Your Tax Liability on Death – Planning on how Your Estate will Best Cover the Taxes Owing

Since retiring from public accounting, I am working part-time as a Tax and Estate Consultant for a Wealth Management (“WM”) firm and as a Quarterback/Part-time CFO for a couple of families.

When working with the WM firm's clients, I like to provide them with an estimate of their anticipated income tax liability on death based on their current net worth. I find this is often a very useful exercise for clients, so that they can plan and consider how their estate will cover their tax liability upon their passing (typically the last spouse to die, as the first spouse can transfer their assets tax-free to there surviving spouse). In my experience, an estate tax liability is dealt with in one or some combination of four ways: 

1. Through a self-funding sinking/savings fund

2. Through the estate’s anticipated cash on hand

3. Through the liquidation of the estate’s assets (potentially at the risk of selling at lower or fire-sale price)

4. Through the purchase of life insurance

While clients are typically “glad” to know their anticipated estate tax liability (based on their current net worth), they often have two questions. The first question is if they anticipate their estate to keep growing from this point in time, how do they factor in the future growth and related tax liability?

The second question they ask (or I point out) is what is the proper income tax rate to use to determine an estate’s future tax liability given potential government funding needs and potential future changes in capital gains rates or marginal tax rates?

Today, I will address the first question and the second question will be covered in my next blog post.

How do you Plan to Cover Your (Ever-Growing) Estate Tax Liability?

This is a very complex question. The answer for many people whose wealth comes in large part from a private corporation (usually an active corporation, but it may be applicable to a passive investment holding company) is often an estate freeze. The characteristics of someone who would consider an estate freeze are that they are typically 55 years of age or older and their current assets would provide more than they need to live comfortably for the rest of their life. 

An estate freeze sets, or “freezes” the value of the shares of a corporation(s) at their current value (say $10,000,000 for discussion purposes). You as the shareholder of the corporation receive freeze shares (preference shares) worth $10,000,00 in exchange for your current common shares and your children then subscribe for new, nominally priced commons shares. Any future growth in the company's value above $10,000,000 accrues to the children’s benefit and not your estate and thereby defers income tax on the gain above the $10,000,000 threshold to the next generation. Once the share value is frozen, the business owner will only be taxed on the capital gains on their frozen preferred shares at the time of the death (which may decrease as discussed below). The freeze is set-up so that you maintain control of the company with voting shares, even though your children own the growth shares. 

In many cases, for tax planning purposes the business owner's freeze shares are redeemed over time, such that the $10,000,000 value is decreased over the years by the shares redeemed. So, if you redeemed $200,000 of your preference shares for 10 years, your estate tax liability would now be based on only $8,000,000, not $10,000,000.

While your other assets may continue to grow over time, your major asset (private company shares) will not grow in value and may decrease as shares are redeemed. I have written previously about estate freezes, here is the link.

I have also written on why some succession experts feel an estate freeze may be the wrong solution. Here are two blog posts that provide an alternative viewpoint. Are Estate Freezes the Wrong Solution for Family Business Succession and Part 2 . 

As noted above, an estate freeze will only stop the growth of your private company shares (or possibly investment company shares), so you must now concern yourself with the likelihood the remainder of your estate will continue to grow (including your company shares if you do not implement an estate freeze).

One potential way to cover the estate tax liability is a self-funded sinking fund/savings fund. While this sounds like a reasonable option, I personally have never seen someone cover off their eventual estate liability using this method, due to fluctuations in corporate profitability (for private company owners) and alternative needs at certain times for capital (home renovations, kid's weddings, houses etc.) or other projects. However, a sinking fund could at least partially offset the estate liability, especially if you create a fund in conjunction with the estate's expected cash on hand (for example cash, money market investments and GIC's in your portfolio).

Most people, whether they are very high-net-worth or not, have no objection to their estate just liquidating their assets upon their death to pay any final personal taxes and having any remaining funds (net of income taxes) become their family’s inheritance. Practically, this is the typical manner in which most estate taxes are paid. The main issue with the liquidation of assets is that the estate may not be selling at an opportune time or even be able to sell the assets unless they fire-sale the asset (if the economic conditions are poor at the time of your passing).

Some people explicitly do not wish their estate to liquidate certain assets. For these people, the assets may be legacy or sentimental, such as family land or real estate properties, a cottage or the family business. Alternatively, it is a business reason, such as the parent thinks the assets have large growth potential if kept say 10-20 years.

Based on the discussion above, if you are fine with your estate liquidating your assets, you likely do not have to worry about your estate tax liability. However, as discussed, there could be timing issues raising the cash and a liquidation at the wrong time in an economic cycle, may not maximize your asset value.

If you are able to self-fund and/or leave significant cash in your estate, your estate may only need to sell some of your additional assets to cover your estate liability and the estate may be able to hold certain legacy assets.

If you foresee any gaps in funding your estate tax liability, or don’t wish your estate to liquidate your assets (or are okay with liquidation, but only when market timing allows your estate to receive fair market value for those assets), then you may wish to utilize life insurance (typically permanent insurance) to cover any anticipated shortfall. Alternatively, some people use insurance (which in the correct income tax circumstances can often have an excellent rate of return even after the premiums) to fully-fund their estate liability or even leave a larger estate for their beneficiaries. If insurance is used, you often build in an estimate of future asset growth to cover any additional tax liability that will accrue between today and the date you pass away. While this estimate of additional taxes may be off-target, you can revisit your insurance over the years depending upon your health.

As with an estate freeze, there again is a definite advantage to having a corporation, as corporate insurance is far more tax effective than personal insurance. I have written on this topic a few times including this post on The Basics and Uses of Term and Permanent Life Insurance and discussed insurance on these Podcasts:

The Blunt Bean Counter: Life Insurance for High-Net-Worth Individuals and Corporate Business Owners - Podcast and Blog 

The Blunt Bean Counter: Some of the Tough Questions to ask When Considering a Permanent Life Insurance Policy - Podcast and Blog

I have not discussed gifting assets, since a gift of capital property creates a deemed disposition and triggers any income tax related to that asset. However, depending upon your circumstances, gifts of capital property can "smooth" out your tax liability over our lifetime.

For all the above considerations, you must consult your accountant, tax professional or financial advisor to determine if any of the planning makes sense for you, based on your personal fact situation.

In my next blog post, I will discuss the income tax rate you should use when trying to determine your estate tax liability, which is not as simple as it sounds.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Common Estate and Tax Planning Issues

Over the years, I have reviewed many individuals’ financial affairs. Most people have their affairs somewhat in order, but there are typically still some issues to be considered or holes to be filled. Today, I list some of the most common issues and gaps.

Estate Issues

The most common estate planning issues I have observed relate to wills, powers of attorney, estate documentation and insurance. I discuss these below.

