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tax matters

As I was sitting on our dock last weekend with my son – my first born – the conversation somehow turned to gifts he'll receive when I'm dead and gone. "Dad, can I have your Wayne Gretzky rookie card?" he asked. "Nope." I replied. "I'm leaving you with my finger-shaped nose hair trimmer. That's it. Your sister is getting the unicorn oil painting, and your brother is getting my lunch box collection. The rest of our stuff is going to charity. Oh, there's something else I could leave you, but I won't – and you'll thank me for it." "What's that Dad?" he asked. "A whopping tax bill. I've looked after it for you."

"Dad, you're too generous."

Although my kids don't appreciate it just now, they'll thank me for the tax planning we've put in place that will result in a much bigger inheritance for them. Today, let me share with you the highlights.

The problem

If you're the proud owner of a holding company that has grown in value, or is expected to grow, you have a triple-tax problem to think about. You see, when you die and your kids (or people other than your spouse) inherit your assets, you'll generally be deemed to have sold those assets at fair market value. If you leave your assets to your spouse when you die, then this tax hit will generally be deferred until your spouse's death. But the taxman is coming eventually.

In the case of holding companies, here's the triple-tax problem: When you die, you'll be deemed to have sold the shares of your holding company that you own, which can cause a tax hit. Next, if the assets of the corporation have appreciated in value, there can also be tax inside the corporation when those assets are sold. Finally, tax will generally be payable by your heirs when they withdraw assets from the corporation to use personally. These three levels of tax can result in much more tax than necessary.

The strategy

A plan called the "pipeline strategy" can work to eliminate one of those three levels of tax. In particular, it can allow your heirs to withdraw the assets of the corporation in a tax-efficient manner after you're gone. There are other strategies, but this one works best where the assets inside the corporation are tax paid – that is, where there is not a significant accrued capital gain on the assets inside the corporation.

Take me as an example. Suppose I own a holding company (TimCo) with assets of $1-million in cash (in case my kids are reading: Don't start jumping to conclusions, it's just pretend). The shares of TimCo that I own, then, are worth $1-million, but my adjusted cost base (ACB) in those shares is a nominal amount, say, $100 – which is common. My kids are going to inherit these shares of TimCo (in addition to the nose hair trimmer) when Carolyn and I are both gone. At that time, the TimCo shares will be deemed to have been sold for their fair market value of $1-million, which will trigger a capital gain of $999,900 and a tax bill.

My kids will inherit the shares, and the ACB for my kids will be $1-million (the value of the shares on the day they inherit them). Now, here's the best part. The kids will now sell the shares of TimCo to a new corporation they create (Newco). They'll sell the TimCo shares to Newco for $1-million, and take back a promissory note worth $1-million as payment. There will be no capital gain, and no tax, on this sale to Newco because their ACB is $1-million. Get it?

At that time TimCo will then be owned by Newco. TimCo will pay its $1-million in cash as a dividend to Newco. This is a tax-free inter-corporate dividend. Tax free is good. Finally, Newco will take the $1-million in cash and pay off the promissory note of $1-million it owes to the kids. The kids will receive this $1-million tax free out of Newco because it's a repayment of a loan owed to them. Presto – the kids have extracted the $1-million in cash from TimCo tax free. We've managed to eliminate one layer of tax upon death.

Speak to a tax professional about this strategy – and other ways to eliminate the triple-tax problem you may face if you own a holding company.

Special to The Globe and Mail