Posts from the ‘Retirement Planning’ Category

Jan 30

Warming Hearts Through Estate Freezes

Imagine ordering a large drink late in a steamy August afternoon after just completing a day’s toil in the sun. After several thirsty minutes waiting, watch in rapturous delight as the waitress finally brings over a tall, frosted glass, beaded with moisture . . . only to discover that it’s mostly ice. For lawyers and financial planners like me, that’s what I see when calculating actual size of the estate many of my clients will leave to their heirs after paying taxes. Although there are many ways to cut down on the ice quotient, the one I want to talk about today is called the “estate freeze.”

In simple terms, a freeze operates to cap or “freeze” the amount of unrealized capital gains on company assets that is taxed on when the grim reaper comes calling for that freezing shareholder. The freezer swaps the common shares that have grown in value for one or more classes of fixed value preferred shares that maintain control over the company but won’t participate in future growth. Instead, the company issues new common shares that are currently without value to the next generation or to a trust that the freezer controls and, when a holding company’s portfolio skyrockets higher or an active business’ widget sales go through the roof, those new common shares soak up all the new growth. Although the freezer will still need to pay tax on any unrealized gains on the preferred shares (s)he owns after their last gasp, (s)he will have at least minimized the tax (although not emotional) pain for those left behind.

Obviously, timing when to do the freeze makes a profound difference to the tax savings the freezer’s estate will eventually enjoy. If the company doesn’t continue to grow in the future or if the freezer dies within a year or two of implementing the freeze and the new common shares haven’t yet had a chance to significantly increase in value, then the whole exercise was likely a waste of time. On the other hand, for a company that doubles in value over 5 years, the savings to the deceased’s estate can be over $250,000 on every million dollars of gains that would have otherwise been taxed in their hands at this point. If amount of capital gains that are included in income and are taxed increases in the future, as many worry, the savings could be even more. For example, if the inclusion rate for capital gains increases from 50% to 75%, a properly done freeze could save the estate $375,000 per million dollars of capital gains avoided.

When to Consider Getting Chilly

Whether a freeze is worth considering depends on a host of factors. Perhaps the biggest are how much have your company shares already increased in value and how much will they continue to grow before your death if you leave well enough alone, as noted earlier. As a friend of mine once said, ask yourself if the juice (i.e., the benefit) is worth the squeeze (the cost and effort involved in extracting the relevant breakfast beverage.) The best candidates for a freeze own active businesses that they are looking to either pass down to the next generation or sell to an outsider. In the first case, minimizing the tax bill at death may make the difference between a business staying in the family poised for continued success or either a forced sale to pay the taxes owing at death or hamstringing heirs with large bank loans in order to pay that bill.

If the goal is instead to minimize taxes on an eventual sale, capping the original shareholders’ share value and transferring future gains to other shareholders allows more family members to claim the lifetime capital gains exemption on their shares upon sale. Every shareholder can avoid most of the tax on almost $900,000 in increases to the value of their shares at this point (the exempted amount increases yearly due to inflation) if they and the business satisfy certain criteria. By doing a freeze to transfer future growth to spouses and children, etc. after your own shares have unrealized gains of about $900,000 can mean hundreds of thousands of dollars in savings in some cases. For example, someone doing a freeze when her shares have grown by $900,000 in value in favour of her husband and 3 children in the expectation that the company would be worth $4,500,000 upon sale may be able to avoid capital gains tax entirely at that time. In that example, the new common shares owned in a family trust would be worth and could be apportioned equally amongst her hubby and children so each could shelter $900,000 of growth, with mom using up her exemption on the $900,000 in shares she retained after the freeze.

By contrast, if she does nothing, remains the sole shareholder and owns $4,500,000 worth of shares at sale, the tax bill could easily exceed $900,000 at today’s levels and far more if the inclusion rate for capital gains climbs in the future. As an added bonus, in some cases, a freeze might help a family save tax along the way by allowing them to sprinkle dividends to qualifying adult family members who actively work in the business but whose salaries aren’t enough to optimize the family’s annual tax savings.