 

Wills

Wills always seem to have multiple issues and errors of omission when I review them. These five are the most common:

1. No Secondary Will – Depending upon your province of residence, a secondary will can be used to reduce the probate taxes due upon your death. This would most typically apply to shares you own in private companies and other personal items. It is my understanding that Ontario and British Columbia are the two main provinces where secondary wills are used, so check-in with your advisor if you live in a province other than Ontario or B.C.

2. Old or Dead Executors - As many people do not update their wills on a regular basis, I have often found their executors have passed away or they are very old (if your children are not your executors). You may want to review your executor selection and ensure you have at least one “youngish” executor.

3. All the Children are Executors – Keeping with the executor theme, many people have all their children as executors. I suggest that if you can finesse this with your children, in some cases it is better to only have one or two of your financial savvy children as executors, to avoid the estate being bogged down. This is not always practical given family dynamics, but is more efficient and can often reduce sibling friction.

4. Individual Bequests are Missing – Estate lawyer Charles Ticker notes in his book “Bobby Gets Bubkes: Navigating the Sibling Estate Fight that one of the biggest issues children have post-mortem, is where a parent had promised a child a certain personal item, be it jewelry, art, purse etc. and it is not reflected in the will. Parents, make your will consistent with your promises.

5. Blended Family Issues – Blended family issues can be so complicated, there is sometimes “paralysis by analysis” and they are just ignored. In this blog post I wrote in June 2020, I note that estate planning is complicated enough in a first marriage; second or third marriages multiply the risks and complexity. You may want to read the wills and estate planning sections of this blog post on blended families.

Powers Of Attorney

The two most common issues I come across with Powers of Attorney "(POA) are:

1. They are often not done!

2. The personal healthcare POA is out of date and does not reflect the significant health care issues that should be considered from extraordinary health measures to mental capacity (see this blog post) to assisted death.

Estate not Documented

I have seen many estates with no documentation in respect to the assets that constitute the estate and where the assets are located. I wrote about this a couple weeks ago, so I will not re-iterate. Here is the link to the blog post.

Insurance

Most people dislike paying insurance. However, parents often have family legacy assets they wish to keep in the family such as cottages, rental properties, family businesses etc. I have seen several instances where these legacy assets must be sold by the estate or to keep these assets in the family, excess taxes are paid as a work around solution. Often, life insurance, typically permanent insurance, such as Universal or Whole life would have made financial and tax sense and emotional sense (where the parent wanted a legacy asset to remain in the family).

I discuss many other uses of insurance for estate planning purposes in this blog post including the most popular, being life insurance to cover an estate tax liability on death.

Income Tax Issues

Capital Dividend Account

The capital dividend account (“CDA”) is a cumulative tax account that tracks certain amounts (most commonly the non-taxable portion of capital gains) that are not taxable to a Canadian Private Corporation and may be distributed tax-free to the company’s shareholders. See this detailed blog post I wrote on the subject.

Over the years, I have often seen this account not tracked or overlooked. A brief discussion of your corporation’s CDA balance should be part of your annual discussion with your accountant to ensure that you are not leaving any tax-free money on the table.

Charitable Donation Tax Efficiency

I have written several times (the last time being this blog) that many people do not maximize the tax benefits of their donations. If you plan to make a charitable donation and you own marketable securities with unrealized capital gains, it is far more tax-efficient to donate the securities in lieu of cash. This is because the capital gain on the security is not subject to tax when donated. For example, if you own shares of Bell Canada with a cost of $1,000 and a fair market value of $5,000, you would have to pay capital gains tax on the $4,000 capital gain when sold. However, if you donate the shares, the capital gain is deemed to be nil and you still get the donation tax credit.

Where you have a corporation and own marketable securities, it is even more tax-efficient to make a corporate donation, as the capital gain is eliminated and the capital gain gets added to the CDA account discussed above.

Unfunded TFSA

I find it very surprising how many people still have unfunded or partially funded Tax-Free Savings Accounts (“TFSAs”). These accounts allow you to grow your money tax-free and provide substantial flexibility in using and replenishing the account.

In the early days of TFSAs, the contribution limits were not large and people did not want the hassle of opening the account. However, as of Jan 1, 2022, the contribution limit for a TFSA is now $81,500. So, if you have not contributed, get going. If you have contributed haphazardly, check your balance with the CRA and get caught-up.

Capital Loss Utilization

I often see people pay tax on capital gains that is unnecessary, as they could have sold securities that had unrealized losses to reduce the gain and the related tax.

As 2022 has been a tough year in the markets, you may want to undertake some tax-loss selling before the end of the year. I will have my annual tax-loss selling blog in a couple weeks which is very detailed to assist in your tax-loss selling planning.

Estate Freeze

As per my blog Estate Freeze -A Tax Solution for the Succession of a Small Business undertaking an estate freeze in the right circumstances is often a great way to defer a families tax liability to the next generation. However, not everyone agrees as per this blog Are Estate Freezes the Wrong Solution for Family Business Succession?

I am a proponent of using an estate freeze where it fits a families needs. Over the last two years I have seen three estates that caused tax havoc for families that could easily have been minimized with an estate freeze several years ago.

Hopefully you and your advisors have already considered most of the issues discussed above. If not, you may wish to “clean-up” any holes in your planning and ensure the efficiency of your estate and tax planning.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Tax Planning Silver Lining for Small Business Owners during COVID-19

As my colleague Jeff Noble notes in this excellent May 2020 guest blog post on The Business Owner’s COVID Contemplation, small business owners have had a herculean task navigating thorough COVID-19 for a myriad of reasons—ranging from lost revenue to keeping staff employed to accessing relevant government programs.

Some small businesses have been fortunate to occupy sectors that have thrived during COVID, including technology, health care, and some retail segments (the grocery chains and big box stores). However, many more have suffered during COVID, which in turn has caused their business to lose financial value and, as consequence, likely caused many business owners to delay the sale of their business until they can regain their value post-COVID.

As discussed in this BDO Tax Alert (see the final heading, “Tax Planning when the business value has declined”), this decline in value may have provided a silver lining in that you can potentially reduce your tax liability at death through either an estate freeze or re-freeze, or an estate thaw, where you have previously undertaken an estate freeze.

Estate freeze

As noted in the Tax Alert, “an estate freeze is a process where you take steps to ensure that the future growth of your estate accumulates in the hands of your intended beneficiaries in a tax effective manner. By freezing the value of your estate, you will effectively lock-in the tax that will arise on your death (subject to changes in future tax rates).”

