Consequences of failing to plan for death.
You may have heard the saying, if you fail to plan, you are planning to fail. This is the story of Canadian taxpayers who fail to plan for the inevitable, sacrificing significant amounts of their estate value that could have been transferred to the next generation.
Yes, you may have heard the cliché that two certainties in life are death and tax. But did anyone tell you, you may have to pay a significant sum of your life savings in tax on death! This may be the case if you decide to pass on your wealth to your children. If you had a successful corporation, well, congratulations, but you might have to pay close to 75% of that value in tax on death. That is not a typo; 75% of your wealth could disappear in taxes, leaving 25% of the remaining wealth to your children. To add insult to injury, the enormous tax burden can cause the estate to sell many of the assets in the corporation to be able to pay this tax.
So how is it possible that 75% of the wealth can be erased on death? Let’s look at an example. Consider an entrepreneur who has established a company worth $10 million. Her two children are heavily involved in the business since completing University. She decides not to consider a plan to deal with the transition on her death, thinking that she has a Will, and all is good. Her Will specified the shares of her operating company would be given to the children. The unforeseen and unthinkable happens, and she passes away.
If you had a successful corporation, well, congratulations, but you might have to pay close to 75% of that value in tax on death.
The first level of tax is triggered on death: Her estate will be expected to pay, $2.6 million, or 26% of the value of her company as capital gains. However, as the estate has no free cash to pay the tax, the estate may have to obtain funds from the company it now controls.
The second level of tax is triggered on the distribution of funds from the company to the estate. Eventually, the corporation will have to distribute the $10 million of cash in the corporation as a taxable dividend. This will result in the estate having to pay $4.8 million or a 48% tax on dividends.
The resulting double taxation amounts to a 74% tax rate by the time the value of the estate has been taxed and distributed. As you can imagine in certain circumstances, the children will not be able to continue the business as the company would have to be liquidated to pay the tax liability.
The good news is that there are options to reduce the tax burden on death. Tax advisors use several techniques; family trusts set up during lifetime and passing along the wealth, life insurance, and post-mortem plans, including pipeline planning. There might be other options you can consider.
It should be in your best interest to have your children continue the business; if so, it is advisable that you learn from the example and not turn your success into your own tax horror story.