How to avoid double taxation on the death of a shareholder

Post-mortem tax planning is important for a deceased shareholder who held shares of a private corporation at the time of death. This is because there is double-taxation at the time of death. First, there is tax (on the capital gain) arising from the deceased taxpayer’s deemed disposition of the private corporation shares at the time of death at fair market value, and secondly for the beneficiaries when they attempt to remove corporate assets. This removal of corporate assets is generally taxed as a dividend to the new shareholders.

A “pipeline strategy” attempts to avoid the payment of tax on this deemed dividend to the estate, but leaves the capital gain on the deceased’s terminal tax return, so you avoid paying the higher rate of tax that would apply on the dividend income to the estate.

In general, this is done by incorporating a new company (“newco”) and transferring the shares from the estate to the “newco” in exchange for a promissory note of the same value. The existing corporation, or “opco”, will then repurchase the shares that are held by “newco”, which will trigger a deemed dividend that will be received by “newco”without tax consequences. “Newco” will then repay the promissory note to the Estate.

In sum, the intended result is that the deceased will be taxed on the terminal return at capital gains rates which are generally favourable to dividend rates, and the Estate receives the corporate assets (i.e. cash or assets without an accrued gain) without tax. However, it is important to review the technical provisions of the Income Tax Act when using a “pipeline” strategy to ensure the plan will achieve this objective.