemed in the first year of the estate, and the estate elects prescribed manner and within prescribed time limits, the capital loss is deemed to be the deceased’s capital loss.  This means that the capital loss may eliminate the capital gain arising from the deemed disposition on death.

The estate will still have the tax liability from the deemed dividend resulting from the share redemption.  The estate has essentially traded a capital gain for a deemed dividend.  The top tax rate on dividends in 2010 is 32.57%, which is higher than the top tax rate on capital gains (which is 23%).  The top tax rate on dividends in 2010 will be 26.57% if the deemed dividend is an eligible dividend.  Also, the dividend might trigger a dividend refund to the corporation if the corporation has an available refundable dividend tax-on-hand account.

                b.      Pipeline Strategy

The pipeline strategy involves the use of a technical rule in section 84.1 of the Income Tax Act which permits surplus stripping in limited circumstances. 

Under this strategy, the estate sells its shares to a new holding company in exchange for a promissory note and shares of the holding company.  In the above example, the promissory note might be as much as $100.  The shares of the holding company in that case would have a nominal value.  This would permit the estate to remove $100 from the corporation tax free through repayment of the promissory note.  Ideally, the estate will receive a promissory note for the full value of the shares ($100 in the above example).  However, section 84.1 will reduce the amount that can be received as a tax-free promissory note by the amount of any capital gains deduction claimed in respect of the shares in the past and by any portion of the ACB which is attributable to the v-day of the shares.

Other strategies may be available to avoid the double tax.  For example, it may be advantageous to wind-up the corporation or to complete a vertical amalgamation under subsection 88(1) or 87(1) of the Income Tax Act.  This strategy may be available if there is a change in control of the corporation at the time of death.  The wind-up or vertical amalgamation can increase or “bump” the adjusted cost base of non-depreciable capital property owned by the corporation to an amount equal to their fair market value at the time of death.  This may reduce or eliminate the double tax.

Ownership and Management of the Corporation

As mentioned, executors may have dual roles as owners (shareholders) and as managers (directors and officers) of the corporation.

The estate may become a shareholder of the corporation or may be required to transfer the shares immediately to one or more beneficiaries such as a spouse.

As shareholder, the estate may need or want to appoint one or more directors of the corporation.  This will almost certainly be needed if the estate controls the corporation.  Executors are often appointed as directors.  The directors must then appoint the officers.  In many private corporations, the executors may also be appointed as officers.

                     a.       Role of the Directors

Under the Ontario Business Corporations Act (the “OBCA”), directors of a corporation are responsible for managing or supervising the management of the business and affairs of the corporation, except as provided under a unanimous shareholders agreement.

Directors stand in a fiduciary relationship to the corporation.  Under the OBCA, the directors must act honestly and in good faith with a view to the best interests of the corporation.  They must also exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.  These duties are owed to the corporation and, in effect, to all shareholders of the corporation.  This means that the duties may be owed to shareholders other than the estate.

The OBCA also contains rules dealing with conflicts of interest.  Executors who are also directors must therefore consider whether conflicts arise because of these dual roles.

Executors who act as directors must therefore realize that they are assuming roles and responsibilities and legal duties which are independent of their fiduciary duties as executors of the estate.

                       b.      Director’s Liability

Directors may also be subject to personal liability under a host of common law rules and statutory provisions.  The following is a list of some (but by no means all) of these rules and provisions:

·               Fiduciary Duties.  As mentioned, directors must act in good faith with a view to the best interests of the corporation and must exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.

·               Employee Wages.  Section 131 of the OBCA may impose personal liability on directors, jointly and severally, for up to 6 months’ wages of employees and vacation pay for not more than 12 months. 

·               Other Employment Legislation.  Directors’ liability may also be imposed under the Employment Standards Act and pension benefits or occupational health and safety legislation.

·               Employee Source Deductions and Remittances.  Directors may be liable for unpaid employee income tax, Canada Pension Plan and employment insurance source deductions and premiums.

