March and April are synonymous with tax, therefore we thought it was appropriate to discuss some potential tax traps for estates that deal with corporations (both operating corporations and investment corporations).
It is not uncommon for an estate to own shares in, and control a corporation. Such situations raise potential tax issues which may have significant implications for the estate, the executor and the beneficiaries. These tax traps may be avoided if one can recognize the pitfalls in advance.
Executor’s Liability under Income Tax Act (ITA) … and the Excise Tax Act (ETA)
It is well understood that the ITA requires the legal representative of an estate to obtain a clearance certificate before distributing property of the estate to the beneficiaries. To be clear, the executor does not need to obtain a clearance certificate prior to distributing and transferring property of the estate, however, he or she is well advised to maintain enough funds to pay for the estate and the deceased’s tax liabilities because he or she will be personally liable for any shortfall.
However, what is often missed is that the ETA also requires the legal representative of an estate to obtain a clearance certificate. The application for a clearance certificate under the ETA is a different form from the one under the ITA. Therefore, an executor who applies for a clearance certificate under the ITA could be under the false impression that he or she has complied with his statutory obligation when in fact, he or she only complied with one while not the other.
TIP: The above paragraphs are a good reminder how the executor would be well advised to ensure the corporation is keeping current with its fiscal obligations. How can the executor learn of the corporation’s tax status? Filing an application under the Access to Information Act requesting the corporation’s tax returns, notices of assessments or reassessments, any communication or correspondence between the CRA, the corporation and its director(s) will provide a good indication as to the corporation’s tax status and if there are any issue under both the ITA and the ETA.
Another thorny issue for an executor of an estate with an interest in a corporation is whether he or she needs to be appointed director of the corporation. The executor must act in the best interests of the beneficiaries, therefore, he or she has an obligation to familiarize themselves with the business of the corporation. As a result, the executor may have to exercise his or her voting rights to appoint himself or herself as a director of the corporation (the executor may appoint a nominee as director of the corporation, however, this raises several distinct issues for the executor).
Once appointed director of the corporation, the director assumes the duties of a legal representative of the corporation; with a higher standard of care as a director. Under both the ITA and the ETA, a director of the corporation has some statutory tax obligations and compliance requirements such as payroll deductions, tax obligations on payment to non-residents, and obligations to collect and remit HST/GST on taxable supplies made by the corporation, to name a few. Upon being appointed director of the corporation, the executor may be held personally liable for the tax obligations of the corporation arising after his or her appointment; in other words, the executor can only be held liable from the moment he or she is appointed director of the corporation and not for the liabilities that existed prior to his directorship.
TIP: From the moment an executor assumes directorship of a corporation, he or she must learn of (1) the corporation’s tax status, (2) the corporation’s filing deadlines and (3) whether the corporation already has a tax debt and if so, to take the necessary steps to rectify the situation. This is important as the executor could raise a due diligence defence if he or she can prove having “exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances”. However, the burden of proof is on the executor and he or she must show that he or she took positive steps to ensure that the corporation would meet its obligations.
Post-Mortem Tax Saving Strategies
The concept of “double or triple taxation” on death of a shareholder is often missed or misunderstood. Most estate practitioners understand the concept of the “deemed disposition” on death and the tax that may arise as a result of this deemed sale for the deceased. What is often missed or misunderstood is that in order to extract value from the corporation, the corporation may have to liquidate some or all of the assets it holds, which may trigger gains and tax in the corporation (double tax at this point). Following this, the after-tax corporate funds must be paid out to the shareholders, triggering another layer of taxation (triple tax).
The significance of post-mortem tax planning should not be underestimated by the executor and the advisors. This is especially true when one must remember that a trustee is expected to act as a person of ordinary prudence would act. This standard, of course, may be relaxed or modified by the terms of a will but, however wide the discretionary powers contained in the will, a trustee’s primary duty is preservation of the trust assets, and the enlargement of recognized powers does not relieve him of the duty of using ordinary skill and prudence, nor from the application of common sense. In other words, one of the duties of the executor is to maximize the value of the estate and minimizing the taxes ought to be considered.
There are three commonly used post-mortem strategies that may be considered (the loss carryback, the step-up/bump and/or the pipeline) to minimize or avoid the double taxation on the death of a shareholder. However, those strategies are complex and impose specific timelines to meet, specific statutory and administrative criteria to respect and one is only available on specific assets. Each of those post-mortem strategies carry their respective challenges and an executor should consult with a professional to assess the worthiness and appropriateness of each strategy.
The issue of double/triple taxation leaves the executor with the dilemma of assessing whether the tax savings resulting from one of those post-mortem strategies would be worth implementing; if one of those strategies would result in tax savings of $250,000, the executor may have an obligation to proceed in order to maximize the value of the estate. On the other hand, if the tax savings would only be a few thousand dollars, then such strategy may not be worth it. Nonetheless, this evaluation requires care and diligence on the executor’s part; after all, it may be his personal liability on the line.
TIP: An executor should always seek professional legal and accounting advice when a corporation is involved. Furthermore, the will should provide guidance and discretion to the executor.
Other Miscellaneous Tax Considerations
There are several other tax considerations that are worth reviewing with an executor. Here are a few:
(1) Lifetime Capital Gain Exemption (“LCGE”) - Has the deceased claimed his or her lifetime capital gain exemption? If the deceased owned shares that qualify for the LCGE and never claimed such exemption, the executor may have to ensure the LCGE is claimed. This can result in tax savings up to $835,000 for the estate in 2017.
TIP: An executor should always enquire with the deceased’s accountant to determine if the LCGE was ever claimed by the deceased and if not, whether the shares meet the requirements under the ITA in order to take advantage of the LCGE.
(2) Election for spousal rollover not to apply – Where any property is transferred to a spouse or a spousal/common law trust, the ITA deems the property to be transferred to the spouse on a tax-deferred rollover basis resulting in no capital gain/loss for the deceased. However, there may be instances where the executor may be well advised to elect out of the spousal rollover thus, having the transfer of property occur at fair market value. As an example, if the deceased has capital losses, the executor may want to trigger some capital gains to be able to use those losses. Another example is if the capital gain is eligible for the LCGE, the executor should ensure the spousal rollover does not apply in order to claim the LCGE.
TIP: The executor should review all assets and property of the deceased and elect on a property per property basis as to whether to make the election for the spousal rollover not to apply.
(3) Is it capital or income? There are instances where a transaction is considered income from a tax perspective, but considered a return of capital from a trust perspective. As a result, determining whether a transaction is accounted for as income or capital is important; especially in the context of a trust where a beneficiary in only entitled to the income. As an example, a shareholders agreement stipulating that the corporation will buy-back the shares of a deceased shareholder will trigger dividend income for tax purposes, but will be considered a return of capital from a trust perspective. In the context of blended family where the will provides a spousal trust where the spouse is only entitled to income, the determination of whether a transaction is capital or income is crucial.
TIP: The lawyer drafting the will should define income.
The above enumerates a few tax traps for the executors and the beneficiaries. Lawyers, accountants and professional advisors must recognize that an estate controlling and administering a corporation has unique tax considerations and opportunities to consider. Furthermore, the ITA has numerous specific sections dealing with taxation at death and these tax rules get more technical when a corporation is involved. As estate advisors, we ought to keep ourselves current with the changes of the tax rules in order to navigate through these “tax traps” when advising executors; this difficulty only increases when a corporation is involved since we are dealing with two different taxpayers with different set of rules.
About the author
Sebastien G. Desmarais, LL.B., J.D (USA), LL.L. TEP, Pryor Tax law