Today, I would like to share an excellent article written by Tim Cesnick published in the Globe and Mail.
Business owners: Keep your business income all in the family!
There are a lot of things I want to pass along to my kids. My love for hockey is one of those things. I’ll admit it: I’m a fanatical hockey dad. How fanatical you ask? Well, consider that each of my kids learned to shoot with a hockey stick before they could eat with a fork.
Next to a passion for hockey, there are other things I’d like to pass on to my children. The cottage, for example. Shares of my holding company, for another. The trick is to avoid tax traps while making these transfers. Today, let me share one of those common traps, and how to avoid it.
The story
Consider Mary. Mary owns a cottage with a value of $700,000, and for which she paid $200,000 many years before. While she still uses the cottage in the summers, her son Mitch uses it much more. She has felt for some time now that she’d like to transfer ownership of the cottage to Mitch. Last year, she did just that.
Specifically, Mary sold the cottage to Mitch at a very favourable price – just $100,000. It was an amount Mitch could afford. The problem is that Section 69 of our tax law deems Mary to have sold the cottage to Mitch for the true fair market value of $700,000. The result? Mary paid tax as though she had sold the property for $700,000, which triggered a tax liability of $116,025 (at the highest marginal tax rate on capital gains in Ontario in 2010; Mary is preserving her principal residence exemption for her city home).
What about Mitch? His adjusted cost base for tax purposes remains at $100,000 – the amount he paid. So, if he were to sell the property for its fair market value of $700,000, he’d pay tax on a $600,000 capital gain. This is a double tax problem, because Mary has already paid tax on the $500,000 gain in value from $200,000 to $700,000. Yikes. This is not good planning.
The solution
What could Mary have done differently? Mary could have instead gifted the cottage to Mitch. This would have still triggered a capital gain for her, but Mitch’s adjusted cost base would be the current fair market value of $700,000. Alternatively, Mary could have sold the cottage to Mitch for the full fair market value of $700,000, and taken cash for $100,000 (which is all he could afford) and taken back a promissory note, or a mortgage, from Mitch for the balance. She could then forgive the promissory note or mortgage at the time of her death with no negative tax consequences. I like this latter alternative because Mary could also have deferred tax on much of the capital gain by taking advantage of the “capital gains reserve” provision in our tax law. This provision allows a taxpayer to pay tax on a capital gain over a period as long as five years when the sale proceeds are not fully collected in the first year.
Other stories
There are other examples where this tax trap can catch you. Suppose, for example, you own shares in an operating company with a value of $1-million, and your adjusted cost base is nominal – assume zero. Suppose you want to transfer ownership to a child and do this by selling your shares to your child’s holding company for, say, $750,000. Perhaps your plan is to claim the capital gains exemption to shelter the $750,000 capital gain from tax.
Your problem? You guessed it. Section 69 deems your selling price to be $1-million, but your child has an adjusted cost base in the shares of just $750,000, which creates a double tax problem if your child ever sells the shares for more than $750,000. In this case, there’s a second problem: The transfer to your child will not be taxed as a capital gain (and therefore can’t be sheltered using the capital gains exemption) but rather will be deemed to be a dividend because of Section 84.1 of the Income Tax Act.
In this case, an estate freeze could have worked to transfer ownership to your child (I’ve talked about estate freezes before)
The moral of the story? Any time you want to transfer assets to others – particularly those related to you – get professional tax help.
