The desire to reduce the tax burden which will be incurred on death is the main motivating factor behind income tax succession and estate planning.
Taxation on Death or Transfer of Assets
While succession duty, estate tax and gift tax are not currently imposed by the Federal or Ontario governments, an individual is deemed by the Act to have disposed of all of his capital property immediately before death for its fair market value at that time. There is an exception for property that is transferred to the taxpayer’s spouse or a trust for the taxpayer’s spouse as discussed below.
The Act provides that where a taxpayer disposes of anything to a non-arm’s length person for proceeds less than fair market value; or to any person by inter vivos gift, the taxpayer is deemed to have received proceeds of disposition equal to fair market value. An entrepreneur who owns shares in a family business with inherent capital gains will realize those gains on death or when he transfers the shares of the business for less than the fair market value to a child.
It is the inherent capital gains tax on the increase in value of the family business which often motivates an entrepreneur to consider how the family business can finance the transfer from one generation to the next.
Estate Planning Methods
Gift to a Spouse or Spousal Trust
One of the simplest ways for an individual to defer capital gains tax on death is to transfer the family business to a spouse or to a trust for the spouse. This, However, does not defer the tax on the accrued value of the business when transferred to the next generation, which tax will occur on death of the surviving spouse.
An election can be made under the Act so that a transfer to a spouse or to a spousal trust will occur at fair market value rather than on a rollover basis. This enables the personal representatives of the deceased entrepreneur to elect to realize sufficient gains to absorb any capital losses owing on death.
A transfer of the family business directly to the spouse may satisfy the planning requirements of the parent in some circumstances. However, where a parent wishes ultimately to transfer the business to the children, but knows that the business cannot fund the tax liability arising on death, the parent can transfer the property to a spousal trust. This allows capital gains tax to be deferred until the death of the spouse, but ensures that the family business is eventually transferred to the next generation. This approval also defers the problem of funding the tax liability to the children.
A spousal trust will, however, not be appropriate in all circumstances. Vesting of the family business in the children will be delayed until the death of the spouse. The desire of the children to increase the value of the business by reinvesting income to allow for expansion may be at odds with the surviving spouse’s need for income. Perhaps most likely to cause problems is the transfer of a family business to a spousal trust for a second spouse where the children are actively involved in the family business and the relationship between the spouse and the children is not good. In such a case, the potential for disruption of the operation of the family business may be sufficiently serious to forego the tax deferral and to make instead a direct transfer of the family business to the next generation. However, in Ontario, a spouse’s right to elect to take an equalization of net family property rather than what is provided under the will must also be considered.
Where there are significant assets outside the family business, some thought should be given to establishing both a spousal trust and a family trust under a will, so that assets with an inherent capital gain can be transferred to the spousal trust and the tax deferral obtained and other assets with little or no inherent capital gains can be available for the children.
An estate freeze allows the capital value of a business to be “frozen” at the time of the freeze and future growth in the value of the business to be transferred to the next generation without triggering capital gains tax. The advantage is the deferral of tax until the death of the next generation in respect of the increase in value of the business after the freeze. As mentioned briefly above, the most common form of an estate freeze is a reorganization of share capital under section 86 of the Act.
Generally, in a section 86 reorganization, common shares of a business would be converted into common and preference shares. The preference shares would be fixed-value shares with their value being equal to the fair market value of the business at the time of the reorganization. As all of the value of the corporation will be reflected in the value attributed to the preference shares, the new common shares will have nominal value. These new nominal value common shares can then either be transferred directly to members of the next generation or can be transferred to a trust for members of the next generation (see the discussion below) without any adverse tax consequences.
An estate freeze can also be carried out by way of a section 85 transfer of the shares of the operating company into a newly established holding company with the transferor taking back preferred or special shares equal in value to the common shares of the operating company transferred to the holding company. The shares of the holding company would be owned by the next generation in the case of a complete estate freeze.
A partial estate freeze, which is one in which some of the future growth is retained by the parents, can also be accomplished either with a section 85 rollover or a section 86 reorganization.
Any growth in the business will result in an increase in the value of the common shares. However, the common shares will have already been transferred to the next generation. Thus, capital gains tax on any increase in value of the business after the freeze will not be triggered on the parent’s death. Capital gains tax will, of course, be triggered on the parent’s death on the difference between the adjusted cost base and the fair market value (the value at the time of freeze) of the preference shares. As set out above, the preference shares may be transferred to a spousal trust to defer this tax until the death of the spouse. Alternatively, the preference shares may be redeemed over time to provide income to the parent. Each redemption will trigger capital gains on the inherent gain in the preference shares which will allow for payment of this tax over time.