For example, say your business was worth $2 million pre-COVID. If you did not undertake an estate freeze and therefore died without a freeze in place, the tax on your death would have been based on the $2 million value (If your leave the shares to your spouse there is no tax until your spouse passes away). In Ontario, for example, this works out to about $535,000 of personal tax if the entire value is taxed as a capital gain at the highest marginal rate. As noted in the Tax Alert, the “freeze will allow you to pre-determine the taxes that will arise on your death so that you can ensure that cash will be available to pay that tax (for example, by taking out sufficient life insurance).”

If you undertake an estate freeze during COVID when the value of the business is depressed, you can reduce the tax liability upon your death. Using the example above, say your business value has fallen during COVID from $2 million to $1.3 million. If you “freeze” your shares now, the $535,000 tax liability on death would be reduced to approximately $350,000.

When you freeze your shares, your strategy will usually be to redeem these shares over time. The proceeds received from the redemption of the freeze shares will be treated as a dividend for tax purposes. As shares are redeemed, this will lower the value of the shares you would hold on death.

If you are interested in learning more, I have previously written on this subject here, here and here.

It is critical to understand that by freezing your shares, you are giving the “bounce-back” and future growth in your business to your children. So if the value of your company bounces back to say $2.3 million by the time you pass away, you have effectively deferred tax on $1 million of value to your children ($2.3 million value less freeze value of $1.3 million).

Finally, it is very important that the freeze share value, your yearly salary and your other assets will provide you more than you need for your retirement, or the freeze may not make sense. 

There are many tax complexities in undertaking a freeze, please ensure you obtain professional advice.

Revisiting a freeze: The estate re-freeze and estate thaw

But let’s say you already executed an estate freeze. Now you are faced with a business the value of which has declined – at least in the short term. Is there a way to undo that freeze to take full advantage of the current economic downturn?

There is, and more correctly there are – two ways. One is an estate re-freeze; the other is an estate thaw.

As noted in the Tax Alert on estate re-freezes, “If you have already undertaken an estate freeze, but the value of your business has declined in the current environment, it is worth considering whether the freeze could be ‘undone’ and you should ‘re-freeze’ your business at the current value of your business. This could make sense if the value of your business is less than its value at the time the original freeze was undertaken, and therefore the value of the fixed value shares you took back on the original freeze is more than the value of the business. A re-freeze would allow you to reset the freeze at the value of your business today and further reduce the amount of taxes your estate would have to pay on your death.”

 Using the example above, assume you had frozen your shares for $2 million in 2007. If the value of the corporation has dropped to $1.3 million, a re-freeze will save you the tax on the $700,000 drop in value, or around $185,000.

Again, you must keep in mind the re-freeze value and your other assets will need to provide you more money than you need for your retirement, or a re-freeze may not make sense. 

An estate thaw works a bit differently.

“You may also decide that you want to undo an estate freeze done in the past due to the decline in value," says the Tax Alert. "Known as an estate ‘thaw,’ this would be possible if you or your spouse are beneficiaries of the family trust that own the common shares of your business. Implementing a thaw would mean that you would transfer the common shares out of the trust to you or your spouse. Whether this makes sense depends on your own situation, and the interests of the other intended beneficiaries.”

Estate freeze vs. estate thaw

As noted above, a thaw is different from a re-freeze. In a re-freeze you just reset the value of your initial freeze shares, lowering your tax liability on death and allowing the future growth from the lower freeze value to accrue to your children. In a thaw you are reversing some or all of the original estate freeze and possibly, depending upon the circumstances, effectively nullifying the prior estate freeze, such that the freezor is put back in the same position as they were before the original estate freeze. Under a thaw, you now lose most if not all the benefit of any bounce-back in the shares going to your children.

Re-freezes and thaws are even more complex than an estate freeze and for all these transactions, I reiterate, you need to seek professional advice.

Fair market value of shares

Determining the fair market value of shares for a freeze or re-freeze during COVID is complex. I would suggest it is mandatory that you engage an independent certified valuator to determine the revised value of your company.

COVID has provided little good news to small business owners. However, if your business has been affected, you may want to speak to your tax advisors about the benefit of a freeze, re-freeze or thaw.

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.

The Revised Tax On Split Income Rules

On December 13, 2017 the Liberals released a new and improved version of their income sprinkling/tax on split income (“TOSI”) proposals. The government’s backgrounder stated, “the revised draft legislative proposals include changes to better target and simplify their application”. I can agree with the targeted assertion; as some overly expansive drafting was corrected, but simplification, not in my world.

The new rules while more objective than the previous version, are still very subjective. In my opinion these revisions will just create more angst among the small business owners caught by these proposals and will result in court cases for years. Add in that these rules were released the week before the Christmas holidays and not issued in conjunction with the passive income rules that are supposedly to come in the next budget (planning for dividends may be dependent or intertwined with the final passive rules) and I don’t think the Finance Minister will be winning any politician of the year awards from any private business associations.

In my opinion, all these TOSI rules would not be necessary if the government would have simply disallowed income sprinkling for anyone under age 25 that that does not work full-time in a business and for all Canadians (whether business owners or not) started taxing spouses as a single-family unit. But then, nobody asked me.

Today, I will summarize whom I see as the winners and losers of these new proposals and those caught in the grey area. Finally, I will provide some details on the revisions to the TOSI rules.

As this legislation is new and will likely still require some clarification, I want to make it clear that this post is solely for general information purposes. You should consult with your professional advisor, so they can review these proposals based on your specific fact situation.

Scorecard

Winners

1. Business owners over 65

2. Individuals who inherited shares of a small business

3. Businesses where shares, votes and value are allocated evenly among family members and are not service businesses

4. Canadians who work at least 20 hours a week on a regular and continuous basis in the family business

5. Retired owners that were caught under the initial rules because they were considered related even though an arm’s length person now ran the corporation

Losers

1. Beneficiaries of shares held by Family Trusts

2. Professionals

3. Small businesses that provide services and do not sell products

4. Estate freezes recently undertaken and/or where there is large redemption value remaining in the preference shares issued upon the freeze

Unclear

1. Families were shares have already been distributed from a trust or were purchased upon incorporation and the parents have voting control

2. Estate freezes where most shares have been redeemed

The New Rules

The new rules are very detailed and I do not intend to regurgitate all of them here. I will summarize the rules only at a high level. For details and FAQ’s, please see this CRA link  (scroll half-way down the page to related products and you will see guidance and other more technical material).

The new rules have four key exclusions: 1. An excluded share test 2. Excluded business test 3. Reasonable rate of return test and 4. Retirement and inheritance exclusion.

I will summarize them below and discuss how they may affect you.

