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Planned giving and the private corporation, part 1

by Robert A. Kleinman C.A.,
May 15, 1996; Canadian FundRaiser

(Part One of a two-part report)

The term "planned giving" connotes the act of charitable giving in a thought out, "planned" manner which presumably considers the particular attributes and desires of the donor. In the parlance of modern marketing theory, it attempts to exploit "the market of one" for charitable purposes.

As Canadians, we may view the American experience in planned giving with some envy, as many American charities appear to have not only created particular tax- and financially-efficient planned giving products but also succeeded in increasing their charitable receipts by using these methods. Terms such as deferred charitable gift annuity, pooled income fund, charitable remainder unitrust, grantor lead unitrust and others have become part of the lexicon of charitable giving and to a certain extent of American society. This success is due to a number of factors, including a tax system which is more benevolent to charities. However, what is sure is that American charities have taken advantage of the tax benefits by understanding the needs of the consumer - the donor - and creating products and mechanisms to fit those needs.

Canadian products and mechanisms must reflect the needs of Canadian donors, in many ways quite distinct from the American experience. The Canadian private company, for example, is an entity which is used by many Canadians to amass substantial wealth, quite differently than its use in the United States. An exploration of its characteristics can help us find the mechanisms for charities to obtain funds from the company in a planned and sensible manner.

Inter corporate fund transfers and integration provide the basic concepts
Corporations are excellent tools to act as business hosts, and perhaps their most desired benefit is limited liability. Shareholders own the company, and via their control of the board of directors and, through the board, of officers of the company, e.g. the president, effect control over its operations. However, the corporation is legally distinct from its shareholders. The acts of the company are not the acts of its shareholders, and thus the shareholders cannot be held responsible for the corporation's activities. For example, if a corporation produces a product which is harmful and in fact causes death, the corporation will be sued. The shareholders, however, generally cannot be held responsible, thanks to the principle of limited liability.

Limited liability is not an attribute special to Canadian corporations, but the Canadian tax system does offer special laws which allow for the accumulation of wealth in corporations. There are two distinct reasons why private corporations in Canada are more used to amass wealth than their counterparts in the USA: the ability to move funds intercorporately free of tax, and the theory of integration.

Tax-free dividends in `connected' corporations
The Income Tax Act, Canada is separated into Parts. Canadian taxpayers remit tax under Part 1, which requires the calculation of net income and taxable income. Based on particular tax rates and credits, a calculation of individual or corporate taxes payable is made.

Dividends received from Canadian corporations by Canadian corporations, although forming part of net income, are effectively not taxed under Part I due to a special deduction in arriving at taxable income. Canadian dividends are taxable under Part IV of the Act at a rate of 33 1/3%. However, if the payor and recipient corporations are "connected" with each other, this tax is not applicable. Simplistically, connected corporations are those where one controls the other or where one owns more than 10% of the votes and values of the shares of the payor corporation. Simply stated, if one corporation has a substantial investment in the other dividends received are tax-free.

Integration of individual income
Canadian tax law is based on a concept known as integration. The theory is that the final amount retained by a Canadian individual on income earned should be the same regardless if the income is earned directly or earned via a corporation. Thus tax rates are set to attain this goal. Assuming a top tax rate of 50%, an individual would retain $50 for every $100 of interest income earned. If the same income was earned in a corporation, theoretically the individual would still retain $50, via a system of rates which would entail both the corporation paying tax on the income and the individual remitting tax on the dividend received from the company.

However, up until 1995, it was clear that even if the absolute tax was the same, a tax deferral was created by allowing the tax to be paid in the corporation and not moving the funds to the individual. Since corporate tax rates are lower than individual tax rates most Canadians retained their money within the corporation. In essence, as long as corporate earnings were to be reinvested and not needed personally, it was advantageous to reinvest within the corporation. This deferral is completely different in the USA, where corporate taxes can equal or top personal rates. Accumulated earnings within a corporation are taxed unlike Canada. In fact, these factors led to the development of the America "S" Corporation, whose income is taxed directly in the shareholders' hands, although the corporation still hosts the business for limited liability purposes.

Canadian wealth tied up in holding companies
The ability to pay tax-free inter corporate dividends, the tax deferral and the corporate limited liability attribute has led to the development of the holding company in Canada. Owners of operating companies (OPCOS) wishing to protect excess earnings transferred the ownership of their shares in OPCOS to newly incorporated companies which became the parent companies of the OPCOS.

These holding companies (HOLDCOS) received tax-free dividends from the OPCOS. The movement of wealth to the HOLDCOS allowed for a separation of assets from the OPCOS. If ever a business setback would occur in OPCO, wealth would still be kept separate in HOLDCO. Usually HOLDCO was used for diversification, perhaps holding real estate or investing in the stock market. Unlike the U.S., wealthy Canadians have their assets tied up in these companies.

The tax problem comes full-circle at death
Again, unlike the U.S., Canada does not impose succession taxes. However, the Income Tax Act, does impose a special deemed disposition of assets upon death. This disposition results in tax paid on assets which have appreciated in value over the course of ownership by the deceased. The basic exception to this disposition occurs if the assets in question will be transferred to the spouse or a spouse trust, in which case, tax is imposed on the death of the second spouse.

As previously discussed, many Canadians maintain their wealth within HOLDCOS. The advantage of tax deferral, however, comes full circle upon death. All that value within HOLDCOS and OPCOS becomes taxable. The generation that amassed incredible wealth in the 60's, 70's, and 80's, as they pass away, will be left with huge tax bills.

