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Stop Loss Rules

Stop Loss Rules. Agenda. Overview What are Stop Loss rules? What is their effect? Examples Solutions. Stop Loss Rules I ncome Tax Act ss.112(3.2). What are they? Rules that impact business and estate planning where… Method used is corporate share redemption

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Stop Loss Rules

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  1. Stop Loss Rules

  2. Agenda • Overview • What are Stop Loss rules? • What is their effect? • Examples • Solutions

  3. Stop Loss RulesIncome Tax Act ss.112(3.2) • What are they? • Rules that impact business and estate planning where… • Method used is corporate share redemption • Funding is with life insurance

  4. Stop loss rulesIncome Tax Act ss.112(3.2) • What’s the effect? • Assuming the rules apply to a share disposition by the estate…. • Double tax exposure • Estate loss reduced by up to 50% of capital dividend • Capital gain taxed on terminal return is increased • Double taxation occurs because…. • Surviving shareholders receive NO ACB increase • The gain is taxed in hand’s of deceased • The gain is taxed again when surviving shareholder disposes of shares

  5. Company Profile • XYZ Inc. • FMV = $2,000,000 • Owners • John owns 50% of shares • ACB of John’s shares $10,000 • PUC of John’s shares $10,000 • Mary owns 50% of shares • ACB of Mary’s shares $10,000 • PUC of Mary’s shares $10,000

  6. Company Profile • Growth rate of company 2% • Personal marginal tax rate on income 50% • Personal marginal tax rate on dividends 33% • Capital gains inclusion rate 50% • Assume John died last night • Assume Mary sells the business in 10 years

  7. 50% XYZ Inc. Premiums Agreement 50% Share Redemptionwith corporate owned insurance • XYZ Inc. buys $1,000,000 of life insurance on John’s life and$1,000,000 of life insurance on Mary’s life

  8. John dies Share redemptionwith corporate owned insurance

  9. $1,000,000 To purchase shares XYZ Inc. John’s estate $1,000,000 Death Benefit 2 1 3 As per Buy-Sell Returns shares XYZ Inc. For cancellation Share redemptionwith corporate owned insurance

  10. Share redemptionwith corporate owned insurance • Taxation • Premiums paid by corporation are a non-deductible expense • Proceeds received by the company are tax-free • Proceeds in excess of ACB are credited to the CDA • Proceeds received by the shareholder’s estate in excess of the PUC deemed a dividend. The dividend could be elected as a capital dividend • Advantages • After-tax premium cheaper if the company is in a lower tax bracket • Fewer policies are required (one per shareholder) • Premium disparities are not an issue • Disadvantages • No increase in the ACB for the surviving shareholder • Insurance proceeds subject to claims from the company’s creditors

  11. Share redemptionwith corporate owned insurance Mary now owns 100% of XYZ Inc.

  12. Tax Implications – John *Exemptions may help shelter

  13. Tax Implications – John’s Estate

  14. Tax Implications – Mary *Exemptions may help shelter

  15. Stop Loss Rules • Prior to the introduction of these rules, it was possible to eliminate all tax on the disposition of shares for a deceased shareholder • The department of finance determined that this was an unwarranted deferral of capital gains tax and introduced the legislation • The Stop Loss rules apply to transactions after April 26, 1995

  16. The lesser of The capital dividend received by the estate, and The capital loss minus any taxable dividends received by the estate Minus 50% of the lesser of The deceased’s capital gain from the deemed disposition on death, and The estate’s capital loss The lesser of $990,000 $990,000 – 0 = $990,000 *$990,000 $990,000 – (0.5 X $990,000) =$495,00 Calculating the loss stopped • Minus 50% of the lesser of *Exemptions may help shelter

  17. Tax Implications – JohnPre-April 26, 1995 vs Post-April 26, 1995 *Exemptions may help shelter

  18. Tax Implications – John’s EstatePre-April 26, 1995 vs Post-April 26 1995

  19. Tax Implications – MaryPre-April 26, 1995 vs Post-April 26 1995 *Exemptions may help shelter

  20. Grandfathering Opportunities • Where a corporation was the beneficiary of a life insurance policy on the life of a taxpayer, on or before April 26,1995, where the main purpose of the insurance was to redeem shares held by the taxpayer grandfathering will be available • Applies even if coverage is increased • Policy is converted or replaced • Policy lapses and is reinstated

  21. Grandfathering Opportunities • It is up to the taxpayer to provide CCRA with ample documentation to prove that the main purpose of the life policy was to redeem shares

  22. Grandfathering Opportunities • Grandfathering will also be available for agreements that were in place prior to April 27, 1995 • As long as the agreements are not modified in any way

  23. One way to reduce the effects of the Stop Loss Rules is to use the Hybrid Method

  24. Hybrid Methodwith corporate owned insurance • The insurance would be corporately owned but the agreement would allow flexibility in determining at death how many shares would be purchased by the surviving shareholders and how many shares will be redeemed by the corporation.

  25. 50% XYZ Inc. Premiums Agreement 50% Hybrid Methodwith corporate owned insurance • XYZ Inc. buys $1,000,000 of life insurance on John’s life and$1,000,000 of life insurance on Mary’s life

  26. John dies Hybrid Methodwith corporate owned insurance

  27. $500,000 To purchase shares XYZ Inc. John’s estate $1,000,000 Death Benefit 2 1 3 As per Buy/Sell returns 50% of shares XYZ Inc. For cancellation 4 5 As per Buy/Sell returns 50% of shares to Mary 7 $500,000 Promissory note To purchase shares XYZ Inc. declares a capital dividend of $500,000 Mary Now owns 100% of XYZ Inc. Mary Hybrid Methodwith corporate owned insurance

  28. Tax Implications – John *Exemptions may help shelter

  29. Tax Implications – John’s Estate$500,000 of shares redeemed

  30. Tax Implications – John’s Estate$500,000 of shares sold

  31. Tax Implications – Mary *Exemptions may help shelter

  32. Hybrid Methodwith corporate owned insurance • Taxation • Premiums paid by corporation are a non-deductible expense • Proceeds received by the company are tax-free • Proceeds in excess of ACB are credited to the CDA • Proceeds received by shareholder’s estate in excess of PUC deemed to be a dividend. The dividend could be elected as a capital dividend • Advantages • After-tax premium expense cheaper if company is in a lower tax bracket • Fewer policies are required (one per shareholder) • Premium disparities are not an issue • Surviving shareholder gets an ACB step up • Disadvantages • Insurance proceeds subject to claims from the company’s creditors • Somewhat complicated arrangement

  33. Comparing the Strategies • Results for each of the relevant parties

  34. Tax Implications – John Share Redemption Hybrid *Exemptions may help shelter

  35. Tax Implications – John’s Estate Share Redemption Hybrid

  36. Tax Implications – Mary Share Redemption Hybrid *Exemptions may help shelter

  37. Total Tax Payable Share Redemption Hybrid

  38. Summary • Both strategies have their pros and cons • Corporate redemption is better from John’s perspective • Hybrid from Mary’s • The best strategy • see if the client can benefit from grandfathering

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