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Steps you can take to avoid paying someone else's taxes

Pleading ignorance won't always get you off the hook. Consider the young man -- call him "Smith" (not his real name) -- who was charged with perjury last year in Muncie, Ind., after he told a judge he was not "Smith," even though "Smith" was tattooed on his back.

Mr. Smith responded, "I can't see what's on my back. If there's some tattoos on my back, somebody's been bothering me when I'm asleep." Hmm. Not quite convincing.

Sorry to tell you, but pleading ignorance is just as ineffective with the tax collector and the courts. One particular situation comes to mind -- and it's easy to get caught in this trap.

The facts

Section 160 of Canadian tax law could require you, in certain situations, to pay a tax bill owed by someone close to you.

We're reminded of this fact again in a court decision handed down on Nov. 8 in the case of Jean Guy LeBlanc.

Jean Guy had purchased a property from his brother, Réjean, and owed Réjean money as a result. Réjean then forgave part of the debt at a time when he owed a tax liability.

That is, Réjean transferred something of value to Jean Guy, by forgiving the debt, at a time when Réjean had a tax liability outstanding. The result? The Canada Revenue Agency (CRA) assessed Jean Guy for taxes that his brother owed. The tax collector won in court.

You see, Section 160 says that where you receive property (and this can include anything of value) from another person with whom you are not dealing at arm's length, and the person making the transfer to you owes tax in that year, or from a prior year, you may be jointly and severally liable to pay all or part of the tax bill owed by that other person.

How much might you be liable to pay? Your actual exposure is the lesser of the taxes owed by the transferor or the value of the property you received less any amount you paid for the property.

Here are the most common situations where Section 160 applies: You receive a gift from someone owing income tax; you purchase something for less than fair market value from someone owing income tax; or you inherit assets from a deceased person or his or her estate who owes income tax.

Keep in mind, for Section 160 to apply, you have to be in a close relationship -- not dealing at arm's length -- with the transferor. Also, our tax law was changed in 2004 to clarify that you'll also be on the hook for any interest owed on the overdue taxes of the other person.

The ideas

So, how can you protect yourself from a potential assessment under Section 160? Consider these ideas:

If you suspect the transferor owes the CRA money, ask the question to know for certain.

Consider paying fair market value for the property received (payment can be in cash or in kind).

Prove that the transfer of property to you was in satisfaction of amounts owing to you.

In the case of a deceased person, ensure the executor has filed tax returns for the deceased individual and his or her estate, has withheld sufficient assets to pay any taxes owing, and obtain a clearance certificate from the CRA.

Buy life insurance to cover the taxes upon the death of someone from whom you'll be inheriting assets.

Every year there are stories of Section 160 applying -- and pleading ignorance won't help here. Don't be the next story.

Tim Cestnick, FCA, CPA, CFP, TEP, is a tax specialist and author of Winning the Tax Game 2005 and The Tax Freedom Zone.

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