Market sell-off creates new tax and estate planning options

In the middle of a global pandemic, tax planning is unlikely to be at the top of your list of priorities. But as managers of our clients’ total wealth picture, it is incumbent on us to be constantly scanning the environment for new planning ideas.

As grievous as the circumstances are, the pandemic-driven market sell-off has created a significant tax and estate planning option for some individuals. In some cases, it is now possible to cap and dramatically reduce potential future tax liabilities on investment assets using tax strategies such as estate freezes. But investors need to act soon.

“Without effective planning, that tax liability can increase exponentially with the fair market value of investment assets,” explains Vincent Didkovsky, Newport’s Director of Wealth Management and a chartered professional accountant with extensive experience in family succession planning.

An estate freeze structure using a family trust ensures that future growth is attributed to the next generation, allows an investor to maintain control of their assets and also allows them draw a significant income from their portfolio.

“This kind of strategy provides tax-and estate-planning certainty at a very uncertain time,” Didkovsky adds.

Death and taxes—Jane’s dilemma

Let’s say that an investor—we’ll call her Jane—has three children to whom she plans to leave her estate. She has an investment portfolio which, as a result of the recent market decline, is now valued at $5 million with a cost base of $4 million. The accrued capital gain tax liability, which would be realized on death, is $267,000.

Let’s assume that Jane adopts a wait-and-see approach and doesn’t undertake any tax planning. Let’s also assume her portfolio rebounds and compounds at a rate of 5 per cent over the next 20 years. As a result, her estate could face a $2.5 million tax bill, which would reduce the value of inheritance passed on to her three children.

The value of an estate freeze

Using an estate freeze structure, Jane would be able to cap her eventual tax liability at the current depressed levels, maintain control of her assets and simplify the succession process for her heirs.

This can be accomplished by introducing a family trust and an investment holding corporation (if one doesn’t already exist). Jane could transfer the portfolio that she holds personally to the holding corporation in exchange for “freeze” shares. The trust would then subscribe for a separate class of shares to which future growth would attribute – known as “growth” shares – for a nominal amount. This transfer can be accomplished in a way that would not trigger immediate taxes.

As a result of this new structure, the future growth of the portfolio would be captured by the “growth” shares owned by the trust. The “freeze” shares should not increase in value as the value of the portfolio increases over the years. This structure would allow Jane to freeze her accrued tax liability, which would be realized on her death at $267,000.

Jane can maintain control of her portfolio in this structure, while drawing a satisfactory level of cash to finance her lifestyle. Future growth (and tax liability) would attribute to the next generation.

In certain circumstances, it may be possible to reduce the accrued tax liability inherent in the “freeze” shares. This could be accomplished by a redemption strategy, which would depend on the desired level of income and available cash in the corporation.

The value of this structure can be significant. In Jane’s situation, her savings due to the reduction of the accrued tax liability would be close to $2 million—or a $2.5 million tax liability with no planning vs. a $267,000 tax liability with the estate freeze plan.

Prescribed rate loans

Another way to accomplish a similar result is to utilize a prescribed rate loan to a family trust.

Using this strategy, Jane would liquidate the portfolio and realize $4.73 million in after-tax cash. She would then lend the $4.73 million to a family trust at the prescribed rate of 1 per cent (as of July 1, 2020 as per Canada Revenue Agency rules). She and her children would be the trust’s beneficiaries. All future growth of the portfolio would accrue to the trust, and with proper structuring, Jane would still retain control over her portfolio.

This approach would deliver an approximate tax advantage of $2 million, however the $267,000 of taxes would effectively be pre-paid upon liquidation of the portfolio. This structure should offer her the ability to split the portfolio income with the trust’s beneficiaries, while Jane would have the ability to extract $4.73 million as a tax-free repayment of the loan.

“This is a strategy we’ve been working with clients to implement over several years given the low interest rate environment,” Didkovsky explains. “It’s a good tool to help finance expenses such as private or secondary school education, to help adult children buy a home or to provide elder care for aging parents.”

Not a DIY option

It’s important to note that complex tax-planning strategies such as estate freezes—which come in a multitude of variations—should be tailored to an investor’s unique circumstances and must be structured properly to avoid costly legal and tax issues.

Doing so requires the involvement of professionals such as a qualified tax accountant and an estate lawyer, not to mention other members of your financial team such as your financial advisor. But this can be a worthwhile investment considering the potential long-term financial benefits. That’s why at Newport, we make it a point to coordinate with your entire advisory team to ensure the most effective and comprehensive planning possible.

“Strategies such as estate freezes are not appropriate for every investor,” says Didkovsky, “but in the right circumstances, such as the current market dip, they can be a highly effective succession-planning tool.”