May 2020
6 Canadian Estate Planning Strategies
COVID-19 is taking its toll in every corner of the world. As researchers work to conquer the invisible enemy, we are more mindful of our own mortality and keenly aware of how lucky we are to have family and friends.
COVID-19 has also served as a reminder of how important financial planning is. Keep reading to learn more about Canadian estate planning strategies that have become even more important in light of the pandemic.
Canadian Estate Planning Strategies During the Pandemic: Overview
Financial advisors are getting calls from clients who want to increase insurance coverage, and ensure that a surviving spouse has the financial means to pay the mortgage, send kids to university, and deal with bill collectors and the Canada Revenue Agency.
As dedicated TaxLetter© readers know, my path to this profession began when my late father suffered a fatal heart attack in 1974 at the age of 50. My family’s financial health was in jeopardy, there was no will, no life insurance, and no key to a safety deposit box. My late mother, then 48, had to rejoin the workforce. Today I work to prevent the same thing from happening to other families.
6 Canadian Estate Planning Strategies to Consider
Getting new life insurance has never been easier - insurance companies have relaxed underwriting requirements - with no medical required and no visits from a nurse to obtain your vitals, blood, and urine samples. You can now get up to $2 million of life insurance and $250,000 of critical illness insurance in about 15 minutes, just by answering a few questions on the phone. No in-person meetings with an insurance advisor, underwriting completed quickly, policy approved within 72 hours. If you have had an executive medical within the last year some insurers are offering up to $5 million in life insurance.
The current pandemic requires a fresh look at your estate planning. Here are six strategies to consider.
Wills
Your will is a bedrock estate planning strategy, a document that informs your executor(s) how you want your assets distributed when you die.
Without a proper will, your estate may incur otherwise unnecessary legal and accounting fees, probate fees and taxes.
You should review your will annually to ensure everything is up to date, taking careful note to include a new spouse or grandchild.
Use our free Estate Planning Toolkit (details at the end of this article), to get organized.
Realize Value on Owned Policies and Save Taxes
Most people buy life insurance – either term or permanent insurance – anticipating that the proceeds of the policy will go to family and/or charity. Sometimes their policies are no longer needed or become unaffordable.
Most policy owners don’t know that their unwanted policies may have genuine financial value that can be realized and put to good use for charitable purposes. In other words, unwanted policies can actually be great estate planning tax strategies.
Additional details are contained in my March 2020 TaxLetter® “Maximize & Preserve: Do Good. Do Well.”
You can borrow against the cash surrender value (CSV) of your permanent life insurance contract that has built up over time. Business owners who need funds for business opportunities, emergencies or to help supplement their retirement particularly favour this approach. Taking all the CSV would terminate the policy, so the situation requires expert advice.
It's important to know that taking a policy loan can create income where the loan amount exceeds the adjusted cost basis (ACB) of the life insurance. Business owners can consider creating a policy gain in a loss year to utilize losses. When times are better, the policy loan can be repaid. This repayment can create a deduction that corresponds to the policy gain created by the initial policy loan.
Immediate Financing Arrangements (IFAs)
Most people who buy life insurance are unaware of leveraged estate planning tax strategies that can allow them to protect and grow their wealth cost-efficiently while enjoying tax deductions.
When asked, most business owners would prefer to tie up as little of their cash as possible on life insurance premiums. They would like to have access to the money allocated to insurance premiums for use in other places, like a business or investment portfolio that will reap profits for them.
Many of our clients use the IFA leveraging strategy to acquire their life insurance. Simply put, they pay the premiums and immediately borrow back those funds from a bank. This allows them to get life insurance at a fraction of the true premium cost, without reducing cash available for their use. As a result, they enjoy tax benefits and increase their estate values.
For additional details, read my TaxLetter® article from March 2016 “Using Immediate Financing Arrangements (IFAs) to Acquire Life Insurance and Preserve Cash”.
Capital Gains Loss/Selling
People typically buy securities anticipating an increase in value over the years. But with COVID-19 pulling down that value, you may consider selling at a loss now to offset gains you have made. If you do this, make sure to wait 31 days before you buy back those securities.
There are two kinds of corporate losses. The first is business losses that are created by active business operations. These losses can be carried back three years and carried forward for 20 years, and can be offset against any income of the corporation.
The second type of loss is capital losses. Capital losses can only offset capital gains, can be carried back three years and carried forward indefinitely. In today’s environment, consideration should be given to the Capital Dividend Account (CDA) tax implications. Before triggering any losses, think carefully about the CDA implications and paying out any capital dividends.
The CDA keeps track of various tax-free surpluses accumulated by a private corporation. These surpluses may be distributed tax-free in the form of capital dividends to the corporation’s Canadian-resident shareholders. The CDA is a cumulative account from the beginning of time of the corporation.
The most common tax-free amounts included in the corporation’s CDA are:
• the tax-free portion of capital gains realized by the corporation to the extent they exceed the non-deductible portion of the corporation’s capital losses;
• life insurance proceeds on certain policies; and
• capital dividends received from other corporations.