Excluded Shares- The share ownership test

The TOSI rules will not apply where you have attained the age of 25 and all of the following conditions are met:

• You own at least 10% of the outstanding shares of a corporation in terms of votes and value and the corporation meets all the following conditions:

(a) It earns less than 90% of its income from the provision of services

(b) It is not a professional corporation

(c) All or substantially all its income is not derived from a related business

At first blush, this test seems like a god-send for private corporations where family members are shareholders and have attained the age of 25. However, in many cases the parents have the majority of the voting rights and may have significant value in preference shares as result of a prior reorganization or estate freeze. Where the issue is only votes, you may be able to reorganize your corporate share structure to meet this condition as the government has stated that even though the rules are applicable January 1, 2018, you have until December 31, 2018 to get your corporate house “in order”.

This rule will essentially preclude the use of family trusts for income splitting purposes other than the capital gains exemption. It is important to note, that the TOSI rules will not apply to capital gains on the sale of qualified farm or fishing property and to the sale of qualified small business corporations (“QSBC”). Most private corporation owners reading this blog post have shares that either qualify as QSBC shares, or can be made to qualify for the capital gains exemption through a purifying transaction (see this post I wrote on this topic). The exclusion for the sale of these shares is not age dependent (however, where an individual is under 18 and the sale is to a related party, the exemption will be problematic). Not that I want to look a gift horse in the mouth, but we have all these complex rules to prevent income sprinkling and you are still allowed to allocate the 2018 exemption amount of $848,252 to a minor?

Professional corporations are excluded, as they have been one of the main targets of the Liberals throughout this whole debacle. However, pay careful attention to the word “services”. At first glance you think services is just another arrow aimed at professionals, but services as written (it is not defined anywhere) would seem to include the services of a barber, gardener, massage therapist, computer consultant etc. Many small businesses may not meet this exclusion if they don’t earn at least 11% of their revenue from the sale of products. In my opinion, this provision may “blow-back at the government once it is better understood; assuming the literal interpretation is the proper reading. It should be noted that if you and your spouse/children 18 years old and over meet the labour criteria for the excluded business test based discussed below, then having a service business will not in itself preclude you from income sprinkling.

The related business in (c) above is just a provision to ensure a service business does not impose another business between it and the family member to get around the rules, although, some tax observers are concerned this provision could accidentally cause issues where shares are held through a holding company. This is one area that the Liberals will need to clarify.

Excluded Business –The labour test

The TOSI rules will not apply where you are 18 or over and have been employed by an excluded business, which is “a business in which the individual is actively engaged on a regular, continuous and substantial basis in the taxation year of the individual in which an amount is received or in any five previous taxation years". The CRA states that “To access the exclusion in respect of five previous years of labour contributions, it is not necessary that the five previous years be consecutive or after 2017. Any combination of five previous years would satisfy the test”. The test will also account for businesses’ that are seasonal, such that the test will apply to the seasonal period

Finally, the CRA says “To provide greater certainty (but without limiting the generality of the test), an individual who works an average of 20 hours per week during the part of the year that a business operates will be deemed to be actively engaged on a regular, continuous and substantial basis for the year. If an individual does not meet the 20-hour threshold, then it will be a question of fact as to whether the individual was actively engaged in the business on a regular, continuous and substantial basis. However, even if an individual aged 25 or older does not meet the regular, continuous and substantial threshold, the TOSI will apply to amounts derived from a related business only to the extent that they are unreasonable (i.e., only the unreasonable excess will be subject to the TOSI)”.

This labour test is a fairly clear bright-line test; you must work over 20 hours per week for at least five previous years or you get into a subjective reasonability test that will likely result in most amounts being in excess of reasonability.

The CRA provided some guidance in the materials stating that records such as timesheets, schedules and logbooks will be sufficient to confirm the hours a person worked.

Reasonable Return on Capital Test

There are two tests within this exclusion:

1. Safe Harbour Test

2. Reasonable return test

Safe Harbour Test

Where an individual 18-24 years of age has contributed capital, and does not qualify for the excluded share or excluded business exclusions, they may still qualify for a “safe harbor exemption” (No that does not mean you take your money and hide it in a safe harbor in the Turks and Caicos).

It means that you will be provided an exclusion from TOSI income to the extent of your capital contribution x a prescribed rate (currently only 1%). i.e. If you contribute $100,000, you multiply the $100,000 x 1%=$1,000 and you can exclude $1,000. To be a blunt bean counter, this exclusion is pretty much useless, since a) The reality is that in probably 95% of the cases, most shareholders only contribute $100 or less to purchase their shares and b) as noted above, the low prescribed rate means even if you did contribute a fair bit of capital, such as $100k, your exclusion is still a meager $1,000.

Reasonable Return Test

For those 25 years of age and older, this very subjective test says that a reasonableness test is to be applied to such factors as:

• Work performed 
• Risks assumed by the individual in the business 
• Any other factors that may be relevant

Your guess is as good as mine as to how this would be applied. Consider Mr. A who is a shareholder and works full time in his business. His daughter also a shareholder, is a computer science student who comes up with a software application that leads to over one million dollars in new revenue for the business. What is her "reasonable" entitlement to dividends?

Retirement and Inheritance

The initial drafting of the proposals appeared to have inadvertently caused the TOSI rules to apply to retired private corporation owners and Canadians who had inherited private corporation shares. The new proposals have addressed these concerns.

The new TOSI rules provide the following exemptions:

1. Where an active owner-manager (someone who met the labour contribution rules) reaches age 65, the TOSI rules will not apply to their spouse (no matter their age). Note: these rules do not mean you can split your dividends like you do your pension income. They only allow you to pay dividends to your spouse who is not excluded by any of the provisions and avoid the TOSI rules where you are 65 or over.

2. If you are over 18 and inherit shares in a private corporation from someone who met the TOSI one of the TOSI exclusions, those shares will continue to be excluded.

Salary

The new rules do not apply to salary. However, there has always been a reasonableness test for salaries paid to family members vis a vie what would you pay an arm’s length persons and that rule will still apply.

Prescribed loans

The new rules do not appear to prevent the use of prescribed loans where you purchase public securities. See this blog and speak to your advisor about whether this strategy would be advisable for your situation.

At this time, I am not entirely comfortable answering questions on these proposals, until we have further clarity. So, if you ask a question or provide a comment on this post, I may not answer the question or will couch the answer. So please don’t expect definitive answers if you ask a question.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Best of The Blunt Bean Counter - Estate Freeze - A Tax Solution for the Succession of a Small Business

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a June, 2014 blog post on Estate Freezes. If this topic interests you, there were two follow-up posts based on noted author Tom Deans, that suggest an Estate Freeze could be the wrong solution for family succession and a discussion of some vital issues when transferring a family business.

