Seniors, an estate freeze can help cap your final tax bill

We've now lived in our current neighbourhood for 16 years. Some neighbours have passed on, and some are just feeling the effects of old age. Henry is one such neighbour.

"Tim, I've got this new prescription from my doctor. He says I have to take these pills for the rest of my life," Henry explained. "My biggest concern," he continued, "is that the bottle says in big bold letters: 'NO REFILLS.' I guess my doctor isn't very optimistic about my longevity."

We had a good chuckle over that, and it was clear to me that Henry's mind is as sharp as ever. We started talking about his tax planning and his frustration over the clawback of government benefits, among other things. I shared with Henry some ideas to consider.

The facts
Henry is a healthy 75-year-old husband, father and grandfather. He has a portfolio of investments that provide sufficient income to look after them as a couple. His annual income is about $120,000. He has a holding company that he set up many years ago because he was once a shareholder in an active business. He was thinking of winding up the holding company to simplify his life but the tax cost to do this would be about $150,000 – so he's decided not to wind it up at this point. Henry and Mary (his wife) have more than they'll spend in their lifetimes. They plan to leave their respective assets to each other upon death, and then to their kids equally when the second spouse dies.

The ideas
With each passing year, the investments that Henry owns are growing. And so is the tax liability that will be realized upon the death of the second spouse to pass away. To cap this tax bill, I suggested to Henry that he consider completing an estate freeze. What would this look like? Henry would transfer a certain portion of his personally held investment assets to his holding company. In this case, I suggested that he transfer the majority of his portfolio – about $3-million – to the company.

In exchange, he'll take back shares in his holding company that are frozen in value, along with a promissory note owing to him (the value of the shares plus the promissory note will equal the value of the assets he's transferred to his company). There will be no tax to pay on the transfer if he uses section 85 of the Income Tax Act to get it done (be sure to visit a tax pro to design and execute this type of transfer – called a "section 85 rollover").

The result is that Henry will own frozen preferred shares in the corporation that will not grow in value in the future, and a promissory note owing to him. The future growth will accrue to new common shares in the company that will be issued either directly to his children, or a trust for them (a trust will allow Henry, as trustee, to control the shares and even take them back later if he wants, and will provide creditor protection over the future growth).

In addition to capping the tax bill that will be owing later, Henry has also accomplished a couple of other things. First, he'll be able to minimize the clawback of his Old Age Security benefits. How so? Much of the income he was earning personally on his portfolio, which created a higher personal income and clawback of his OAS benefits, will now be earned inside the corporation where his investments now reside. Henry can draw cash from his corporation on a tax-free basis as a repayment of the promissory note owing to him.

Another idea to consider would see Henry's corporation declare, but not pay, dividends to him annually (dividends are not taxable until they are actually paid). These dividends payable have two benefits: As a liability of the corporation they will reduce the value of the company, which can reduce taxes owing at the time of the death of the second spouse. Second, these dividends owing to Henry can be reported on a separate tax return – called a "rights or things" return – in the year of his death, which can save taxes at that time.

A final benefit to Henry from this planning is a reduction in U.S. estate taxes. Although Henry is not a U.S. citizen, he does own shares in U.S. companies in his portfolio, and given the level of his total assets he would have paid some U.S. estate tax. By moving those securities into a holding company, he now avoids that tax.

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.