CharityVillage® Research: Planned giving and the private corporation, part 2

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Planned giving and the private corporation, part 2
by Robert A. Kleinman C.A.,
June 5, 1996; Canadian FundRaiser
(Part Two of a two-part report)
Charities should understand the corporate world in order to offer product which best suits the needs of shareholders. This concept is strange to most charities, which usually run their corporate campaigns without thought to shareholders. Nonetheless, examining opportunities in the private corporation is in fact another way to solicit individuals, albeit wealthy individuals with capacity for large gifts. To this end we must understand how shareholders interact with their corporations.
Shareholders who work within their corporations are often labeled shareholder-managers (S-Ms). Typically S-Ms have the opportunity to choose their method of remuneration which can be in the form of salary or dividend (on the shares they own) or a combination of the two. A dollar in the corporation is not equivalent to a dollar in a shareholder's hands, as it cost tax dollars to move funds to the shareholder. Thus a charitable donation receipt (which creates cash savings to the donor) is more valuable in the shareholder's hands than in the corporations hands. On the other hand, the actual cash expenditure representing the donation is preferred to be disbursed out of corporate funds rather than shareholder funds.
Corporation makes the donation; shareholder gets the receipt
The optimum situation, therefore is to have the donation paid from the corporation with the receipt issued to the shareholder. This appears nonsensical but there are situations where this can result which we will review. Shareholders invest in their own corporations in two ways - capital stock or shares, and by lending money to the corporation. Shares, common or preferred, reflect the shareholder's ownership in the corporation. Capital gains may arise on disposition of shares calculated as the difference between the proceeds received on disposition and the Adjusted Cost Base (ACB) of the shares.
Shares may be redeemed
If shares are redeemed or brought back by the company itself the tax treatment is a bit more complicated, and involves the concept of paid-up capital (PUC), the number that appears on the financial statements at the capital stock line. It often, but not always, equals the ACB of the shares. For example, if Mr. A started Co. A with a subscription for 100 common shares and the cost of the shares were $1 each, he would pay Co. A $100 and receive a certificate evidencing ownership of 100 common shares. His ACB of the shares would be $100. The company would account for the transaction by adding $100 to its cash account and by crediting its common stock account for $100. Thus, the financial statements would illustrate $100 at the capital stock line and consequently the PUC of the shares would be $100. If five years later Mr. A sold these shares to Mr. B for $50,000, he would realize a capital gain of $49,000. Mr. B's ACB in the shares would be $50,000. The PUC of the shares would remain at $100 as the transaction did not affect the financial statements of Co. A.
If, however, Mr. B would have his shares bought back by Co. A for say $75,000, the tax ramifications would be calculated a follows, the order of calculation being important:

First the Income Tax Act requires a calculation to determine if a deemed dividend (not a real dividend, but an amount taxed as if it were a real dividend) results. The calculation is the proceeds, $75,000, less the PUC of $100 or a deemed dividend of $74,900.