Estate Freeze – A Tax Solution for the Succession of a Small Business

Winston Churchill once said, “Let our advance worrying, become advance thinking and planning.” Small business owners often worry about their exit strategy and/or succession plan. They may also be concerned about what would happen to their business if they have a health scare or receive an ultimatum from a child working in their business. Often a small business owner’s worry becomes their anxiety, instead of their advanced planning.

As a small business owner, at the end of the day, there are essentially only two exit strategy/succession options you need to plan and/or consider:

(1) A sale of your business, typically to a competitor, sometimes to current management or very infrequently, an actual sale to a child or other family member; or

(2) A transfer of the business to your children without a sale (for purposes of this article I will refer to this option as an “estate freeze”).

My blog post today discusses estate freezes. How you can transfer your business tax-free to a successor (typically your children, sometimes to existing management) while continuing to control and receive remuneration from your business.

As noted in the links in the first paragraph, Tom Deans the author of Every Family's Business (the bestselling family business book of all-time) believes a business should in most cases be sold and never handed over to the next generation (such as done with an estate freeze) without the parent(s) adequately being compensated for the business, including their children.

What is an Estate Freeze?

The most tax efficient manner to transfer your business to your children is to undertake an estate freeze. An estate freeze allows your child(ren) to carry on your business, while at the same time you receive shares worth the current value of your business. In addition, once your share value is locked-in, your future income tax liability in respect of your company’s shares is fixed and can only decrease. Keep in mind that when you freeze the value of your company you are not receiving any monies for your shares at that time. There may be ways to monetize that value in the future, but on an estate freeze, you typically only receive shares of value, not cash.

The key risk in any estate freeze is that your children may partially or fully devalue these shares and your company. So while an estate freeze may be the most tax efficient way to transfer your business, it may not be the best decision from an economic or monetization perspective. 

In a typical estate freeze, you exchange your common shares of your corporation on a tax-free basis for preferred shares that have a permanent value (“frozen value”) equal to the common shares’ fair market value (“FMV”) at the time of the freeze. Subsequently, a successor or successors, say your children or family trust can subscribe for new common shares of the corporation for a nominal amount.

This concept is best explained with an example. Assume Mr. A has an incorporated business worth $3,000,000 and wants to undertake an estate freeze. In the course of the freeze, Mr. A is issued new preferred shares worth $3,000,000 and his children or a family trust subscribes for new common shares for nominal consideration. Mr. A’s tax liability in relation to these shares on death, is now fixed at approximately $750,000 in Ontario at the high rate. Often, a key aspect of an estate freeze is a plan to reduce the tax liability by redeeming the preferred shares on a year by year basis as discussed below.

If you have access to your lifetime capital gains exemption (currently at $813,600 but indexed for inflation), your income tax liability may be reduced when the shares are eventually sold or upon your death if you still own them at that time. Finally, you may choose to crystallize your exemption when you freeze the shares.

The preferred shares received on the freeze can be created such that they allow you to maintain voting control of your corporation until you are satisfied your child(ren), is(are) running the company in the manner you desire. This maybe a double-edged sword, as you may tend to hold onto control long after your successors have proven themselves. This may become a contentious issue.

Preferred shares can also serve as a source of retirement income. Typically what is done is that your preferred shares are redeemed gradually. So, for example, if you need $100,000 before tax a year to live, you can redeem $100,000 of your preferred shares each year. Let’s say you live 20 years and redeem a $100,000 a year. By the time of your death, you will have redeemed $2,000,000 ($100,000 x 20 years) of your preferred shares and they will now only be worth $1,000,000 ($3,000,000 original value less $2,000,000) at your death. Your income tax liability on these shares at the time of your death will now only be approximately $250,000.

The Benefits of an Estate Freeze

1. On death (something we should all be planning for), an individual is subject to a deemed disposition (i.e. a sale) on all of his/her assets at FMV, which would include his/her shares of the business. An estate freeze sets your maximum income tax liability upon this deemed sale and as discussed above, this liability can be lowered over the years by redeeming the shares.

2. Family members will be able to become shareholders of the business at a minimal cost and be motivated to build the business (although Tom Deans would dispute this assertion).

3. Instead of having children directly subscribe for new common shares, you can create a discretionary family trust to hold the common shares. Every year, the corporation can pay dividends to the family trust which can then allocate the dividends to family members with lower marginal tax rates. This mechanism allows for great income splitting opportunities.

4. On the eventual sale of the business, the children or family trust may realize a significant capital gain. Assuming that the business qualifies for the capital gains exemption, the family trust can allocate this capital gain to each beneficiary who may be able to use his/her own lifetime capital gains exemption limit to shield $813,600 or more of capital gains from income tax.

One of the more critical aspects of an estate freeze is the determination of the fair market value ("FMV") of your business. In order to ensure that an estate freeze proceeds as smoothly as possible, the FMV of the company must be calculated. In the event that the FMV determined is challenged by the Canada Revenue Agency (the “CRA”) the attributes of the preferred shares will have a purchase price adjustment clause that will let the freezer reset the FMV. The CRA has stated in the past that they will generally accept the use of a purchase price adjustment clause if a “reasonable attempt” has been made in valuing the company. Engaging a third party independent Chartered Business Valuator to prepare a valuation report is generally accepted as a “reasonable attempt” in estimating the FMV.

Issues to Consider Before Implementing an Estate Freeze

An estate freeze does not make sense for all business owners. While the above benefits do sound very enticing, it depends on each owner’s personal circumstances. Issues to be considered include:

1. Are you relying on the value of the company to fund your retirement? If so, it may be best to sell and ensure you have a secure retirement.

2. Do you have an identified successor, i.e. child, able and willing to work in your business?

3. Can you bring one child into the business without creating a dispute amongst your children?

4. Are your children married and how may a divorce or separation impact the business?

Long-time readers of my blog will know that I am a proponent of family discussions and getting over the money taboo. I cannot overstate the importance of having a detailed discussion with your family if you plan to hand your business over to one or more of your children. If you pass that hurdle, you must speak with your accountant and lawyer to ensure you understand the implications of the freeze and how to properly implement the corporate restructuring. Finally, your tax advisor will want to structure the freeze such that it can be “thawed” if the business suffers a setback due to the economy, or your child(ren) prove incapable of running the company.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Are Estate Freezes the Wrong Solution for Family Business Succession? - Part 2 and Giveaway

On Monday I discussed why an estate freeze may not be the right solution for a family’s business succession plan and why Tom Deans considers an estate freeze to generally be the absolute wrong way to go about transferring a family business.

Today, I discuss my interpretation of Tom’s thoughts based on a panel discussion I participated in with him, my reading of his book and a review of interviews he has given. To be absolutely clear, these are my interpretations and Tom has not reviewed or commented in any way. Finally, I have a 4 CD audio set giveaway of Tom's book Every Family's Business.

