Preamble: It is far beyond the ability of this short article to list all the problems and solutions regarding this subject. The objective of this paper is to bring awareness to the planning required and the potential problems that accompany poor planning. The following examples will assume that all the situations illustrated below involve one corporation and 2 shareholders, in an effort to keep it simple.
The Cross Purchase
In this situation, the surviving shareholder agrees to buy the deceased shareholder’s shares upon death. This is pretty simple. The purchase of these shares can be funded by cash, or by life insurance that is either owned by the corporation, or by the surviving shareholder. The surviving shareholder receives the life insurance proceeds tax-free, either directly, or by way of a tax-free capital dividend. He or she then uses the proceeds to purchase the shares from the deceased’s estate for fair market value. The deceased may realize a capital gain on death, but the shareholder’s estate does not incur a capital gain on the sale to the surviving shareholder.
Using this strategy, the corporation would redeem the shares of the deceased shareholder using life insurance proceeds and would designate the resulting deemed dividend as a capital dividend to the deceased’s estate. The capital dividend is received tax-free by the estate and reduces its proceeds of the disposition on the redemption to zero. The zero net proceeds result in a capital loss to the estate which can be carried back to the deceased shareholder’s terminal return and applied against the capital gain which happened as a result of death. The result of these transactions is a tax-free disposition by the deceased shareholder and the estate. This may work If the agreements and or policies were created prior to April 26,1995.
This strategy is similar to the Stop Loss Rules mentioned above, except that now the stop-loss rules allow that only 50% of the previously available capital loss can be claimed by the estate. This reduces the capital loss which can be carried back to the deceased shareholder’s terminal return. So, this means that that the capital gain that arose on the deceased shareholder’s death cannot be fully eliminated. This problem can usually be eliminated with proper planning.
The 50% Solution
Operates similar to the 100% capital dividend solution, except the dividend paid to the deceased shareholder’s estate is half capital dividend and half taxable dividend. This method is compliant with the stop-loss rules and offers greater tax savings to the deceased shareholder’s estate than a cross purchase method, but planning is needed to further reduce the tax payable.
The Spousal Rollover and Redemption
The deceased shareholder needs a surviving spouse. Upon the deceased shareholder’s death, the surviving spouse receives the deceased’s shares on a spousal rollover. The surviving spouse will then have a “put option” under the Unanimous Shareholder’s Agreement (USA) to require the corporation to purchase the shares. Alternatively, the corporation may have a “call option” to redeem or purchase the shares. Upon the sale or redemption, the corporation declares a tax-free capital dividend to the surviving spouse. This reduces his or her proceeds of disposition to zero. This eliminates the capital gain which the deceased spouse would have realized on a disposition. The stop-loss rules do not affect this strategy because no gain is realized on the deceased shareholder’s death to which the loss needs to be applied.