One of the most important issues which must be addressed by a parent considering an estate freeze is whether the parent’s frozen interest in the business, along with his or her other assets, will be sufficient to maintain his and the lifestyle of his spouse.
Inter Vivos Trusts
A transfer of property to the trustees of an inter vivos trust (other than a spousal trust) results in a disposition under the Act for deemed proceeds equal to the fair market value of the property at that time and therefore triggers tax on any inherent capital gain.
As outlined above, a transfer of property to a trust (other than a spousal trust) is deemed to occur at the fair market value of the property at the time of the transfer. However, property can usually be distributed to a beneficiary in satisfaction of his or her capital interest in a trust on a roll-out basis.
The Act provides that where property of a personal trust has been distributed by the trust to a beneficiary of the trust in satisfaction of all or part of the beneficiary’s capital interest in the trust:
- The trust is deemed to have disposed of the property for proceeds equal to its cost to the trust and
- The beneficiary is deemed to have acquired the property at a cost equal to its cost to the trust.
Because property is deemed to be disposed of at fair market value when it is settled on a trust, but subsequently can be transferred to a beneficiary in satisfaction of the capital interest in the trust on a roll-out basis, trusts are commonly used in conjunction with an estate freeze. Common shares acquired in an estate freeze would not normally have significant inherent capital gains (as most of the value of the business will be attributable to the preference shares issued as part of the freeze) and so can be transferred on a trust with minimal tax consequences. If the common shares increase in value while held in the trust, they can then be distributed to the beneficiaries on a roll-out basis.
The advantages of settling the common shares (or “growth” shares) on the trustees of a trust are:
- Common shares can be held by trustees for the benefit of minor children and so the freeze can, if otherwise appropriate, be effected before the children are old enough to own the shares directly
- The trust can be drafted to include unborn issue and issue of deceased children and so can accommodate changes in the family structure
- Using a discretionary trust allows the parent to delay making a decision respecting ultimate ownership of the common shares until the parent has had an opportunity to assess the interests and ability of the children to operate the family business
- Legal title to the common shares and the ability to vote the common shares is vested in the trustees of the trust. This may give the parent who retains an interest in the family business an increased level of comfort that the business will be appropriately operated.
Once a decision has been made to settle shares of the family business on the trustees of a trust, the choice of appropriate trustees is crucial. Often the settlor will wish to be a trustee during his lifetime. If the settlor of a discretionary trust is to be the sole trustee or even one of three trustees but has the ability to effectively veto decisions of the remaining trustees, the Act may apply to attribute income and capital gains from property in the trust to the settlor. It may be possible for the parent to be the sole trustee of the trust if the trust is settled by a third party such as a grandparent and the trustees borrow from an independent third party to acquire the common shares.
Subsection 75(2) of the Act provides that where property is held on trust on condition that the property (or substituted property) may revert to the person from whom the property was received or pass to persons to be determined by the person after the creation of the trust, income and capital gains of the trust will be attributed to the person.
“The individual has the capacity or discretion to select the proportion of the Trust Fund to be allocated to a specific person among the group of beneficiaries, [so] paragraph 75(2) will apply”.
Subsection 75(2) of the Act does not attribute income to a settlor who is the sole trustee of a fixed trust and does not attribute business income. Attribution under this subsection can be avoided for income from property if the settlor is one of at least three trustees and a simple majority of trustees can make decisions respecting beneficial entitlement.
One significant disadvantage of earning income in an inter vivos trust is that such a trust does not obtain the advantage of the marginal tax rates. Rather, all of the income of the trust is taxed at the top marginal rate. The trust obtains a deduction from income for amounts paid or payable to a beneficiary and such amounts are taxed to the beneficiary.
By way of contrast, the income and taxable capital gains of a testamentary trust are taxed at the marginal rates of tax, which are progressive. In addition, the personal tax credits are not available to testamentary or inter vivos trusts.
The transfer of control from one generation to the next is a key issue when the transfer is to occur prior to the parent’s death.
The two main types of control are operational control and legal control.
Operational control is the day-to-day management and operation of the family business. It is often in this area where a child or children who are active in the family business will begin to assume control.
The parent and child must define the employment roles for each of them during the transition period. Generally, the parent will decrease his involvement in the day-to-day operations of the company and the child will assume those day-to-day operations of the company.
Legal control is generally defined as the ability to elect a majority of the Board of Directors of a corporation. The transfer of the family business from one generation to the next will also require transfer of legal control. There are a number of methods for dealing with transfer of legal control of a business.
However it is very important to ensure that control does not pass to the next generation before the parents are ready and without insuring sufficient income to support the parents in their lifestyle.