Buy the Business, Are You Kidding Me?

In the postscript to Tom’s book Every Family's Business: 12 Common Sense Questions to Protect Your Wealth, he says the one part of his presentation that always elicits an uneasy response is when he says ‘in this room there are children who believe their parents will gift their business to them and parents who believe their children will purchase their business”. He goes on to say “this lack of clarity over the future ownership of the business is the greatest source of conflict and wealth destruction in a business".

What Tom is poignantly noting is the lack of communication between parents and their children and the unspoken assumptions that are often far from the truth. A parent needs to be honest with their child(ren) if their expectation is that their child(ren) will have to purchase the family business. Children need to be honest with their parent(s) about whether or not they are willing to purchase shares in the business or if they even have an interest in carrying on the business. The best business families are able to talk openly, honestly and frankly about money, business and family succession.

Just Sell the Damn Thing

Tom says “The legacy is not the business. The legacy is the family”. Many business owners believe their greatest legacy is their company and their job as entrepreneurs is to transition that business into their children’s hands. Tom suggests that owners need to grant themselves permission to take care of themselves first by selling for cash and looking at their business as an instrument of wealth creation. Although the business will typically be sold to competitors, Tom has no problem offering the business to children, as long as they purchase it on commercial terms and take on the risk of ownership (children may get preferential payment terms).

Tom says that when children find out they will not be gifted the business (through an estate freeze) they are often perturbed, however, when it is explained to them that someone is paying mom or dad millions of dollars, some of which may be allocated to them immediately or will ensure a significant inheritance for them in the future, they suddenly change their tune. Essentially, Tom is saying that the equity in your business does not have to be passed down as shares in the business, but can be passed as liquid wealth to your children down the road. To deal with the liquid wealth created by a sale, Tom wrote a second book entitled Willing Wisdom: 7 Questions to Ask Before You Die.

Transitioning Your Business to Your 65 Year Old Child

If a parent decides against selling the business and undertakes an estate freeze, often the parent becomes their own worst enemy. Tom half-jokingly noted during our panel discussion that when your parent has a heart attack at 71, twenty years ago they died. Now doctors put in a coronary stent and your parent is good for another 20 years. So when parents tell a child it will all be yours one day, that one day could be when you turn 65 and up until you obtain control of the company, your parent(s) may keep their thumb(s) on you (since they often maintain voting control as per my estate freeze discussion last week). Parents; skipping a generation is not succession planning! 

Find the End Before it Finds You

Tom says that in many cases your succession plan as an owner is no plan and until you suffer a health event, there is no urgency to plan. He suggests that it is important to start planning from day one, while you are healthy and clear of mind. Determine if there is a buyer in the house (family member) and as noted above, do not assume your children will be the buyer. He feels that if your children will not put up their own money (or obtain their own bank financing) to buy some or all of your shares, you should look elsewhere. If a child is not willing to risk their own capital, Tom feels that means they are either not committed to the business or they truly feel the business is old and past its freshness date.

Whether you want your business to be enticing to your children or an arms-length buyer, you must ensure your business adapts to changes and risks in the market place and that you continuously strive to improve operations and efficiency. By doing such, you make your company more valuable to an outside party and more attractive for a child to risk their own capital and carry on the business.

If you own a business, I strongly suggest you buy Tom’s book. In the end, he boils family succession planning down to 12 commons sense questions that start the family succession conversation but also cleverly have the ability to end the conversation quickly. I hope the two posts this week and last week’s blog on estate freezes, has given you plenty of food for thought.

Every Family's Business 4 CD Set Giveaway

I have two copies of a 4 CD audio set of Every Family's Business narrated by Tom. If you would like a copy, email Lynda@cunninghamca.com and I will randomly select the two winners and announce them on June 16th.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Are Estate Freezes the Wrong Solution for Family Business Succession?

Last week I discussed how an estate freeze provides an efficient income tax solution for the succession of your family business by allowing you to lock in the value of your business and pass the ownership tax-free to your children. However, a freeze does not provide you with immediate liquidity, nor does it require your children to risk their own capital. Some family succession experts believe an estate freeze is a misplaced income tax solution; when what is really required, is a business

solution.

A few months ago, I was one of the “experts” on a panel that discussed family succession. The guest speaker and main attraction for the night was Tom Deans (yes, believe it or not, I was not the draw). Tom is the author of Every Family's Business: 12 Common Sense Questions to Protect Your Wealth, the best-selling family business book of all-time with more than 300,000 copies in circulation. Tom is an outspoken advocate of parents taking care of themselves, which often means selling their business, whether to a competitor, their own child or management, rather than just handing it over to their children for free (via an estate freeze). 

Tom's suggestion to monetize your business, rather than hand it over to your children, runs counter to the commonly held belief that your business is your legacy and that the ultimate family business is multigenerational. For many business owners, I would suggest that Tom’s advice to sell and safeguard your retirement is often the prudent decision.

Tom says an “estate freeze usually sets the stage for what I like to describe as the beginning of the ‘perpetuity project.’ This is when a family shifts its thinking away from the business as a money-making asset and toward the business as a legacy, with the goal of ‘longevity’ trumping all other strategic options for creating value.”

With statistics suggesting that only 30% of family businesses transition successfully to the 2nd generation and a meager 10% to a third generation, Tom may be correct that many parents are compliant in destroying their business by trying to ensure its perpetuity.

Why Parents May Choose to Undertake an Estate Freeze

In my experience, parents often cite three reasons for preferring an estate freeze over an outright sale to an arms-length party or to one of their children.

1. They see the family business as an annuity, so why sell for $4,000,000 ($3,200,000 or so after-tax) when it will make $4,000,000 every 4 to 5 years indefinitely if the business continues as it is or grows.

2. They feel they can easily redeem enough of their frozen shares each year to cover their living expenses so why burden the children with additional debt.

3. What is the point in selling shares to their children, if their children need to borrow from the bank to purchase the shares; especially since if the business goes sour, the parents figure they may need to step-up and cover the default anyways?

What Is so Bad About an Estate Freeze?

As many accountants can attest to, often a well- intentioned estate freeze that has saved the family thousands or even hundreds of thousands of dollars in tax ends up being the catalyst to family conflict and/or the ruin of the families business. Here are some of the downsides to an estate freeze:

1. In undertaking a freeze, shares are issued for no consideration. The children have no risk capital invested in the company, which can alter their commitment to the business. (More on this on Wednesday.)

2. Whether a company’s share value increases due to market forces or because of the children’s efforts or non-efforts is irrelevant; your children may end up making far more than you ever did, despite you handing them a turnkey operation (that may be fine with you).