Can our Canadian charities recognize this problem and offer product to meet the needs of this generation?

The theoretical solution: reduce the assets prior to death
The key lies in how the Act reads in prescribing when to calculate the deemed disposition. The Act prescribes that the deceased be deemed to dispose of his/her assets immediately prior to death. The proceeds of disposition is `equal to the fair market value of the property immediately before the death'. The solution would therefore be to reduce the value of assets before death and to replace the capital with assets received after death. The charity will help the donor reduce the value of assets prior to death; insurance will be used to replace the capital after death.

Insurance proceeds received upon death are received tax-free. If the corporation owns a policy upon the deceased the proceeds from the policy will not be included in the value of the deceased's shares for deemed disposition purposes as the policy is not payable immediately prior to death. If, however, cash surrender value (CSV) is attached to the policy, this CSV will be included in the value of the shares for deemed disposition purposes.

Assume Mr. A owns Co. B which he has used to hold a diverse group of assets which is valued at $10 million. His adjusted cost base (ACB) in Co. B is insignificant and therefore the potential tax on the death of both Mr. and Mrs. A could be calculated as follows: proceeds of $10 millions less a nil ACB leaves a $10 million capital gain. 75% of this gain is taxable and at a top marginal tax rate of 52% the potential tax is $3,900,000 or 39% of the value.

Further assume that Co. B makes a gift of $1 million to charity C. The first result is that upon the death of the As, $390,000 of taxes are saved. Let's also assume that Co. B can use the charitable donation receipt to reduce its taxable income over a six-year period. Assuming that it is investment income on which tax is saved, the tax savings will yield a total of $500,000 over the six-year period.

Further assume that Co. B purchases an insurance policy on a last-to-die basis on the lives of Mr. and Mrs. A. The policy is for a face value of $1 million, and will be paid-up over six years at a total cost of $250,000 (50% of the tax savings).

On death of the As, the value of the Co. B shares will not include the $1,000,000 donated to the charity but will include the CSV on the policy, which we assume is $100,000. Thus $351,000 of tax will be saved. The company will receive $1,000,000 of tax-free insurance proceeds which in effect replaces the capital utilized to fund the donation. A portion of the proceeds (in this case, the proceeds of $1 million less the ACB of the policy, say $250,000 or $750,000) will form part of the capital dividend account of Co. B and could thus be passed out to the estate free-of-tax.

Creating a major gift without a loss of capital
To summarize, $500,000 of tax savings due to the donation deduction less the insurance cost of $250,000 or a net benefit of $250,000 was earned. Taxes on death of $351,000 were saved. Finally, the $1 million gift was replaced by the insurance policy.

The donor has effectively created a major gift without a loss of capital. He has, however, lost the use of the $1 million during his lifetime. Event this concern can be overturned, however, by labeling the gift a "ten year gift" pursuant to the Income Tax Act. The Act prescribes that a charity must spend a minimum of 80% of receipted gifts from a previous year. However, the Act also sets out an exception for gifts labeled ten-year gifts by the donor. In essence, the donor restricts the charity from disbursing the capital gift for a minimum of ten-years.

In this way, the $1 million can be treated as an endowment, the interest upon which will be used for charitable purposes. The donor can therefore direct the recipient charity to use the interest to make his annual gift to that charity. If the charity is a community foundation, all of his annual charitable giving can be effected in this manner. Thus, although the capital has been transferred to the charity it is still being used by the donor during his lifetime.

The Insured Annuity can reduce taxes and fund a significant charitable gift
The insured annuity is a popular investment product. The investor in his sixties or seventies is sold on the premise that investing in term deposits yields significantly lower after-tax returns than converting the term deposit into a life annuity and using a portion of the annual annuity proceeds to fund a life insurance policy to replace the capital used to purchase the annuity.

This investment technique can be beneficial in the corporation as well, not only as an investment technique, but also to reduce taxes on death and to help fund a significant charitable gift.

Assume Co. D owned by Mr. W, holds a term deposit of $1 million invested at 7%. Based on current tax rates on investment income (reviewed later in this article) Co. D retains $35,000 a year after tax. Co. D purchases a life annuity of $120,000 year on the life of Mr. W with the $1 million. When receiving the annuity, $75,000 is considered a return of capital and $45,000 taxable interest.

The company will receive the $120,000 annually and spend the proceeds as follows:

1. Purchase a $1 million life insurance policy on the life of Mr. W for an annual premium of $45,000.
2. Purchase another identical policy assigning charity B as beneficiary (Co. D will be allowed a $45,000 charitable deduction to apply against the $45,000 of annual interest income.).
3. Retain $30,000 after tax, which compares to the $35,000 after-tax return earned previously via the term deposit.

The consequences:

1. Co. D has removed $1 million from its balance sheet and replaced it with an annuity receivable. The shares deemed to be disposed of on Mr. W's death will be valued that much less, with the possibility of significant tax savings (perhaps $200,000 to $400,000);
2. the $1 million of capital is replaced with tax-free insurance proceeds, most of which will add to the capital dividend account of Co. D and be distributed tax-free to the estate or beneficiaries;
3. the charity received $1 million in memory of Mr. W; and
4. the cost is effectively $5,000 annually.

Note: A variation of the above occurs if the second insurance policy is left in the company.

Robert A. Kleinman C.A., Jewish Community Foundation of Greater Montreal.

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