A fourth strategy to deal with double taxation of your shares also requires the windup of your professional corporation within one year of your death to create a capital loss to offset your capital gain. Your capital gain is eliminated and only a deemed dividend remains. The steps required for an effective wind-up are also described in the previous article, entitled “Estate Planning for Healthcare Professionals: Part 3 – Double Tax Planning Strategy “Windup” Corporation Within the First Year”.
To improve the tax result further, a life insurance policy held in your professional corporation allows some, or even all, of this deemed dividend to be paid tax-free, which increases the after-tax value of your estate.
The “life-insured windup” strategy works as follows:
- As an incorporated medical professional, your life insurance will typically be owned, and paid for, by your professional corporation. For simplicity, let’s say your professional corporation’s only asset is an insurance policy with a cash value and a death benefit of $5 million. For tax purposes, the value of your shares is $5 million (i.e., the policy’s cash value). The deemed disposition of your shares at death triggers a capital gain of $5 million on your final tax return. The adjusted cost base (“ACB”) of the shares increases to $5 million, which ensures the $5 million value already taxed in your hands will not be subject to tax again.
- Your professional corporation receives the $5 million proceeds from the life insurance policy tax-free. In addition, its capital dividend account (“CDA”) is credited with $5 million, which is equal to the insurance proceeds less the policy’s adjusted cost basis, if any. The CDA credit allows subsequent dividends paid from your professional corporation to be received by your estate tax-free, up to the amount of the $5 million CDA credit.
- Next, your professional corporation is “wound up”, meaning it is dissolved and its assets distributed to its shareholders (i.e., your estate). The distribution has two tax results.
- First, it triggers a deemed dividend equal to the value of the assets distributed (i.e., $5 million). However, your estate receives the deemed dividend tax-free because the corporation can use its $5 million CDA credit to elect that the deemed dividend be a tax-free capital dividend.
- Second, the wind-up triggers a disposition of the shares by your estate at their fair market value, which creates a $5 million capital loss. The loss is determined as the proceeds of disposition minus the deemed dividend minus the share’s ACB. Provided the loss is realized within one year of death, your estate can apply its capital loss against the capital gain on your final tax return. Accordingly, you do not pay any tax on the capital gain.
The result of the insured windup is the elimination of both the taxable capital gain on your final return and of the taxable dividend to your heirs.
Note that, for simplicity, this example does not take into account the “stop-loss rules”, which can limit the tax advantages of the life insurance. Depending on your circumstances, there is additional planning to avoid or reduce the impact of these rules.
You should also be aware that premiums for corporate owned life insurance are generally not deductible as expenses of the company. However, corporate owned life insurance does offer the opportunity to fund premiums using the company’s funds rather than after tax personal funds.
Planning with corporations can be very complicated. Need help with your estate planning? The experienced team of professionals at Ernst and Company CPA is available for personalized assistance. Please contact us today.