3. An estate freeze requires decisions regarding which child(ren) will work in the business, how they will be compensated and which of them get shares and what percentage of the shares. All these decisions can blow-up. For example, let’s say you undertake an estate freeze and give your daughter who will work in the business all the shares of the business (which are in theory worthless at the date of the freeze, since you have all the current value in your special shares, say your shares are worth $2,000,000 in this example). You leave your other two children say $100,000 each in your will to “compensate” them for not being involved in the freeze. Imagine the sibling conflict if the business grows to $3,000,000 in value. The child working the business has benefited to the tune of one million dollars ($3,000,000- $2,000,000 freeze value) plus a full-time job, compared to the $100k the other children will receive in the will.

4. Parents often like the concept of freezes because it locks in the maximum amount of income tax they will owe on death, however, the freeze is also often viewed as a way for them to slow down and move away from the business. If the child who takes over the business makes a mess of the family company, mom or dad or both are often forced to step back in to save the company – not exactly the stress-free retirement they imagined.

5. In a blog posting by Tom, he states that an estate freeze “magnifies family genius – and incompetence – precisely because the market rules of ownership were violated through gifting, all in the name of saving tax. Families pay the highest price when they lose their mutual trust and respect for one another when gifting goes bad. And when trust is lost, family members resorting to litigation is the saddest progression of a family business in decline”.

The Benefits of Estate Freezes

My personal experience with estate freezes has been good. While the overwhelming majority of my clients over the years have sold their businesses, there have been several that have frozen their companies and everything worked out. I would say that is because most of these clients were able to distinguish which child(ren) deserved to work in the business and were committed to the business (in most cases, the children have been uniformly intelligent and often academically brighter than their parents, though not necessarily as street smart). The parents also gave significant thought to how they would compensate the children both involved in the business and those excluded from involvement. Finally and probably most import, the parents tried to understand the sibling dynamic within their families and whether a freeze made sense within these family dynamics.

When I spoke to Tom about this before his speech, he asked me “If all these children were so committed to the business and so bright, why would they not have agreed to purchase shares from their parents?”

After reading this post, you may be thinking to yourself that an estate free may not be the succession planning panacea it is marketed as; at least from the non-tax perspective. On Wednesday in part two of this post, I will discuss the issues Tom considers vital in regards to selling or transitioning your family business. In addition, I will give away two copies of a 4 CD set of Every Family's Business narrated by Tom.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Estate Freeze – A Tax Solution for the Succession of a Small Business

Winston Churchill once said, “Let our advance worrying, become advance thinking and planning.” Small business owners often worry about their exit strategy and/or succession plan. They may also be concerned about what would happen to their business if they have a health scare or receive an ultimatum from a child working in their business. Often a small business owner’s worry becomes their anxiety, instead of their advanced planning.

As a small business owner, at the end of the day, there are essentially only two exit strategy/succession options you need to plan and/or consider:

(1) A sale of your business, typically to a competitor, sometimes to current management or very infrequently, an actual sale to a child or other family member; or

(2) A transfer of the business to your children without a sale (for purposes of this article I will refer to this option as an “estate freeze”).

My blog today discusses estate freezes. How you can transfer your business tax-free to a successor (typically your children, sometimes to existing management) while continuing to control and receive remuneration from your business.

Next week I’ll discuss Tom Dean’s thoughts on this matter. Tom who is the author of Every Family's Business (the bestselling family business book of all-time) believes a business should in most cases be sold and never handed over to the next generation (such as done with an estate freeze) without the parent(s) adequately being compensated for the business.

What is an Estate Freeze?

The most tax efficient manner to transfer your business to your children is to undertake an estate freeze. An estate freeze allows your child(ren) to carry on your business, while at the same time you receive shares worth the current value of your business. In addition, once your share value is locked-in, your future income tax liability in respect of your company’s shares is fixed and can only decrease. Keep in mind that when you freeze the value of your company you are not receiving any monies for your shares at that time. There may be ways to monetize that value in the future, but on an estate freeze, you typically only receive shares of value, not cash.

The key risk in any estate freeze is that your children may partially or fully devalue these shares and your company. So while an estate freeze may be the most tax efficient way to transfer your business, it may not be the best decision from an economic or monetization perspective. 

In a typical estate freeze, you exchange your common shares of your corporation on a tax-free basis for preferred shares that have a permanent value (“frozen value”) equal to the common shares’ fair market value (“FMV”) at the time of the freeze. Subsequently, a successor or successors, say your children or family trust can subscribe for new common shares of the corporation for a nominal amount.

This concept is best explained with an example. Assume Mr. A has an incorporated business worth $3,000,000 and wants to undertake an estate freeze. In the course of the freeze, Mr. A is issued new preferred shares worth $3,000,000 and his children or a family trust subscribes for new common shares for nominal consideration. Mr. A’s tax liability in relation to these shares on death, is now fixed at approximately $750,000 in Ontario ($3,000,000 x capital gains rate). Often, a key aspect of an estate freeze is a plan to reduce the tax liability by redeeming the preferred shares on a year by year basis as discussed below.

If you have access to your lifetime capital gains exemption (currently at $800,000 but indexed beginning in 2015 for inflation), your income tax liability may be reduced when the shares are eventually sold or upon your death if you still own them at that time. Finally, you may choose to crystallize your exemption when you freeze the shares.

The preferred shares received on the freeze can be created such that they allow you to maintain voting control of your corporation until you are satisfied your child(ren), is(are) running the company in the manner you desire. This maybe a double-edged sword, as you may tend to hold onto control long after your successors have proven themselves. This may become a contentious issue.

Preferred shares can also serve as a source of retirement income. Typically what is done is that your preferred shares are redeemed gradually. So, for example, if you need $100,000 before tax a year to live, you can redeem $100,000 of your preferred shares each year. Let’s say you live 20 years and redeem a $100,000 a year. By the time of your death, you will have redeemed $2,000,000 ($100,000 x 20 years) of your preferred shares and they will now only be worth $1,000,000 ($3,000,000 original value less $2,000,000) at your death. Your income tax liability on these shares at the time of your death will now only be approximately $250,000.

The Benefits of an Estate Freeze

1. On death (something we should all be planning for), an individual is subject to a deemed disposition (i.e. a sale) on all of his/her assets at FMV, which would include his/her shares of the business. An estate freeze sets your maximum income tax liability upon this deemed sale and as discussed above, this liability can be lowered over the years by redeeming the shares.

2. Family members will be able to become shareholders of the business at a minimal cost and be motivated to build the business (although Tom Dean's would dispute this assertion).

3. Instead of having children directly subscribe for new common shares, you can create a discretionary family trust to hold the common shares. Every year, the corporation can pay dividends to the family trust which can then allocate the dividends to family members with lower marginal tax rates. This mechanism allows for great income splitting opportunities.