A capital gain calculation is now effected. The $75,000 proceeds less the deemed dividend of $74,9000 (for a net $100) less the ACB of $50,000 yields a negative $49,900 result or a capital loss of $49,900.
This illustrates how the dividend calculation is affected by the PUC balance.
Super capital gains exemption of up to $500,000
Assuming a donor owns 100% of a corporation, are there advantages to donating shares to a charity (on the premise that the shares would be redeemed for cash subsequent to the gift)? Unfortunately, a donation of shares results in a disposition for tax purposes of the shares. Although a charitable donation receipt will be issued for the value of the shares, the donor will be deemed to have disposed of the shares for proceeds equal to that value. These proceeds less the ACB will yield a capital gain, of which 75% is taxable. This appears to be tax efficient - to receive tax savings on 100% value but to only pay tax on 75%.
A more beneficial tax treatment results from shares known as small business corporation shares (SBCs). The Income Tax Act allows for a special `super" capital gains exemption for up to $500,000 for capital gains realized on dispositions of SBCs, shares of Canadian-controlled private corporations which use at least 90% of their assets in active Canadian businesses. Many accountants and lawyers have suggested to their clients that they crystallize this `super exemption'. In essence a corporate reorganization would be effected such that the shareholder would dispose of his SBCs, realize a capital gain subject to exemption, and receive as consideration other shares.
Why is this done? The shares received will have an ACB which has been increased due to the realization of the capital gain. Thus numerous Canadians now own $500,000 of shares with an ACB of $500,000. Is this a benefit? Yes, although limited. Even though the ACB was increased, the PUC of these shares remained the same, and consequently a redemption of these shares would result in a taxable dividend. The ACB bump is only of value if a bona fide sale takes place or to reduce the tax cost of a deemed disposition on death.
What happens if we use these shares as donations? Say Mr. F gifts $50,000 shares worth $50,000 and with an ACB of $50,000 to a charity. He is deemed to dispose of the shares for proceeds of $50,000 but as his ACB is $50,000, no gain arises. He receives a donation receipt which is used to save $25,000 of tax. The corporation redeems the shares now owned by the charity for $50,000. Note what has been achieved. The donation receipt has been used by the individual, but the actual cash is being paid by the corporation. The redemption of shares results in a deemed dividend to the charity; as the charity is non-taxable, this is not a concern.
The individual is $25,000 richer, but the corporation $50,000 poorer. To place $25,000 in a shareholder's hands, the corporation would normally have to pay him a dividend of $41,667. It is now doing the same at a cost of $50,000. Or in other words, for an additional cost of $8,333 a donation of $50,000 has been made. The cost of the donation - 16 2/3%.
Loans may be assigned to the charity, but not necessarily repaid
Another way for shareholders to invest in their company is through loans. It is simple, the monies can be returned easily and tax-free; and the opportunity for creditor-proofing exists. In effect, a creditor of a corporation upon liquidation of the corporation receives payment before the shareholders. Thus, many shareholders tend to make their corporate investments in the form of loans. Further, they have legally attached security to the loan in order to become secured creditors. The loan with such security is called a debenture.
Funding gifts via the corporation but obtaining personal deductibility can be strategic. Thus the gift of a loan by a shareholder can achieve a deduction for the individual, and funding for the gift occurs when the loan is repaid by the company. It is not technically necessary for the loan to be repaid. Charities can hold debt instruments as part of their investment portfolios. The following plan has been developed:

A shareholder who is owed by his company formalizes the loan on paper by creating a debenture.
The shareholder gifts the debenture to a charity. The debenture is repayable 60 days after demand, but no later than 90 days after death of the shareholder.
The company takes out a life insurance policy on the life of the shareholder. The face value of the policy equals the debt.
If the loan remains unpaid at the time of the shareholder's death, the proceeds from the life insurance policy is used to repay the loan.
Get a valuation from the company's public accountant
The gift of the debenture will yield a charity receipt, and the tax savings can help pay for the policy premiums. Revenue Canada has questioned the suitability of this plan, which effectively uses tax savings to fund the life insurance to pay for the gift. However, the key appears to be valuing the gift of the debenture to the charity. Is a $100,000 debenture worth $100,000 and therefore sufficient to cause a $100,000 receipt to be issued?
Valuation is a special field of its own. Debt can be valued in the marketplace. The first indicator of value lies with a determination of the possibility for repayment. The second lies with the interest rate attached to the debt. The combination of these two factors sets the value. The higher the risk the lower the value; the higher the interest rate the higher the value.
A charity issuing a receipt should receive a valuation from the company's public accountant evidencing the value. Obviously the company should be sound and preferably not operating an active business which would add risk. A debenture with its security feature adds value. Lastly, a market-driven interest rate should be attached and paid.
Donating via dividends is another route
The corporate tax system as it relates to the earning of passive or investment income is a bit complicated. The concept of integration is special to Canadian tax, and as a result peculiar characteristics have evolved, including Refundable Tax on Hand (RDTOH) and the dividend refund.
In order for integration to work, a portion of basic corporate tax which is paid is allocated to a special account, RDTOH. When dividends are paid, the amount in the RDTOH account is refunded to the corporation, the dividend refund. Recent amendments to the Income Tax Act have accentuated the effect of this system, which may affect charitable corporate planned giving.
The basic corporate federal tax rate for 1996 is 29.12%. Of this, 20%, or about 2/3, is placed in the RDTOH account if the income taxed is investment income. Previously, the RDTOH would be refunded to the extent of 25% of dividends paid. Two amendments are now in effect. As of July 1, 1995, an additional refundable tax of 6 2/3% is levied, bringing the federal tax to 35.79% on investment income, with 26.67% potentially refundable. In addition, the dividend refund rate as of July 1, 1995 is 33 1/3% of dividends paid.
For further analysis, note the following 1996 tax rates which include provincial levies. For illustrative purposes, combined Quebec and federal rates are used; these rates can be used by provincial residents for analytical purposes.
Corporate tax rate on investment income: 52.04%
Corporate tax rate on business income (1st $200,000): 18.00%
Corporate tax rate on business income (> $200,000): 38.00%
Top personal tax rate: 52.94%
Top personal tax rate on dividends: 38.70%
It is important at this point to note that:

The new refundable 6 2/3% tax increases the cash tax on investment income to 52.04%. Given the choice, donations may be better made from the holding company rather than the active company to maximize cash flow.

Some corporations have accumulated substantial RDTOH accounts. With the dividend refund rate increased to 33 1/3% perhaps the RDTOH can be used to help finance donations. Assume Ms. D intends to contribute $100,000 to her favourite charity. If the funds were paid personally the donation receipt would save her $48,000 of tax, for a net out-of-pocket cost of $52,000. Instead, however, she receives a $100,000 dividend from HOLDCO, which entitles HOLDCO to a $33,333 dividend refund. She passes on the $100,000 to the charity. Ms. D pays $38,700 of tax on the dividend, but saves $48,000 of tax due to the donation receipt, a net saving of $9,300. The corporation has a net cash reduction of $66,667. It appears that the second scenario is net cash flow negative. However the key is that in the second scenario, Ms. D is $57,300 richer personally, cash flow having moved from the corporation to the individual.
Donation base may be expanded
As announced in the recent federal budget, The Income Tax Act limits the corporate deductibility of donations to 50% of net income. If within a corporate group this limitation poses a problem, one can work around the issue as follows.
Assume HOLDCO earns $100,000 of investment income and has made a $100,000 donation. Ostensibly, only $50,000 can be deducted as a donation in the year with the balance carried forward for future use. However, if HOLDCO causes its subsidiary OPCO to declare and pay a $100,000 dividend, HOLDCO's net income would now be $200,000. Its $100,000 donation would now be fully deductible based on the 50% of net income test. In arriving at taxable income, the dividend is deductible along with the donation so that taxable income is now nil. If OPCO needs the $100,000, HOLDCO can reinvest the monies back in OPCO in the form of a loan or preferred shares.
Another method to extend the 50% limitation in a shareholder-manager situation, is to reimburse the S-M in the form of dividends rather than salary. As salary is deductible, corporate net income will be higher if dividends are paid. For the individual, as dividends are grossed-up by 25% in arriving at net income, net income will again be higher, and the higher the net income, the more donation can be deducted or taken as credits.
Foundations can be used as part of an overall estate freeze
Previously we have examined the key role that charities can play in estate planning. Consider a typical estate freeze. Mr. A, the owner of Co. R, exchanges his common shares for equal value preferred. New common shares are issued for nominal amounts to his children. The effect is that the current value of the company is frozen in the preferred shares owned by Mr. A and it is on this amount on which taxes will be paid at death. The future growth of Co. R will accrue to the new common shareholders and will not be taxable on Mr. A's death.
Can we extend the freeze by having Mr. A donate the preferred shares to a community foundation or a private foundation? Thus the tax at death would be eliminated. Control of the company can be retained in Mr. A's hands via shareholders' agreement. The preferred shares could be redeemed over time to help fund Mr. A's annual charitable contributions. If at death preferred shares would still be outstanding, the children can continue the redemption policy or buy their shares from the charity.
The private company can be an important participant in the gift planning process. As we progress in the field, a plethora of opportunities will be developed which hopefully, charities and donors will seize.
Robert A. Kleinman C.A., Jewish Community Foundation of Greater Montreal.