An Overlooked Source of Major Donations
I have often thought that the old maxim of Jean Baptiste Colbert “The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing” applies just as well to soliciting for donations as it does to taxation. And of course, discussions abound in the sector about how to make donations (especially large ones) as palatable as possible for the donor. So it is with some surprise that we do not often see charities thinking strategically about unlocking the capital value of shares in Canadian businesses. The key to the strategy involves an understanding of what tax and estate lawyers call an estate freeze. An estate freeze is based on the principle that the Income Tax Act allows the sale (or gift) by Canadians of $750,000 of shares of a Qualified Small Business Corporation (a “QSBC”). This amount is cumulative over the Canadian’s lifetime. A QSBC has a technical meaning which we will not canvass here, but is not limited to small businesses, rather it is generally limited to Canadian businesses involved in active businesses (i.e. not passive businesses like royalty or rent collection). Once the value of a business reaches $750,000, lawyers often recommend exchanging the common shares of the corporation for preferred shares which have a “frozen” value of $750,000. The common shares are then held by another family member and allowed to appreciate until the next $750,000 of value is ‘used up’ and then the freeze can be done again. The freeze is accomplished by making a condition of the preferred shares that they can be purchased by the corporation for a set amount, in this case $750,000. Because the corporation can force the sale at $750,000 no third party would ever pay more than that for the shares so their value is effectively frozen. As a matter of law, the shares can also be designed so that the shareholder can force the corporation to buy them for that same amount. Let us assume that an estate freeze has occurred. It is not important who holds the common shares but in our example the donor holds preferred shares of a QSBC frozen in value at $750,000. Assuming the shareholder has not used the lifetime capital gains exemption before, she can now donate these shares to a charity and receive a $750,000 receipt (noting of course that there are certain hoops to jump through when donating shares of a private corporation to charity) and pay no tax on the donation. So the donor now has a $750,000 receipt (worth, in Ontario approximately $345,000) and the charity owns the shares. The charity now has several options. The shares may pay dividends and for that reason the charity may wish to hold on to the shares. More likely, the charity wants to liquidate these shares (indeed there may be legal reasons why they would have to sell the shares). If the shares are retractable, the charity can force the corporation to purchase them for the full price. On the other hand, it may have to convince the corporation to buy them back all at once or according to some schedule. Perhaps the most interesting plan may be where the corporation uses the proceeds of life insurance to repurchase the shares. In this scenario, the corporation takes out a life insurance policy likely on the principle of the business (although, as long as the corporation has an insurable interest in the individual this does not have to be the case). When the insured dies, the corporate beneficiary receives the proceeds which are used to buy back the donated shares. Even better, is that the corporation has now received a ‘bump’ to its capital dividend account. This effectively allows the corporation to distribute the amount of the insurance proceeds to the shareholders on a tax free basis. As a result, not only does the charity receive its money but the new shareholders of the corporation receive the same amount paid out from the corporation’s revenues (assuming it has them). While this plan is complicated and therefore requires professional advice, it achieves a trifecta in that a) the donor receives a $750,000 tax receipt b) the cash to pay for the donation comes from the donor’s corporation, and c) the charity not only receives the funds but can also receive dividends over many years. Even with the simplified examples used here the planning is complex, but the potential can be huge as different family members may be able to take advantage of this strategy at the same time. Donors can donate any amount they want, (although some amount may be taxable) and the actual cash comes directly from their corporation. Keep in mind that the best time to do a freeze is when the business can legitimately be given a high valuation. This typically occurs while the principle is working (as opposed to retirement) which is when people often require large donation tax credits to offset their income. If your charity or donors need more information about this strategy please feel free to contact the author.