Reducing the estate planning tax burden through proper planning

Appropriate tax and estate planning can significantly reduce the tax burden experienced by wealthy families at the time of inter-generational transfers. First and foremost the family and its advisors must ensure that mistakes are not made that can in fact result in higher than expected taxation. In order to illustrate the range of possibilities, this memo breaks down the options as follows:

1. What if we screw it up and make all the wrong moves?
2. Assuming basic planning, what would the tax liability be and how would we pay it?
3. Can we do anything to minimize or at least cover the tax payable if we use insurance?
4. Is there anything else we can do outside of using insurance and will it be effective?

In each case, we will assume that there is a holdco/opco structure, an asset freeze on the shares has already been completed by the founders, there is a family trust in place to facilitate the transfer to the next generations, and the value within the corporate structure is $60 million with negligible cost base (ACB.) So, let’s walk through the possibilities.

Option 1 – making the wrong moves

Let’s assume the parents each have a simple will that says “everything to my spouse and if my spouse predeceases, then to our children equally.” This, or some variation of the sort, is what we often find whether the parents are wealthy or of modest means. The sentiment is sound but the tax results can be draconian. Without proper planning, this could result in double taxation.

First, on the second death (assuming use of the spousal rollover) the capital gains are triggered. On $60M, this would result in a capital gains tax liability to the parents of $15M. Assuming the parents had the resources to cover this liability, the children would, as the will intended, then inherit the shares equally. Secondly, the not if, but when the children want to access the value within the corporation, they would have to take taxable dividends. On a complete liquidation, the dividend tax on $60M would result in approximately $20M in additional taxes being paid. Combine the two and the result is approximately 58% lost to taxes.

This double tax problem is very real. However, through some basic planning there are ways to prevent double taxation and leave the family with only one tax to pay (on either the capital gain or the dividend.)

Option 2 – better off through basic planning

The Income Tax Act provides a mechanism whereby the capital gain can be eliminated on the parents’ death. In this case, rather than gift the shares to the children on the second death, we instead cause the corporation (holdco in our example) to redeem the shares from the parents’ estate. This has two consequences: first, the taxable dividend that would have gone to the children now goes to the estate and second, the transaction creates a capital loss in the estate exactly equal to the capital gain in the final return of the deceased parent. This loss results from the fact that after the death the estate receives the shares at their FMV and gets a bump in the ACB to the full FMV of the shares (by design within the Act to ensure that there is not the same capital gain twice – once to the deceased, and then to the estate as a separate taxpayer.) Closing the loop on this planning option is that subsection 164(6) provides that the capital loss created in the estate can be carried back to offset exactly the capital gain in the deceased’s final return.

Looking at the numbers then, the $15M tax liability on the capital gain is eliminated, leaving only the $20M tax on the dividend to the estate. The shares themselves are no longer available to gift through the will since they will have been eliminated. Keep in mind, however, that this does not necessarily mean the corporation itself has to be wound up, only the shares of the corporation that were owned by the parents. If, as in our example, a freeze has been done and new shares issued, those new shares will continue to exist and the corporation remains whole provided the parents estate can come up with the cash to meet the $20M obligation.
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Through so-called “windup” planning, the double tax at 58% is reduced to the dividend tax rate of about 34%. An improvement, but it is possible through another similar type of planning to have an even lower tax rate. This is known as “pipeline” planning, the idea being that if we want to eliminate one of the taxes in the double tax scenario, better to eliminate the 34% dividend tax than the 25% capital gains tax,

Pipepline planning involves making some post-mortem maneuvers including creating a new corporation, selling the shares from the estate at FMV to the new corporation in exchange for a note (which results in no capital gain to the estate due to the operation of the Act) then subsequently, winding up the old holding corporation into the newly created corporation which results in a bump in the ACB of the shares of the new corporation under subsection 88(1)(d). Finally, assets now within the new corporation are liquidated and the note is paid off. This series of transactions means the estate itself will have paid no tax. However, there remains the capital gain liability that was on the deceased’s final return. The net effect is a tax of only 25% or $15M, rather than the 34% or $20M that would normally occur on the windup described above. The double tax problem was eliminated this time leaving only the capital gains tax.