4. On the eventual sale of the business, the children or family trust may realize a significant capital gain. Assuming that the business qualifies for the capital gains exemption, the family trust can allocate this capital gain to each beneficiary who may be able to use his/her own lifetime capital gains exemption limit to shield $800,000 or more of capital gains from income tax.

One of the more critical aspects of an estate freeze is the determination of the fair market value ("FMV") of your business. In order to ensure that an estate freeze proceeds as smoothly as possible, the FMV of the company must be calculated. In the event that the FMV determined is challenged by the Canada Revenue Agency (the “CRA”) the attributes of the preferred shares will have a purchase price adjustment clause that will let the freezer reset the FMV. The CRA has stated in the past that they will generally accept the use of a purchase price adjustment clause if a “reasonable attempt” has been made in valuing the company. Engaging a third party independent Chartered Business Valuator to prepare a valuation report is generally accepted as a “reasonable attempt” in estimating the FMV.

Issues to Consider Before Implementing an Estate Freeze

An estate freeze does not make sense for all business owners. While the above benefits do sound very enticing, it depends on each owner’s personal circumstances. Issues to be considered include:

1. Are you relying on the value of the company to fund your retirement? If so, it may be best to sell and ensure you have a secure retirement.

2. Do you have an identified successor, i.e. child, able and willing to work in your business?

3. Can you bring one child into the business without creating a dispute amongst your children?

4. Are your children married and how may a divorce or separation impact the business?

Long-time readers of my blog will know that I am a proponent of family discussions and getting over the money taboo. I cannot overstate the importance of having a detailed discussion with your family if you plan to hand your business over to one or more of your children. If you pass that hurdle, you must speak with your accountant and lawyer to ensure you understand the implications of the freeze and how to properly implement the corporate restructuring. Finally, your tax advisor will want to structure the freeze such that it can be “thawed” if the business suffers a setback due to the economy, or your child(ren) prove incapable of running the company.

As noted above, next week I will discuss Tom Dean’s views. Tom feels an estate freeze is not a succession plan or the best way to liquidate or sell a business.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Introducing a Family Trust as a Shareholder in a Private Corporation

Two weeks ago I discussed using a holding company as a simple method to creditor proof excess corporate funds or other assets in a private corporation. In this blog I will discuss a “fancier” and far more complex transaction that can not only achieve creditor proofing, but potentially provides a means to income split with family members, potentially provides multiple access to the $750,000 capital gains exemption and finally, may provide a means to crystallize or "freeze" the income tax liability related to your company's shares at death.

For the purpose of this blog, I will  use the example of Starlet Yohansen who owns all the common shares of Movie Star Limited ("MSL"). The shares initially cost Starlet $1 and are now worth $3,000,000.

For Starlet to concurrently achieve all the objectives noted above, she would typically “freeze” the value of her  common shares in MSL. At the date of the “freeze”, Starlet would exchange her common shares for special preferred shares with a value equal to the value of the common shares exchanged, that being $3,000,000. Thus, at this point in time, there are no common shares and Starlet owns special shares worth $3,000,000. These special shares cannot increase in value, hence the term "freeze".

Any future growth in the value of MSL over the current value of $3,000,000 will accrue only to the new common shares that are issued as part of this reorganization. That growth will accrue directly, or indirectly through a family trust, to potentially Starlet's family members and/or a Holding company by having them subscribe for the new common shares issued in MSL (Starlet can also maintain some of the future growth if she subscribes for the new common shares or is included in the family trust). Often we see this strategy being used in succession planning when the owner-manager wishes to transfer ownership of their operating company to the next generation, but this strategy can be used without succession being the objective.

The beauty of the freeze is that Starlet's maximum income tax liability on her MSL shares has been established (unless she subscribes for more common shares). At Starlet's death, her income tax liability on her MSL shares will be equal to $3,000,000 times the applicable income tax rate at that time, likely around 23%. As Starlet knows the maximum income tax liability on her special shares she can plan to pay this liability by putting aside funds or by purchasing life insurance.

In addition, we often further reduce Starlet's  income tax liability by redeeming her frozen shares over time, which typically creates a current taxable dividend to Starlet, but also serves to reduce the value of the frozen shares by essentially the value of the dividend reported [ie: if Starlet redeems 500,000 shares that have a paid up capital and adjusted cost base of $1, she will have a deemed dividend of approximately $500,000 to report on her personal income tax return and her special shares are now only worth $2,500,000 ($3,000,000-$500,000 redeemed)]. Thus, if Starlet lives long enough, much if not all of her income tax liability can be eliminated prior to her death by redeeming her shares slowly over time.

If Starlet uses the Yohansen Family Trust to subscribe for the new common shares of MSL, the beneficiaries of the family trust would typically include Starlet, her spouse (although given Starlet's past history, we may want to leave her spouse out of the trust), her children and a Holding company. The inclusion of these beneficiaries can provide tax-effective income splitting on dividends received from MSL when the children are 18 years of age or older or when a spouse is in a lower income tax bracket (Starlet may have a trophy husband who does not have much income). The trust can also provide tax-effective income splitting on the sale of a business irregardless of the beneficiary’s age.

Generally, a family trust is discretionary. The trustees can tax effectively allocate the income received by the trust (i.e. dividends from MSL) to any or all of the beneficiaries including Starlet, so long as they are 18 years of age or older. A beneficiary who is 18 years of age or older and has no other sources of income can receive up to $37,500 in dividends tax-free. This strategy is a great way to help fund a child’s post-secondary school education (in addition to an RESP) or other expenses, while also lessening the family’s overall income tax liability.

If the shares of MSL are sold in the future, any sale proceeds in excess of the value of Starlet's original  frozen special preferred shares ($3,000,000 maximum) can be allocated to the beneficiaries of the trust. This may permit the utilization of the $750,000 capital gains exemption by each of these beneficiaries. A word to the wise though, any sales proceeds allocated to a beneficiary of the trust, including a minor child, will result in the money legally belonging to the child.

Finally, back to the original creditor proofing issue. The inclusion of a Holdco as a beneficiary of the trust would provide a means to transfer any excess funds in MSL as a tax-free via a dividend from MSL to Holdco thus creditor proofing the excess cash in MSL by moving it to Holdco.

I am sure there are very few readers still awake or with eyes not glazed over; but believe it or not, this type of reorganization has been simplified greatly for discussion purposes. There are several pitfalls along the way and in the future that must be avoided in order to successfully achieve the objectives noted at the beginning of this blog. If you are contemplating undertaking such a transaction, you must consult your accountant and lawyer to ensure that the transaction makes sense given your personal situation and that no details are missed in carrying out the finer points of the reorganization.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the material is time sensitive and subject to changes in legislation or law.