Donating and redeeming private corporation shares
Successful entrepreneurs and other wealthy individuals are increasingly looking at methods of “giving back” to society. Many donors choose to make significant donations during lifetime, so they can see their donations at work and enjoy the public recognition that often follows. There are, however, many strategies that can be used to benefit charities on an individual’s death, and a number of ways in which life insurance can be used as part of the planning.
There are simple methods of using insurance for philanthropic purposes. A policy can be donated to charity, with the donor receiving a tax receipt equal to the policy’s fair market value. A tax receipt is also available for premiums paid by the donor after the policy is gifted. Alternatively, the individual might decide to retain ownership of the policy and designate a charity as beneficiary. In that case, the tax relief comes at the time of death, when the estate receives a receipt for the amount of the proceeds.
More sophisticated planning is available to those individuals who own shares of private corporations. This involves the use of corporate-owned life insurance to fund a redemption of shares on death, the proceeds of which are used to benefit a charity of the shareholder’s choice (often a private foundation).
Consider the example of Herbie, a widower, who is the sole shareholder of a successful haberdashery, Herbie’s Hats Inc. (the “Corporation”). Herbie has built significant equity in the Corporation and eventually would like to use some of that wealth to support his foundation, The Herbie Fund (the “Foundation”). Herbie’s shares are worth $5 million and he would like to use these shares to fund a $1-million gift to the Foundation on his death. His insurance and tax advisors have suggested the following plan:
Herbie will convert his common shares into $5 million of redeemable and retractable preference shares. Properly planned and documented, the conversion of shares will take place on a tax-deferred basis. Herbie (or perhaps a family member or family trust) will subscribe for new common shares, which at that time will have no fair market value. These shares will reflect any future increase in corporate value.
• Herbie will amend his will to provide that, on his death, his estate will make a $1-million gift of the preference shares to the Foundation.
• The Corporation will acquire a $1-million permanent insurance policy on Herbie’s life. The Corporation will pay the premiums and be the beneficiary of the policy. There is an agreement between the Foundation and the Corporation that the insurance proceeds will be used to redeem the shares gifted by Herbie.
• Shortly after Herbie’s death, $1 million of preference shares will be gifted to the Foundation under the terms of his will. Immediately thereafter, in accordance with the above agreement, the insurance proceeds will be used to redeem the shares. No capital dividend is declared on the resulting deemed dividend. After the redemption, Herbie’s estate and/or his beneficiaries will be the only shareholders of the Corporation.
The tax consequences arising from Herbie’s death, and the gifting and redemption of his shares, are as follows:
• On Herbie’s death he will be deemed to have disposed of his preference shares for their $5-million value. Before taking into account the impact of the charitable donation, the tax liability relating to these shares will be in the range of $1.25 million.
• The Foundation will issue a $1-million tax receipt, which will result in approximately $500,000 of tax savings. The savings may be applied against capital gains tax and other taxes payable in Herbie’s final tax return. (Assuming Herbie’s estate is a graduated rate estate, it would also possible to use the tax savings in the year prior to his death, or in the taxation year of the estate in which the shares were donated.)
• The insurance proceeds will be taxfree to the Corporation. The amount of the proceeds less the adjusted cost basis (“ACB”) of the policy will be credited to the corporation’s capital dividend account (“CDA”). Assuming the policy has an ACB of zero, this will result in a CDA credit of $1 million. Insurance companies will be able to provide ACB information and projections for both in-force and new policies.
• The redemption of $1 million of preference shares will result in a “taxable” dividend being received by the Foundation. However, this will result in no tax payable, as the Foundation is a tax-exempt entity.
• The payment of a taxable dividend to the Foundation on the share redemption means that the Corporation’s $1 million CDA is unaffected. This CDA credit remains for the benefit of the Corporation’s new shareholders (Herbie’s family).
The use of life insurance has allowed Herbie to achieve his philanthropic goals on a cost-effective and tax-effective basis. It also allows him to benefit his family through the preservation of corporate assets and the creation of a CDA credit that will result in future tax savings.
This document is published by Advocis through its FORUM magazine.
GLENN STEPHENS, LLP, TEP, FEA,
is the vice-president, planning services at PPI Advisory and can be reached at firstname.lastname@example.org.