Pipeline planning is clearly more aggressive but to date, CRA has not chosen to audit these transactions. Still, some are concerned that it could be subject to GAAR so efforts are made to spread the transaction out and in some cases get advanced rulings from CRA. The idea of spreading it out contrasts with windup planning that must be completed within a year. Pipeline planning usually is completed within the year (in order to get funds to deceased to pay the tax bill) but needn’t be and therefore may be the only option is there are estate delays caused by things such as litigation.

Option 3 – better off using insurance

Whenever you are paying out a dividend, it can be a taxable dividend or a non-taxable capital dividend (provided that there is any capital dividend account (CDA) available in the corporation.) CDA results from any tax-free receipt by a corporation including, for example, the tax-free portion of any capital gains experienced within the corporation or importantly, the tax-free receipt of life insurance proceeds. In our planning process then, life insurance can be used to create CDA available for distribution by way of tax-free dividends most notably as part of a windup plan.

To illustrate the effectiveness of adding insurance to the plan, consider what would happen if we had a joint-last-to-die policy on the lives of the parents for $15M held and paid for inside the holding corporation. If we then did a windup plan, the $60M taxable dividend would be reduced by the $15M which could be paid out as tax-free capital dividend. The net tax payable would therefore be reduced from $20M to about $15M. In other words, simply moving some of the assets in the corporation from other investments into life insurance will in this example reduce the ultimate tax bill by $5M.  If that same insurance was a product with an increasing death benefit and at the time of death had grown to a $25M death benefit, the tax bill will be reduced further. Instead of a tax bill of $20M on the windup of the parents’ shares, the tax bill would be only about $12M.

It can be seen then that in corporate settings, insurance is a tool not so much for paying the tax bill, but actually reducing it. The cost of the insurance in these cases is really nothing more than the difference in opportunity cost between what the insurance itself produces and what a similar alternative investment would earn. If, the parents are conservative investors, you would find that the insurance actually produces a better after-tax return than similar fixed-income type investments. If, however, the parents are aggressive investors and expect higher returns, there may be some point at which they are better off investing rather than transferring assets to insurance but the hurdle rate will be quite high given the tax efficiency not only of the insurance itself but in particular given the tax savings it produces in a windup plan.

With respect to the use of insurance in a pipeline plan, there can be gains but the gains to the parents will not be as striking as when used in a windup plan. This is because the CDA that is created will not be accessible by the parents having chosen to recognize taxable capital gains over taxable dividends through the planning process. However, where insurance is used in a pipeline plan, there are residual benefits to the next generation. Going back to our example, in the pipeline plan, the parents will still have a $25M capital gains tax liability but the $15M or $25M of life insurance described above will create CDA that is available to the children. In other words, they will be able to extract that amount tax free from the corporation in the future. Therefore, if the parents are looking at the family as a whole, they may in fact choose the pipeline plan using insurance for ultimate long-term family tax planning. Another reason they may actually require the insurance is if they don’t have sufficient outside resources to pay the $25M tax liability. The insurance in the holding corporation can be used to extract some funds tax free in order to pay the tax bill.

Option 4 – any other choices?

In short, no. Under our current tax system, the windup or pipeline are the only options available to eliminate the double tax problem and in either case, insurance is the most effective and accessible tool available to reduce the tax liability further. It really just comes down to choosing between these two planning options and deciding how much insurance to use.

With proper planning, it may in some cases be possible to eliminate the final tax bill altogether. This would require doing a windup, getting all the assets into insurance before death and having the perfect set of circumstances and planning. However, this is impractical for most families. The best result for most will be a compromise. In general, due to limitations put into the Act in 1995, our starting point is an upper limit of eliminating 50% of the tax by having insurance that equals 50% of the asset value at life expectancy. Given the variables, it is not easy to do but we can get close working with the client’s advisors to craft the right planning technique paired with the right amount of insurance.