This article was originally published by the Jewish Foundation of Greater Toronto.
The tax benefits that arise from cash donations and the donation of publicly-traded securities are quite well-known and are often used by taxpayers to meet their charitable objectives and reduce their tax bill. However, the tax benefits that can arise to taxpayers from the donation of private company shares are often overlooked and are not widely considered as part of tax planning strategies.
The Tax Results
At first glance, it would appear that the donation of private company shares can never be beneficial. Unlike the case where publicly-traded securities are donated, any difference between the fair market value (“FMV”) and the adjusted cost base (“ACB”) of the private company shares will be subject to a capital gain and taxed accordingly upon the donation. However, the tax benefits can still be significant.
Consider an example where Mr. A owns fixed value preference shares of a private company with a FMV of $1,000,000, an ACB of $1,000, and paid-up capital (“PUC”) of $1,000. Mr. A falls within the highest tax bracket in Ontario and is looking to donate to his favorite charitable foundation.
Mr. A has the option of either redeeming his shares and donating the after-tax funds to the foundation (“Alternative 1”), or he can donate the shares directly to the foundation (“Alternative 2”).
Under Alternative 1, there is a net tax cost of $208,1301. Under Alternative 2, there is net tax savings of $236,7682. The significant difference in savings of almost $450,000 under Alternative 2 arises for two reasons:
- Capital gains are taxed at more favorable rates than dividends at the top tax brackets; and
- A donation tax credit is available on the full value of the shares under Alternative 2, as opposed to just the after-tax redemption proceeds under Alternative 1.
In a typical estate freeze involving a family-owned private company, the first generation will be left with fixed value preference shares (with high value, low ACB, and low PUC). If nothing is done with the shares following the estate freeze, the inherent gain on the shares will be taxable on the death of the taxpayer3. Further, the FMV of the shares will be subject to provincial probate fees4. Donating the shares during the life of the taxpayer will avoid tax on death, probate fees, and any further estate planning requirements with respect to the shares since the shares will not form part of the estate.
Other Key Benefits
- If the shares are donated and the redemptions occur over a period of time, the taxpayer can obtain the tax benefit immediately in the year of the donation, but the private company would be able to retain the cash until the redemptions occur.
- To the extent that the private company has a balance in its non-eligible refundable dividend tax on hand (“NERDTOH”) pool, the company can obtain a dividend refund and clear its NERDTOH pool on the redemption of the shares now owned by the charitable foundation5.
- The ordinary donation limit to a taxpayer of 75% of net income is increased by 25% of any taxable capital gain incurred on the donation.
There are many issues that need to be considered before a taxpayer decides to donate his/her private company shares:
- A valuation of the private company shares would be required to determine the amount of the donation.
- Prior to the donation, the donor and the recipient would need to agree to the timing of redemptions and annual dividend entitlements; the donor would need to consider the related cash flow impacts to the company.
- Unlike public foundations and charitable organizations, private foundations can only issue donation receipts once the cash proceeds from the redemption are received, and only in respect of shares redeemed within 60 months of the donation.
- Shares held for only a short period of time before they are donated may be subject to anti-avoidance rules that would limit the donation amount to the ACB of the shares; exceptions are available for shares received as part of an estate freeze.
- Alternative Minimum Tax (“AMT”) implications need to be considered where significant capital gains arise on the donation.
The tax benefits that can arise from the donation of private company shares can be significant. However, there are a myriad of rules and considerations that would need to be managed to ensure that the donation of the shares afford the benefits that have been described above.
This article has been prepared for the general information of our readers. Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article. Please note that this publication should not be considered a substitute for personalized tax advice related to your particular situation.
1 Tax on Redemption ($473,526) [$999,000 deemed dividend * 47.40%*]Donation Tax Credit $265,396 [($1,000,000 - $473,526) * 50.41%]
Net Tax Savings (Cost) $ (208,130)
*Assuming the company has no amount in its General Rate Income Pool (“GRIP”) account.
2 Tax on Capital Gain $ (267,332) [$999,000 capital gain * 26.76%]
Donation Tax Credit $504,100 [$1,000,000 * 50.41%]
Net Tax Savings (Cost) $236,768
3 Unless a loss-carryback strategy is utilized, in which a taxable dividend will likely arise to the estate in its first taxation year.
4 Unless planning is undertaken to include the shares of the private company as part of a secondary will.
5 Anti-avoidance rules that could deny the dividend refund do exist and must be considered.