·               GST.  Directors may be liable for unpaid corporate GST.

·               Environmental Legislation.  Directors may be liable under various federal and provincial statutes dealing with environmental protection matters relating to water, air, pesticides, waste management or other matters.  Directors may be subject to “strict liability” which would impose liability unless they can establish a “due diligence” defense showing that they took reasonable care to prevent the occurrence of the offence.

                         c.       Assessing and Managing the Risk

Every prospective director should obtain as much information as possible about the corporation and its business and assets before accepting an appointment as a director so that they can fully understand their responsibilities and properly assess the potential risks.

The nature and scope of this investigation will be decided on a case by case basis and will depend on the corporation and its business and assets.  For example, different investigations will be needed for an investment holding company than for an operating business or a corporation that owns real estate. 

These investigations might include the following:

·               Review of the financial position, viability and prospects of the corporation, including a review of financial statements.

·               Review of the management team, including their experience, performance and abilities.

·               A risk audit on matters relevant to the particular corporation, its assets and business, such as environmental risks, employee matters, income or sales taxes, occupational health, product liability or other matters.

After accepting appointment as a director, the director should take all appropriate steps to manage and minimize their risk.  These steps might include:

·               Schedule and attend board meetings and keep detailed minutes of those meetings.

·               Identify specific risk areas and take measures to manage those risks.  This might include, for example, specific measures to ensure payment of employee source deductions or to ensure compliance with occupational health and safety or environmental legislation.

·               Obtain an indemnity from the corporation (and possibly even the estate) with respect to director’s liability.

·               Obtain directors and officers liability insurance.

·               Watch for problem areas and deal with them when they arise.

Sale, Transfer or Wind-up of the Corporation

The estate will need to deal with the shares in accordance with the terms of the Will.

                    a.       Transfer to Beneficiaries

The estate may simply transfer the shares to one or more beneficiaries of the estate.  The executors should consider if tax planning transactions should be completed before any such transfer to address the double tax problem.  In some cases this may be done fairly quickly and the executors might not have to become directors or officer of the corporation.

                    b.      Shareholders Agreement

There may be a shareholders agreement in place which provides for the sale of the shares.  The structure and terms of the sale will have important tax implications.  The structure and terms will usually be specified in the shareholders agreement.  There may be some flexibility to establish or modify the structure or terms in order to improve the tax consequences to the estate. 

In general, the sale could be structured as a sale of shares to the purchaser, a redemption of shares by the corporation or a combination of these two methods. 

Under section 69 of the Income Tax Act, the estate will be deemed to receive sale (or redemption) proceeds equal to the fair market value of the shares on the closing date if the estate and the purchaser are not at arm’s length.  That amount may be different than the purchase price payable under the shareholders agreement or other buy-sell agreement.  In result, the estate could be taxed on an amount which is larger than the amount actually received.  It may be appropriate to include a price adjustment clause or a tax indemnity in these circumstances.

A sale (as opposed to a redemption) will generally result in a capital gain.  The top tax rate on capital gains is 23%.  All or part of the gain may qualify for capital gains deduction. All or most of this gain may have been realized by the deceased as a result of the deemed disposition on death, resulting in an increase in the ACB of the shares.  The increased ACB will reduce the capital gain which would otherwise be realized on a sale of the shares.

A share redemption will generally result in a deemed dividend.  The top tax rate on deemed dividends is 32.57% in 2010. The corporation may be able to pay part or all of the deemed dividend as a tax free capital dividend to the extent that the corporation has available capital dividend account arising from life insurance proceeds received on the life of the deceased. 

