Jason Kinnear, CPA, CA, CBV
Manager, Family Office Services, T.E. Wealth
Family businesses are as unique as the people who run them, and for each, there are different financial solutions to help minimize taxes and simplify estate settlement for greater wealth longevity. For business owners, transferring wealth requires careful planning that considers the potential financial, tax, and legal issues that can affect the wealth they seek to transfer. Which means, you need to really think about where to plant your trees.
Three common wealth transfer strategies we’ve implemented with our clients to help them meet their legacy goals are estate freezes, asset clean-up, and trusts. Here are some client scenarios that illustrate their usage.
“Someone’s sitting in the shade today because someone planted a tree long ago.” – Warren Buffett
1. Estate freezes
An estate freeze allows business owners to cap the value and applicable income taxes on their shares in the family company and transfer its future growth to their beneficiaries on a tax deferred basis. For example, the current business owner can exchange their common shares (which grow in value with the company’s value) for preferred shares (fixed at the current value of the common shares they just exchanged). The company in turn issues new shares of common stock to the beneficiaries at a nominal value.
Alicia has owned and operated a company for several decades, over which time the value of her business has grown. She’s now considering slowing down and letting her family take on some of her responsibilities before she retires, but she would like to maintain control of the business for the foreseeable future.
The increase in the value of her private company shares will eventually trigger a large tax bill when she either sells or redeems her shares. By using an estate freeze to exchange her common shares for fixed value preferred shares, Alicia and her advisors will know the exact value of her shares and can then begin planning how to minimize the unrealized taxes on her shares (e.g., redeeming a small portion of her preferred shares each year to take advantage of her personal marginal tax rates).
Alicia can then have her company issue new common shares to her children (and/or company management), and any future company growth will be allocated to these new shares. This transfer of future company growth to these new shares will also transfer the eventual capital gains and taxes on this growth into the future.
2. Asset clean-up
Business owners may acquire different types of assets over their working lives, for both investment and personal reasons. As they approach retirement, these assets may no longer be relevant to the needs of the business owner and could better serve the needs of their family if they were converted into more useful assets. This asset clean-up may also reduce the complexity, time, and cost incurred by their children to settle the business owner’s estate when they pass.
After several decades in business, Miguel has acquired many types of assets in addition to his company. These include shares in a few of his friends’ start-up companies, a warehouse and a strip mall, and an antique car collection. While these assets have been interesting and somewhat financially lucrative, Miguel is now approaching retirement and considering his family’s wealth transfer goals. He thinks it may be time to let go of some of these assets. Let’s look at some options available to him.
Miguel’s first step is to determine the tax impact of either liquidating or gifting these assets as part of his broader wealth transfer plan. If he were to sell them and pay the taxes, he will be able to:
1. Make a cash gift.
2. Buy new assets that make sense for other family members (e.g., fund a starter home for his children).
3. Make donations to his family’s favourite charity(ies) and receive a charitable tax credit to offset any taxes that were triggered.
As a bonus, disposing of these assets may also trigger some tax losses that Miguel can use to reduce taxes on his other sources of income.
While changes to the Income Tax Act over the last decade have decreased the number of tax planning opportunities available for the use of trusts, they can still provide many wealth transfer benefits. For example, taxpayers over the age of 65 can set up an Alter Ego Trust for themselves, or a Joint Spousal/Partner Trust with their spouse/common-law partners to hold certain assets during their retirement (e.g., family home, cottage, taxable investment portfolios). These trusts can preserve a family’s wealth by reducing probate fees/estate administration taxes (in certain provinces), and shelter family assets from creditor claims with the added benefit of simplified estate settlement.
At age 67, Sanjay decided to retire from his manufacturing business and pass it on to his adult children. As an Ontario resident, he’s concerned about probate fees, legal claims by former business partners and employees, and wants to ensure his children will not be burdened with winding up his estate. What are his options?
By setting up and holding his home and taxable investment portfolio in an Alter Ego Trust, Sanjay can address each of these concerns. He will also benefit from additional privacy since the settlement of his Alter Ego Trust will not be part of the public record.
Sanjay can also use trusts to assist and protect his children and grandchildren. For example, if he uses the estate freeze noted above, he can redeem his new preferred shares over time (to minimize the taxes) and use the after-tax proceeds to fund new family trusts for each of his children. These trusts will also enjoy the same creditor protection and probate fee savings as his Alter Ego Trust.
Alternatively, if Sanjay decides to sell his company, he could allocate a portion of the after-tax sale proceeds to each of his children’s family trusts. The funds in each family trust could then be invested to generate annual income to pay his children and grandchildren’s living expenses (e.g., annual vacations, post-secondary education, etc.).
These are just three of several wealth transfer approaches available to business owners to reduce their income taxes, simplify their estate, and take care of their family. Implementing any of these strategies can take time, so it’s never too early to speak with your financial advisor about putting them in place.
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