David A. Altro is the managing partner of Altro LLP, which specializes in cross-border tax and estate planning, corporate and real estate and has offices in Canada and the United States. Bradley Richard Thompson is an international tax partner at Altro LLP.
COVID-19 has created a global public health crisis. But the economic impact of this pandemic is also staggering and provides an opportunity for tax planning by using something called an estate freeze.
Between Feb. 21 and March 23, the S&P/TSX Composite Index lost more than 35 per cent of its value. During this same period, the U.S. dollar appreciated against the loonie by almost 9 per cent. As of May 19, the S&P/TSX has recovered more than half of its losses while the Canadian dollar remains down by a bit more than 5 per cent versus its Feb. 21 value.
North of the border, this health scare has led many Canadians to update their estate plans, to make sure that their last will and testament is current and to look at how they can pass along their wealth to their children or beneficiaries with the least amount of tax on death.
The recent deep losses in both the stock market and the Canadian dollar are key because many estate tax plans are based on valuation. In Canada, one such tax plan is known as an “estate freeze.” In effect, this is the process of taking certain assets that you own today, freezing the tax on death at today’s value, retaining the voting control while passing future growth to children or other designated beneficiaries.
In Canada, the tax consequences of a person dying are different from the United States in that the deceased is deemed to have sold their assets immediately before death, with the exception of assets transferred to a spouse. As a result, there is a significant incentive in freezing the value of your estate today rather than at the higher value it would be at the time of your death.
The freeze needs to be valued at “fair market value,” which in our present recessionary market means freezing your estate in a low-value environment. This should mean significant tax savings for your future estate, allowing you to leave more value to your loved ones.
Canada also allows a “lifetime capital gains exemption” of up to about $880,000 if you sell the shares of your active business. So planning for a freeze, and what assets to freeze, should be carefully considered.
Take an example of Bob, 65, and Mary, 67. Assume Bob and Mary are 50/50 owners of their family holding company that is valued at $5-million. Depending on the particular facts it would not be uncommon for Bob and Mary to have very low “cost” in their shares of the holding company. In other words, if they were to sell their holding company shares – or were to pass away and be deemed to have disposed of those shares – they would realize a gain of upward of $2.5-million each.
Assume further that the holding company has invested in a portfolio of securities that is expected to grow in value to $10-million over the next 20 years. If Bob and Mary were to hold onto their existing holding company shares for the next 20 years on the second spouse to die (assuming their wills provide that the first-to-die leaves their holding company shares to the other spouse) they could expect to have a federal and provincial tax liability of approximately $2.5-million on the deemed disposition at death.
By implementing an estate freeze, Bob and Mary can generally “lock-in” their estate value at $5-million in aggregate, resulting in a tax liability of approximately $1.25-million on the passing of the second-to-die rather than $2.5-million – a $1.25-million savings that can be left to their loved ones.
The estate freeze technique in this example would have Bob and Mary exchange their holding company shares for “fixed value preferred shares” that carry all of the voting power in the family holding company. In other words, Bob and Mary would retain control over the family nest egg during their lifetimes. A new class of non-voting common shares could be issued directly to children or to a family trust created for the benefit of Bob and Mary’s children.
The incremental $5-million of growth in the value of the family holding company over the next 20 years would accrue on these non-voting common shares and would therefore not be subject to the deemed disposition on the second-to-die of Bob and Mary because these shares would already be the assets of their children or the family trust.
Tax planning may not be top of mind for Canadians during this period of pandemic. But taxpayers planning for the future can take advantage of depressed valuations to eventually leave more to their loved ones.
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