Two-generation farm estate planning: A Will planning fix that will save over $1,000,000 in tax!
Getting the Will drafting right allows a tax deferral and elimination of double tax on family farm corporation shares
Sean Rheubottom, B.A., LL.B., TEP
In this article we learn about a client (Jim) who wants to leave Family Farm Corporation shares at death in a way that benefits his wife (Pam) for her lifetime, and ultimately passes the shares to his children. The client’s Will was drafted in a way that practically could accomplish this, but would cost well over $1,000,000 in tax at death. Drafting the Will in a way that satisfies certain tax rules will defer this tax and will allow the FarmCo shares to be dealt with in the most tax efficient way possible, avoiding a “double tax” problem that would otherwise happen on Pam’s death.
I recently had an opportunity to review the Will of a client (Jim) and I noticed the Will had some provisions regarding farmland or farm corporation shares. I didn’t see any farm assets in Jim’s list of assets, so I asked about his parents’ estate planning. It turned out that Jim will soon receive shares of a Family Farm Corporation (“FarmCo”) from a Family Trust that was set up by his parents almost 20 years ago.
FarmCo owns farmland with total value of $5,000,000 to $6,000,000. The common shares of FarmCo are held by the Family Trust. The shares held in the Family Trust are worth $5,000,000 although they originally cost the Trust only $100. Since the “21-year rule” is fast approaching, the FarmCo shares have to be moved out of the Family Trust. If they are still held in the Family Trust on the 21st anniversary of the Trust, they will be deemed sold at fair market value and capital gains of $5,000,000 will be triggered and subject to tax.
There are various ways to deal with this, but in this case the simplest option is best. Jim’s mother controls the Trust. She is very senior in age and prefers a nice simple planning solution. Tax rules for trusts allow the shares to roll out to Jim, a beneficiary, without triggering any capital gains. So Jim will receive the shares from the Trust, avoiding the 21-year tax bill. Simple!
But we need to consider Jim’s estate planning. He will own the FarmCo shares very soon so we need to plan as if he already owns them. Jim needs an estate plan that will work even if he never updates it. When I asked Jim about what he intended his Will to say, he explained that in the event of his death, the FarmCo shares or farmland would be held for his wife Pam, and then on her death, all would go to their children. This sounded like a good plan. But when I read Jim’s Will, I noticed that it directs that the shares or farmland are to be held in a single trust for his wife and his children.
This creates a big tax problem. Jim could take advantage of a “rollover” at death, deferring all the tax. He could use either a “spousal rollover”, or a “farm rollover”. But the wording in his Will would not allow either of these rollovers. On Jim’s death, the FarmCo shares will be deemed sold at fair market value, and the resulting capital gain will be taxed on Jim’s final tax return. If they are worth $5,000,000, the tax at current Saskatchewan rates would be $1,187,500. If a $1,000,000 capital gains exemption is available at the time, the tax would still be $950,000. The fact is, the FarmCo shares will be worth much more than $5,000,000 when Jim’s time comes. The tax bill could be huge.
Why no rollover?
Why will this tax apply on Jim’s death? Why isn’t there a spousal rollover or a farm rollover?
We need to look at just a bit of information about trust tax rules. Stay with me here – we’re talking about saving well over $1,000,000 in tax!
Spousal rollover
The Income Tax Act provides that assets including FarmCo shares or farmland can pass on a tax-deferred “rollover” basis to a surviving spouse if:
The assets pass outright to the surviving spouse, or
The assets pass to a trust in the deceased’s Will for the benefit of the spouse, if the trust expressly provides that
The spouse is to receive all of the income of the trust as long as the spouse is alive, and
No one but the spouse can ever receive or access the capital of the trust as long as the spouse is alive.
In other words, the “spousal trust” must be for the exclusive benefit of the spouse without even a theoretical possibility that someone else could receive income or capital from the trust. Jim’s Will does not contain such provisions. The children, not just Pam, might benefit from the income or capital of the trust, so there is no rollover to Pam.
Farm rollover
Furthermore, even though the FarmCo shares would currently qualify for the farm rollover to the children, it’s not Jim’s intention to leave the shares to his children without going to Pam first. It’s not possible to get a farm rollover where farmland or FarmCo shares are left to a trust in your Will, except under very specific scenarios that do not help here.
Solution: careful Will drafting
Fortunately this tax bill can be deferred by revising the terms of Jim’s Will in a way that totally satisfies his intentions.
The FarmCo shares can be left to a spousal trust for Pam with the “rollover” terms described above, and the trust can provide that on Pam’s death, the FarmCo shares or the farmland itself will go to the children.
Planning and drafting the spousal trust for FarmCo shares
Planning and drafting a spousal trust for farmland, FarmCo shares or shares of any private corporation is specialized work. The Will must be drafted by someone who understands the legal aspects as well as the tax aspects.
From a tax perspective
It must be kept in mind that on the death of the beneficiary spouse (Pam), the FarmCo shares will be deemed sold at fair market value, triggering the capital gains that were deferred on Jim’s death. The capital gains are realized in the spousal trust. At that time, the Trustee must consider tax-efficient methods of dealing with the FarmCo shares. Without proper planning and drafting, a double tax burden can result. The trust is subject to tax on the shares’ value, and then later if the children extract the farmland from FarmCo, there is tax on the gains in the farmland. This is double tax.
Once again, proper Will drafting for Jim’s Will is going to result in very significant tax savings. There are tax efficient methods of dealing with the FarmCo shares after the spouse’s death, but only if the Will allows it. In spousal trusts that are not planned with these tax options in mind, the shares are automatically given to the children on the spouse’s death and there is no chance to do this tax planning while the shares are still held in the trust. Tax efficient planning can allow the farmland to eventually be transferred from FarmCo to the spousal trust, in such a way that the tax in the trust is minimized and the farmland can then be transferred to the children with a full cost base equal to the fair market value of the land. The double tax is avoided. The spousal trust has to be drafted in a very specific way to allow such “post mortem planning” options.
From a trust law perspective
Planning and drafting a Will that with a spousal trust must take into account trust law principles which can make life difficult for the trustee. Without proper drafting the trustee may be forced to deal with FarmCo in a way that Jim did not intend. The Will drafting must anticipate these trust law problems and provide the trustee with the ability to deal with things as Jim intended. These trust laws can be most problematic where the trust will hold farmland or private corporation shares in a spousal trust, and then give the assets to children on the spouse’s death.
See another article on planning a spousal trust to hold farm property, here.
When it comes to farm estate & tax planning, it’s best to work with someone who understands the tax issues as well as the legal issues.
© 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.