As mentioned above, the share redemption may also result in a capital loss to the estate which could be deductible against the capital gain to the deceased arising from the deemed disposition on death, subject to the stop-loss rules.  The stop-loss rule contained in section 112(3.2) may reduce the capital loss if the redemption is funded with a capital dividend.  Under a tax planning strategy called the “50% solution”, the corporation would redeem 50% of the shares as a tax free capital dividend and would redeem the remaining 50% of the shares as a taxable dividend.  The corporation would keep the remaining unused capital dividend account for the benefit of the remaining shareholders (to avoid in effect “wasting” this portion of the capital dividend).  This strategy permits the estate to receive half of the redemption proceeds as a tax free capital dividend and avoids the application of the stop-loss rule in section 112(3.2).

The above description is only a snap shot of the tax rules.  These rules are technical and ever changing.  Tax advice must be obtained.

The estate must take all other steps that would normally be completed in connection with a sale of shares.  These steps might include the following:

·               Repayment of shareholder loans and any unpaid wages or salary.

·               Return of personal property owned by the deceased from the corporation.

·               Release of any personal guarantees signed by the deceased.

·               Execution and delivery of other documents in connection with the share sale

                 c.           Sale to a Third Party

The estate may have the responsibility to find a buyer for the corporation or its assets and to negotiate the sale to that buyer.  The estate may wish to engage an accounting firm or business broker to help package the business and solicit offers from potential buyers.  This process may take some time.  During that time, the estate must ensure that the corporation and business assets are properly managed to preserve value for the estate.

If the corporation owns an active business the board of directors will need to properly fulfill their responsibilities to manage or supervise the management of the business.  The executors may act as directors and/or officers and may wish to recruit other individuals, business persons or professionals to act as directors.  The board should take all steps to fulfill their fiduciary duties to the corporation and to manage their own personal risk.

                  d.           Wind-up of the Corporation

In some cases it may be best to wind-up or dissolve the corporation.  This decision may be driven by tax or non-tax considerations.

A wind-up may be the best way to reduce or eliminate the double taxation described above.  A wind-up may also make sense if the corporation is no longer needed.  For example, the beneficiaries may wish to dissolve an investment holding company and own the investments personally rather than through a corporation.  If there are two or more beneficiaries, such as siblings, they may wish to each own their own share of the investments separately.  This could be achieved by winding-up the corporation and distributing the assets, or possibly by separating the assets into a separate holding company for each beneficiary using the corporate reorganization rules in the Income Tax Act.

Planning Considerations

There are many planning considerations which flow from this discussion.

1.      Succession Planning.  Business owners should prepare a succession plan.  This may include training a management team or a successor who could take over management.  The management team or successor could be a potential purchaser of the business or could manage the business until it can be sold.  In some cases it might even be appropriate to sign a buy-sell agreement with a non-shareholder purchaser, such as a family member or other purchaser.

2.      Shareholders Agreement.  A shareholders agreement containing buy-sell terms should be considered if there are two or more shareholders of the corporation.

3.      Advance Tax Planning.  The shareholder should obtain tax advice now concerning the business structure and Will and estate planning.  For example, the shareholder should consider what techniques may be used to avoid the double tax problem and whether the corporate structure and Will should be designed or changed to accommodate that plan.

4.      Choice of Executors.  Executors should be chosen who will have the knowledge, time, experience and ability to carry out the tasks they will be expected to perform.  It might be appropriate to have a “special executor” who would only have responsibility for the corporation.  Professional trustees such as a trust company might be an option.  Any professional trustee (and indeed any third party trustee) should complete their own due diligence before accepting appointment as trustee.   That due diligence might be quite similar to the due diligence discussed earlier in this paper with respect to prospective directors.

5.      Will Drafting.  The Will should be drafted to facilitate the appropriate disposition of the shares and to minimize income tax.  The executors should be reminded to obtain tax advice as soon as possible during the first year of the estate.  If the will includes a spousal trust, it may be critical to permit the executors to delay the distribution to the beneficiaries after the spouse’s death in order to permit the spouse trust to dispose of its shares to realize a loss for deduction against the capital gain arising from the shares upon the spouse’s death.  The powers and authorities granted to the executors should be comprehensive and sufficiently detailed to include provisions to permit them to carry out the necessary corporate and tax planned transactions. For example, the following provisions may be appropriate to permit certain post-mortem tax planning to avoid double tax[4]:

a.       the ability to seek tax and professional advice;

b.      the power to sell, call in, exchange and convert any of the estates assets into other assets including cash, credit and securities;

c.       the ability to vote shares owned by the estate and elect the board of directors of any of the corporations owned by the estate;

d.      the ability to incorporate new corporations, and /or restructure, wind-up, or sell any corporations owned by the estate; and

e.       the ability to make elections and designations under the Income Tax Act.