Share terms can be drafted so as to divide up voting control, rights to dividends and rights to participate in the growth in value of the corporation in almost any way a client would like. The main types of shares are preference shares and common shares. Preference shares are generally fixed-value shares with specific rights, for example the right to fixed or preferential dividends or the right to vote. Common shares generally have the right to participate in the value of the family business. A common way to ensure control is for the parents to retain a class of voting, non-participating shares once the estate freeze takes place.
By separating the voting rights of shares from other rights, a parent can retain legal control by holding voting shares. In theory, these non-participating shares should have nominal value and so there should not be any significant tax on the deemed disposition of such shares on the death of the parent.
A written agreement is another method of preserving control in the hands of the parents. Typically an unanimous shareholders agreement will be entered into.
An unanimous shareholders agreement takes control of a corporation from the Board of Directors and vests it in the shareholders. Such an agreement can be entered into by a parent and child who are shareholders of a corporation and can deal with, and bind the parties to deal with, all aspects of the management and voting of shares of a corporation. It can also provide a staged method for transfer of legal control of the corporation, buy-outs, restrictions on transfer of shares and redemption of shares. It is important to remember that to the extent that the directors are relieved of their responsibilities by the shareholders, attendant director liabilities are also transferred from the directors to the shareholders. Caution should therefore be exercised in drafting unanimous shareholders agreements.
An unanimous shareholders agreement is a very effective method of dealing with transfer of legal control and operational control during the transitional phase. It can also set up a blueprint for shares management, ownership and operation of the family business for the next generation.
In many cases, the parent will not be prepared to relinquish control of the family business during his lifetime. In these circumstances, the elements of the parent’s will become extremely important since it can delay vesting of shares of a business for a fixed period of time, or until the happening of a particular event. The will can be drafted so that the trustees have the power to operate the business until the appropriate date for distribution to the ultimate beneficiaries. This is particularly helpful for a parent with younger children who are not presently ready or able to assume control of a corporation.
If there is an expectation that the executors and trustees will operate the family business for any significant period of time, the choice of executors and trustees is of crucial importance. Where the parent owns the business with a third party, that third party, while usually the most knowledgeable person, is also in a position of conflict of interest. In these circumstances, a team of trustees and executors with different skills, abilities and interests is often the most effective.
When transferring the family business from one generation to the next, particularly on an inter vivos basis, it is essential to ensure that the parent and, after the parent’s death, a surviving spouse, has sufficient income generated by the business, or other assets, to maintain an existing lifestyle.
This income can be generated in a number of ways. The parent can be employed in the business and receive employment income for services performed for the business. Caution should be exercised to ensure that the employment income paid for services rendered by the parent is reasonable, and that the parent actually performs the services, otherwise the business runs the risk that the payment of employment income will not be deductible to the business.
Issues of fairness between the parent and children should be dealt with in advance, particularly where the parent is significantly lessening his contribution to the operation of the business but wishes to continue receiving employment income.
Ensuring an adequate income for the parent and children who are active in the business should be resolved as part of the planning for change of control rather than being left to be dealt with if and when a conflict arises. Bonuses may be used to generate income for the parent, but caution should be exercised to ensure that the bonuses are reasonable in the circumstances, so they will be deductible to the business.
One of the most difficult things for the entrepreneur to determine when considering whether or not to do an estate freeze is whether his net worth is sufficient to ensure that he will be able to maintain an existing lifestyle. It is a problem because it is not possible to predict either rates of inflation or life expectancies with a great deal of accuracy on a case-by-case basis.
If the parent is unsure whether the assets will be sufficient to maintain an existing lifestyle, if frozen, a partial estate freeze should be considered.
To effect a partial estate freeze, the parent would exchange only a portion of the existing common shares of the business for preference shares. The remaining common shares owned by the parent would continue to appreciate in value as the business increased in value. This will allow the parent to participate in a portion of the future growth in the value of the business. The disadvantage of doing a partial estate freeze is that capital gains tax will be payable on the inherent gain on the common shares retained by the parent on the parent’s death.
However partial freezes can be carried out more than once as the value of the parent’s estate increases. Each time a partial freeze is conducted the capital gains liability is fixed on the portion of the common shares which are frozen at that time.
Property in the U.S.
If you own property in the U.S., your estate may have to pay U.S. estate tax on the property after your death. The U.S. imposes its estate tax on all assets owned by Canadians that it considers to be U.S. property, which includes real property such as vacation homes and may include other items such as furniture. In addition, shares in U.S. corporations and U.S. Government Savings Bonds are considered U.S. property even if the certificates are kept in Canada.