A) Tax-Free Capital gains net of non-deductible capital losses
In general terms, the non-taxable portion of capital gains consists of the non-taxable portion of capital gains in excess of the non-deductible portion of capital losses (including business investment losses) realized by a corporation in the relevant period. This first component of the CDA is the excess of the non-taxable portion of capital gains over the non-deductible portion of capital losses realized by the corporation over the relevant period. When a capital loss is realized, the amount of the first component added to the corporation’s CDA is reduced. However, a negative balance in that component is not carried over to the computation of the CDA balance itself. This means that it does not reduce the aggregate amount of the other components included in the corporation’s CDA. Instead, no amount in respect of the first component will be recognized as an addition to the corporation’s CDA until the running balance of the first component is once again a positive amount.
B) Life insurance
Life insurance proceeds less the Adjusted Cost Basis (ACB) of the policy.
C) Capital Dividends Received by the Corporation
The amount normally added to the CDA is the full amount of a dividend received in respect of which the payor corporation made a capital dividend election under subsection 83(2). This is so even if the amount of the dividend exceeded the payor corporation’s CDA balance immediately before the dividend became payable.
D) Capital dividends paid out – this represents a cumulative calculation of all capital dividends paid out.
This is best demonstrated through an example:
In year 1 Corporation Z realizes a capital gain of $200,000, of which $100,000 represents the non-taxable portion. Later in that year, the corporation pays out a $100,000 capital dividend to the shareholders. In year 2 Corporation Z realizes a capital loss of $300,000, of which $150,000 represents the non-deductible portion.
In year 3 Corporation Z receives net proceeds of a life insurance policy in the amount of $1,000,000 with a zero ACB.
The amount that Corporation Z could pay from the CDA immediately after receipt of the life insurance proceeds would be calculated as follows:
Component A (capital gains/losses) adds $0 to the balance, being the non-taxable portion of the capital gain realized in year 1 minus the non-deductible portion of a capital loss in year 2 ($100,000 - $150,000);
Component B (life insurance proceeds) adds $1,000,000 to the balance, being the net life insurance proceeds realized in year 3; and
Component D (capital dividends paid) reduces the balance by $100,000, being the capital dividends that were payable in year 1.
As a result, Corporation Z’s CDA balance is $900,000 and $900,000 could be paid out tax-free to the shareholder.
Long story short: Consider the CDA balance prior to loss selling.
Estate Freeze and Refreeze
According to our tax laws, taxpayers are deemed to have sold all their property at fair market value immediately before they die. This often results in a hefty final tax bill, eroding the estate that gets passed on to beneficiaries.
Take the example of a woman in her 50s who sought our advice on behalf of her siblings and elderly parents. Their mother, 85, and father, 90, own a portfolio of commercial real estate worth $50 million but do not qualify for life insurance by virtue of their ages and poor health. At one time, the family could have employed the estate tax planning strategy of buying inexpensive life insurance to offset the $10-million tax liability that will be due when the parents die.
The family could have instituted an estate freeze, a tax planning strategy in which the owner/parents give their children shares in a family business. This technique allows families to cap their own tax liability when transferring their shares to someone else. That way, the future growth of their business would have accrued to the children, who could do their own planning.
Because they didn’t seek advice from an estate planning professional years ago, the adult siblings will have to sell valuable income-producing assets just to pay the tax bill when the parents die.
Instead of waiting as these people did, you should understand that the present is a great time to get an estate freeze or even a refreeze. For example, if you had done an estate freeze when the market value of your business was $10 million and it’s now worth $6 million, think about refreezing at the reduced value and buying life insurance to cover that tax exposure on the reduced $6 million valuation.
Prescribed rate loans
Taxes can eat away at your savings quickly. Strategies are available to help reduce that tax burden. “Prescribed rate loans” are an income splitting strategy that may be appropriate for you. This works best when one spouse or partner has significantly higher income that gets taxed at a higher marginal tax rate than the other.
Typically, if you give cash or investments to a spouse, minor child or even a family trust, the income from the investment will likely be attributed to you - the person who made the gift. A prescribed-rate loan is an exclusion to the attribution rules. The prescribed rate is set every quarter by Canada Revenue Agency. The prescribed-rate loan strategy allows for the lower income spouse/minor children to have the income taxed in their hands as long as they pay the prescribed rate of interest each year to the higher income spouse and by January 30 of the following year. The tax department announced the new prescribed rate at 1 per cent in this quarter. There has never been a better time to use this strategy for your family.
Don’t Attempt These Canadian Estate Planning Strategies Alone
Comprehensive estate planning and tax friendly structuring of your investments requires professional help. Don’t do it alone, especially if you are the custodian of family wealth for the next generation. The Canada Revenue Agency is your uninvited silent partner waiting patiently for “a piece of the action.” Proper planning will ensure you have organized your affairs in the most tax-efficient manner and won’t be required to pay a dollar more than legally required.
Our advisors are available to help you across the country. Please do not hesitate to contact us to arrange your personal no-obligation consultation. It will be time well invested.
Times have changed. Social distancing is the new norm, and we’ve learned how to work from home, helping clients with meetings on the phone, Skype, and ZOOM. We want to wish you and your families continued good health. Stay safe.