A careful review of your estate plan may reveal an imbalance you did not intend

Reviewing the tax results of your plan is necessary to ensure that the distribution is exactly as intended.

Sean Rheubottom, B.A., LL.B., TEP

A client’s existing plan had not taken into account the tax results of his Will distribution. He hadn’t considered the fact that if he leaves shares of his holding corporation directly to his son, his estate (effectively his wife) is still responsible for the tax resulting from the deemed disposition of the shares at death. This created an unexpected imbalance in the division of the estate. He also had not considered the fact that his corporately-held insurance proceeds would benefit one beneficiary, his son, rather then being used in a more tax efficient way. A flexible and extremely tax efficient “roll and redeem” plan is the solution. It provides a way to achieve precisely what the client expected while saving about $2,000,000 in tax.

I recently had an opportunity to review the estate planning of a business owner, Andrew, and we discovered that the division of his estate between his son Bart (from his previous marriage) and his wife Casey, was not what he intended. It was out of balance because he was not aware of the tax results of the plan. There was also an opportunity to make the plan much more tax efficient through appropriate use of an existing permanent life insurance policy on Andrew’s life – leaving more for his family.

Andrew owns, among other things, shares of a private holding corporation (Holdco) which owns an investment portfolio and shares of another holdco which in turn owns shares of an operating company (Opco). Andrew owns preferred shares worth $8,000,000 and common shares worth about $2,000,000. Opco holds an insurance policy that will pay Opco a death benefit of $8,000,000 on Andrew’s death. There are a few other shareholders of Opco.

Under a shareholder agreement regarding Opco, Opco has agreed that in the event of Andrew’s death, the shares of Opco that are owned by Andrew’s Holdco will be either repurchased or redeemed to the extent of available life insurance proceeds, and beyond that may be purchased by the other shareholders. The $8,000,000 life insurance money will ultimately land in Holdco.

Andrew’s current Will provides that all of his shares of Holdco will go to his son Bart, and the entire residue of the estate will go to his wife Casey. In his Will planning Andrew had arrived at a distribution that he and his family regarded as fair and reasonable.

However, Andrew had not taken into account the tax results of his Will distribution. He also had not considered the fact that the insurance proceeds would land in Holdco which would go to Bart. There is a better and more tax efficient way to achieve exactly what Andrew really intended. Andrew's intentions are respected but it is done in a more tax efficient way.

The tax problem

At death, Andrew’s shares will be deemed sold for fair market value proceeds immediately prior to the death. There is no exception here, because the shares are going to someone other than Andrew’s spouse. If shares go to the surviving spouse, the tax rules allow a tax-deferred “spousal rollover” so that the shares would go to Casey without triggering any capital gains.

Under Andrew’s existing plan (in his Will), there would be tax in his terminal year on the capital gains realized in respect of the Holdco shares. At Saskatchewan’s 2021 capital gains rate of 23.75% the tax would be $2,375,000.

Here’s the main problem: The assets of Andrew’s estate must be used to pay the tax. But his Will says that the Holdco shares are to be given to Bart, so they can’t be liquidated to help pay the tax. Effectively, Casey will pay the tax out of the assets she is to receive, and Bart will receive Holdco which owns all the insurance money and investments. Furthermore, Bart will receive the Holdco shares with full cost base which provides him with other potential tax advantages.

The above would be fine if it were Andrew’s intention. But it is not what he expected. It would leave an estate for Casey that is much less (at least $2,375,000 less) than intended, and an estate for Bart that is about $8,000,000 more than intended (because the insurance proceeds were not considered).

A solution: “roll and redeem”

I suggested a better plan for Andrew that would allow him to achieve precisely the distribution of value he intends. The plan would involve “rolling” some of the Holdco shares (any number Andrew wishes, from a relatively few shares, up to all the shares) to Casey, or to a carefully drafted “spousal trust” for her benefit. This would allow the shares to pass to Casey or the spousal trust without triggering capital gains. The shares would then be redeemed or repurchased in Casey’s hands or in the spousal trust, using the life insurance proceeds to pay for the redemption of the shares. Using a “capital dividend” election on the payment to Casey or the spousal trust, Holdco can ensure that the payment is tax-free to Casey or the spousal trust. If the entire $8,000,000 proceeds are used this way, that saves about $1,900,000 in tax.

Using a spousal trust would allow Andrew to leave a more generous amount for Casey with a direction that she will receive all of the income from the trust for life, may access capital in either a generous or limited way as long as she is the exclusive beneficiary, and on her later death the amount remaining could go to Bart.

Or Andrew could leave Casey’s share to her outright. He would just need to decide how much goes to Casey and how much goes to Bart. There’s a ton of flexibility in this plan.

There are some post mortem plans for corporations that rely on triggering a capital loss in an estate in order to carry the loss back to the terminal year to offset capital gains. There are certain “stop loss” rules that may apply where life insurance is involved. However, this “roll and redeem” plan completely avoids those problems because it does not rely on any capital loss to reduce any capital gain. No gain is triggered, and no loss is created, or needed. It’s simply a tax-free buy-out using life insurance proceeds.

Technical planning and drafting issues

Certain technical issues have to be addressed in this planning.

For example, Holdco should be obligated under a simple agreement to actually make the above-mentioned capital dividend election. Otherwise the payment to Casey or the spousal trust will be a fully taxable dividend, and Holdco and Bart can walk away with the tax-free “capital dividend account” that resulted from Holdco receiving the life insurance proceeds.

Also, to ensure that the shares “roll” to Casey or the spousal trust tax-free, the buy-out arrangement must be optional from the perspective of the corporation and Casey or the spousal trust. This ensures that the shares “vest indefeasibly” in the spouse or spousal trust, which is a requirement of the tax rules allowing the spousal rollover. Although the buy-out is optional, there is a way to draft the option so there is complete certainty that it will happen.

On Casey’s later death, shares held in a spousal trust for her will be deemed sold at fair market value. If the shares are simply given immediately to Bart, a “double tax” problem results: the spousal trust will have been subject to tax on the shares on Casey’s death, and then when Bart later extracts assets from the corporation, he and the corporation will be subject to tax again on the same value. Liquidating the Holdco shares while they are still held in the spousal trust allows the Executor to take steps to eliminate one of these two layers of tax. Such planning may include a “loss carryback” strategy or possibly, a “pipeline” strategy. The trust has to expressly allow this planning to be done, or it will not work. Careful drafting of the spousal trust is critical to satisfy complex tax rules.

Shares that will benefit son Bart

For any shares that stay with the estate to benefit Bart, a post-mortem liquidation plan should be implemented while the shares are still in the estate, rather than directing executor to immediately give the shares to Bart. This averts a similar “double tax” problem to that described above. The post mortem plan may include an “executor year” strategy or a “pipeline” strategy.

Results

Andrew and family will reduce their overall tax exposure in the estate plan by millions of dollars, and Andrew can fine-tune a plan that leaves Bart and Casey with precisely the distribution he intended. The plan will be easy to update as well by adjusting the number of shares left to Casey or the spousal trust.

Some of the above concepts may seem very technical and unfamiliar. But these are routine considerations for an experienced estate and tax lawyer.

© Heritage Private Wealth Law

General information only; not intended as legal or tax advice. Readers are encouraged to obtain legal and tax advice before acting in their specific circumstances.