When you die, there is normally a deemed disposition of all your capital assets at fair market value (FMV) as at the time of your death. This includes things such as your house, investments, shares of private companies, and personal effects.
This can result in huge income tax liabilities for your estate and heirs, as the capital gain on some of these items could be quite large.
However, there are a number of provisions in the Income Tax Act (ITA) to reduce, defer or avoid income taxes on death. For example, the principal residence exemption allows you to avoid tax on the deemed disposition of your house. Most personal effects will not be subject to capital gains taxes because a) they haven’t gone up in value, or b) the ITA generally won’t tax you on any gains for items worth less than $1,000.
Another important consideration is that generally speaking, when one spouse dies the deceased can transfer capital assets to the surviving spouse at the original cost. What this means is that the capital gains tax is effectively deferred until the second spouse passes away.
However, if you die owning shares of a private company the rules get a little more complicated and could result in double taxation – a very unhappy financial hit at a very difficult time for the family.
The best way to explain this is by using an example.
Suppose the deceased spouse was a doctor who has built up investment assets inside a corporation (formerly a professional corporation) worth $1,000,000. Also, let’s assume that the doctor originally paid $100 for the 100 shares in this corporation and there are no other assets or liabilities and the value stayed at $1,000,000 at the time of the second spouse’s death. On the second spouse’s death there would be a deemed disposition at FMV of $1,000,000. The capital gain would be $999,900 on this gain ($1,000,000 less $100 original cost) and there would be a large amount of capital gains taxes to pay. This is the first tax.
Because the investment assets are inside a corporation and remain inside a corporation on the deemed disposition on death, the estate and the beneficiaries have to get the funds out of the corporation. The only way to do that is through dividends, which result in taxes again. In this example, the estate would have to dividend out $1,000,000 from the corporation, resulting in a second level of tax. So, there has been tax paid on $1,000,000 twice, first as a capital gain, the second as a dividend.
Let me use the same figures I used in the scenario above, to illustrate how you can avoid this double-tax on death.
Step 1: There is a deemed disposition for a $999,900 capital gain on the date of death tax return (sometimes called the terminal return). This is the same as in the above example.
Step 2: Once the person passes away, the shares of the corporation go into the estate. The estate is a separate legal entity (a trust) and is deemed to have acquired the shares for their FMV of $1,000,000. So, this becomes the deemed cost base of the shares of the company for the estate.
Step 3: The Corporation buys back the 100 shares owned by the estate for $1,000,000, which results in a deemed dividend for the estate of $999,900.
Step 4: The estate has a capital loss as follows: the proceeds equal the FMV of the shares $1,000,000 less the deemed dividend of $999,900, so the net proceeds are deemed to be $100. From this you subtract the deemed cost base of the shares, which is $1,000,000 (see step 2 above) resulting in a capital loss in the estate of $999,900.
Step 5: The estate trustee must file an election under Section 164(6) of the ITA that allows the estate to carry back this capital loss to the date of death tax return. This election form must be filed within the prescribed time, and in the prescribed manner.
Step 6: The date of death tax return must be amended, so that the $999,900 capital loss from the estate completely offsets the capital gain of $999,900 from the deemed disposition on death above. This results in zero tax on the date of death tax return.
At the end of the day, the only tax owing was the $999,900 deemed dividend in the estate. So, in essence, tax is only paid once rather than twice.
One caveat is that the estate only has one year end to carry out all six steps as detailed above. The impact of this is that the estate trustee should choose a year-end for the estate that is one year (or close to it) from the date of death. For example, if the taxpayer dies on October 25, 2011, the trustee should choose a…