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.

Financial Rules of Thumb

I thought today, I would discuss some financial rules of thumb. All these rules should be taken with a large grain of salt, but they can sometimes provide an initial starting point from which to work. Please do not consider any of these rules as gospel.

Investment Returns

The “Rule of 72” is an actual rule you can use with confidence, as it is mathematical. The rule simply tells you how long it will take for your money to double, at a fixed rate of return.

The formula is 72/interest rate (or annual rate of return) = number of years it will take for your money to double.

For example, if your interest rate is 10%, that means your money will double every 7 years or so (divide 72 by 10 = 7.2 years to double).

A return of 5% will take 14.4 years to double and a return of 7% will take 10.3 years to double.

Retirement Withdrawal Rate

The 4% Rule

Financial planner William Bengen advocated the 4% rule almost 30 years ago to address his clients’ questions about what is a safe yearly withdrawal rate from their retirement portfolio. Mr. Bengen looked to data from as far back as 1926. He determined that given a portfolio split evenly between stocks and bonds, a 4% withdrawal rate (adjusted for inflation each subsequent year) should provide adequate cash flow for a retirement spanning at least 30 years.

The 4% rule has been one of the most debated rules in finance for several years and I have written numerous articles on this topic over the years. Mr. Bengen has suggested in recent years, that an even higher withdrawal rate would be safe, while others suggest a more conservative rate such 3%. 

 

Given the current rate of inflation, one would wonder if the 4% rule would quickly fall offside. However, in an interview on the Rational Reminder Podcast ,Mr. Bengen comments in the podcast that one scenario that broke the 4% rule, was a scenario in which the retiree encountered double digit inflation for the first 15 years of retirement. So surprisingly, the rule seems to withstand inflation well.

The 4% rule works as follows: say you need $100,000 a year to fund your retirement expenses; you would dividend $100,000/4% and the calculation would suggest you need a nest-egg of $2,500,000. The $2,500,000 nest-egg would allow you take draw $100,000 a year for 30 years without running out of money. 

The Rule of 20

The rule of 20 or for some 25, means you need $20 or $25 of savings for every dollar you expect to spend in retirement.

For example, if you want to live off $100,000 a year, you will need either $2,000,000 ($100,00 x 20) or $2,500,000 ($100,000 x 25).

You will note the 25 times number brings you to the same retirement nest-egg as the 4% rule; that is because the rule is a derivative of the 4% rule.

Budgeting

The 50/30/20 Rule

This rule was created by Senator Elizabeth Warren (a Harvard law professor when she coined the term) and her daughter, Amelia Warren Tyagi, in the book All Your Worth: The Ultimate Lifetime Money Plan.

This rule of thumb suggests you allocate 50% of your after-tax income to your needs (rent, groceries, utilities etc.), 30% to your wants (hobbies, restaurants, streaming services etc.) and 20% for retirement and savings goals.

A small variation on this rule is the 80-20 plan. Under this method you first set-aside 20% of your after-tax earning into a savings account and the remaining 80% is then spent as needed.

Emergency Fund

A common rule of thumb is to set aside three to six months of expenses in an emergency fund. It is suggested the number of months increase to 8 or more months where you have a job in a volatile field of work.

Unfortunately, the reality and shortcomings of this rule were reflected when COVID-19 shut down the economy and job market for many people.

Life Insurance

How much life insurance you need is really dependent upon your personal situation. A general rule of thumb is you require 6-10 times your gross annual salary in life insurance (in almost all cases this type of insurance should be term insurance, with possibly a conversion option at a future date in the policy). However, the 6-10 multiplier can be higher if you have young children, a mortgage, stay at home spouse etc. You really need to review your specific situation and what you think your family would need if you passed away. I discussed some of these considerations in this 2016 blog.

Appliance Repairs

I have no idea of the origin of this rule, but this rule of thumb states that when an appliance breaks, buy a new one if the appliance is 8+ years old or the repair would cost more than half the replacement cost. 

Big Ticket Purchases

The Rule of 10

I like this rule. The rule of 10 is like the twenty-four-hour rule in hockey before a parent can talk to the coach. It provides for a cooling period. The rule of 10 is for large discretionary purchases. The rule says to reflect on how the purchase will make you feel in 10 days, 10 weeks and 10 years.

The cooling period should be equal to one day for every $500-$1,000 of purchase costs, which seems a little long to me. I would suggest a 7-10 day cooling period should be sufficient for most people.   

 

Rules of thumb are simple, convenient and in some cases, a good guideline. However, please do not consider any of these rules as gospel.

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.