This is part one of a two-part series on estate planning. Read part two.
There are two main times when clients are deemed to have sold all their assets at fair market value, even if they haven’t actually done so: when they become a non-resident of Canada, and when they die.
The latter is more likely. From July 1, 2016 to June 30, 2017, about 67,000 people emigrated from Canada while nearly 279,000 people died.
“Generally speaking, the capital property that you’re owning at the time of death is deemed disposed, or considered to be sold at fair market value,” says Tony Salgado, director of Financial Planning and Advice at CIBC.
This deeming provision “creates probably one of the most, if not the most, significant tax liability of your entire life,” he adds.
Salgado notes it’s difficult to minimize that tax liability upon death. “If you’re not taking advantage of a spousal rollover, there’s very little that you have available to you,” he says.
A spousal rollover allows a surviving spouse or common-law partner to inherit capital property and pay taxes on the capital gain when he or she dies instead (or otherwise disposes of the property). The property is transferred from the deceased to the surviving spouse at the property’s adjusted cost base, and the spouse is taxed on any increase above that amount.
When preparing and updating estate plans, clients should also ensure their beneficiary designations are up to date on eligible investment vehicles such as TFSAs, RRSPs/RRIFs and life insurance. With TFSAs, spouses can be named successor-holders so that, on death, the TFSA rolls over to the surviving spouse; in that scenario, the funds and any growth remain sheltered.
There are more options for people who own Canadian-controlled private corporations.
Help for business owners
Business owners can implement estate freezes as part of their overall estate plans to help manage their tax liability on death, says Salgado.
But first, check if a freeze is suitable. “They can be somewhat costly to implement, so we want to make sure it makes sense for them and their family.” (In 2016, a lawyer told Advisor’s Edge that a freeze costs at least $15,000 to implement properly.)
“An estate freeze can make sense specifically when we are expecting the value of the business to grow over time, and if we want to defer the tax liability upon death,” says Salgado.
Corporations should also be worth enough to make a freeze worthwhile. A corporation should have sufficient value that will increase in the future—for instance, doubling from $1-million to $2-million in five years.
A business owner considering a freeze should also have enough current net worth to really support herself through her golden years. Salgado says a freeze is meant to allow the owner’s children “to assume ownership of the future growth of the business. We are now pushing that future growth, along with the associated future tax liability, to the next generation.”
Salgado says the tax deferral can be significant.
“On a $10-million business, if you’ll be paying capital gains tax upon death, you’re facing an estimated $2.5-million tax liability,” he says by way of illustration. “If that $10-million business becomes a $20-million business, that $2.5 million tax liability upon death now becomes $5 million.”
An estate freeze implemented when the business is only worth $10 million could freeze the owner’s tax liability at $2.5 million, and have the children pay the remaining $2.5 million in the future.
How an estate freeze works
In brief, the original owner exchanges existing shares for preferred shares. The preferred shares should be worth the same amount as the company’s present fair market value, and are “frozen” at that amount.
The company then issues common shares. The successors buy those common shares for a nominal amount (e.g., $1 per share), and any further increase in the company’s value accumulates in their hands.
For example, if MomCo is worth $10 million and Mom wants to do an estate freeze, MomCo can issue preferred shares for $10 million to Mom. Mom’s tax liability on her company shares is now frozen since her shares won’t increase in value.
Then, MomCo can issue common shares to her daughter and son for a nominal value of $1 per share. Mom’s children will then hold shares that increase in value as the business increases in value. When the children eventually dispose of their shares, they will be taxed on the increase in the company’s value post-freeze, minus the adjusted cost base of $1.
This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.