The following additional powers and provisions might also be useful:

f.        the power to establish the value of estate assets from time to time by any method the executors and/or trustees choose;

g.       the right to transfer assets to the beneficiaries in specie and to allocate assets to the beneficiaries in any way the executors and/or trustees choose;

h.       the right of an executor and/or trustee to act as a director and/or officer and/or manager of any corporation or business of the estate has an interest and the right to be paid compensation in the usual way in addition to being compensated as an executor and /or trustee; and

i.         the right to be indemnified by the estate and/or any corporation in which the estate has an interest against all claims and losses arising from the office of executor or trustee or from the office of director or officer of any corporation in which the estate has an interest if that office is held because of the estate’s interest in the corporation, other than claims or losses arising from deliberate misconduct.

If there is a corporate trustee, the trustee may request the inclusion of additional powers.  The corporate trustee may also request a signed fee agreement which would normally be referred and attached to the will.  It is also good and usual practice to provide a draft will to the corporate trustee for review and comments before it is signed

6.      Post-Mortem Tax Planning.  The executors should obtain tax advice as soon as possible during the first year of the estate so as to have lots of time to implement any necessary tax planning during the first year.

Conclusion

Estate planning with private corporations can be very interesting and rewarding.  It can also provide estate lawyers with an excellent opportunity to spend more time with their tax and corporate law colleagues in the accounting and legal community.

Select Bibliography

1.             Bocock, Randall, The Swinging Pendulum of Directors’ Obligations and Liabilities:  Who Ought to be One and Who Ought Not?  Hamilton Law Association, November 29, 2007

2.             Christian, David, Post-Mortem Tax Planning, Canadian Tax Foundation. 2007 Conference Report.

3.             Kimberly Myers, Directors Statutory Liabilities, Aird & Berlis LLP – Business Law, April, 2003

4.             MacFarlane, Alex and Oliel, Michelle Advising Directors of Companies which are Insolvent or in the Zone of Insolvency, Fraser Milner Casgrain LLP.

5.             McNulty, Bryan T. and Weisman, Marc D.  Post-Mortem Planning to Avoid Double Tax on Death of Private Company Shares – Strategies, Traps and Solutions,  Law Society of Upper Canada 6th Annual Estates and Trusts Forum, 2003

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[1] Christian, David, Post-Mortem Tax Planning, Canadian Tax Foundation. 2007 Conference Report, page 37-2

[2] The discussion of tax strategies and rules in this paper is intended to highlight some of the basic principles but does not review all applicable tax rules and does not describe all steps needed to achieve the desired tax objectives.

[3] In addition, under 2004 amendments to the Income Tax Act the application of the stop-loss rule in 40(3.6) was restricted so that it will not apply to restrict a loss to the extent that the loss is deducted by the deceased in his or her terminal year tax return under section 164(6).  That amendment is helpful but does not solve all potentialproblems with section 40(3.6).  For example, the stop loss rule could still apply to a spousal trust.  The 2004 amendments also clarified that the identity of the trustee of a trust is irrelevant for the purpose of determining whether a trust is affiliated with a corporation and hence whether the stop-loss rule applies to shares owned by the trust.

[4] McNulty, Bryan T. and Weisman, Marc D.  Post-Mortem Planning to Avoid Double Tax on Death of Private Company Shares – Strategies, Traps and Solutions,  Law Society of Upper Canada 6th Annual Estates and Trusts Forum, 2003, page 5-52