On a related note, a freeze requires an accountant or business valuator to put a value on the company at the time of the freeze. Businesses hit hard by Covid may be able to turn this to their benefit if they are confident that the blip in value is short-lived by doing the freeze based on the current Covid-influenced levels so the new common shares can reap the rewards when the economy and business value both improve.

On the other hand, freezes are not just for active businesses. Doing a freeze for your holding company can still save your family a host of potential taxes on your eventual passing, particularly if combined with some of the other options I talk about in my next article on “wasting freezes” and share redemptions on death using life insurance. As I will also discuss, investors with large non-registered portfolios or perhaps rental properties might even consider setting up a new holding company, then rolling those assets into the company on a tax deferred basis (but do watch out for property transfer tax) to cap the future tax bill owing at death. This strategy works best if the plan is for the children to keep the assets, such as a real estate portfolio, for the long term after your death but can even mean huge savings if that isn’t the plan in some cases. If nothing else, it may provide your heirs with the flexibility to wait a few years after your death for the real estate or stock market to improve rather than forcing them to sell as soon as you’re in the ground in order to cover your final tax bill.

Reasons for Giving Freezes the Cold Shoulder

Admittedly, freezes are not for everyone. Besides taking into account the cost of doing the freeze and any additional annual expenses that might result, particularly if creating a family trust to hold the new common shares or setting up a new holding company, I suggest taking the following into account:

• A freeze may only delay the day of reckoning. Although shifting part of the potential tax bill from one generation of taxpayers to another is often great tax planning, it might not be so beneficial if the kids will need to wind up the company in short order anyway. It still may be worth proceeding if the freeze provides the heirs with some discretion regarding when to sell assets like real estate or if there are still tax savings to be had despite the desire to wind thing up shortly after your death.

• A freeze only works if the company continues to grow or you use the aftermath of the freeze to decrease the value of the freeze shares. If you plan to draw down the value of any company during retirement and suspect that it will eventually be worth less than it is now, then a freeze is not for you. The only exceptions may be if you also do a “wasting freeze” during retirement, as I discuss in my next article, to more actively transfer some of the capital gain tax bill to the next generation.

• Are you too young? If doing a freeze using a family trust, realize that the trust has an effective lifespan of 21 years in this situation, as all unrealized gains inside the trust are taxed on its 21st anniversary. Although the shares can be transferred out of the trust on a tax-free rollover basis at any time prior to then, some parents may not be keen to gift the shares directly to the children at that point, particularly children with rocky marriages, financial issues or similar problems. On the other hand, 21 years is a long time for children to get their act together and the parents can always just allocate the common shares to back themselves if that has not happened. This would undo the benefits of the freeze but it is always good to have this option if life does not turn out as expected.

• How much does control matter? How solid are your children’s lives? Practically speaking, doing a freeze doesn’t mean having to give up control of the company if the freezers retain all of the voting shares and control the family trust that also owns the new common shares. This allows them to continue with business as usual inside the company and to continue to pay themselves as many dividends and as much salary as their hearts desire and the Income Tax Act allows. If shares are gifted to the children directly, there is less control, which increases the chances of problems if a child is divorced or has creditor issues. Even if the shares are held in a trust, there are at least theoretically potential problems if one of your children divorces. One way of minimizing that risk is making it a precondition of the freeze than any married children get prenuptial or marriage agreements excluding the value of any shares from any divorce settlement.

• Are there other tax fighting weapons in the armoury? A freeze can be a silver bullet in the right circumstances but a empty shell in others compared to some of the other tax minimizing options available. Corporate life insurance can help minimize, reduce or pay the final tax bill, particularly if there is a big tax-free payout on the first death. Loaning money to a family trust (assuming most of your capital gain assets are outside of a company) at 1% so you can actually sprinkle income to your descendants now can be a really effective strategy in many situations. Even if you have to pay more tax now to get a critical mass of assets into the trust, it might be a blessing in disguise if the taxable amount of capital gains increases in the future anyway. Unfortunately, the trust idea may not be a particularly useful one if most of your assets are held corporately.

Conclusion

The tax bill faced by many estates on their corporate assets or non-registered holdings often takes a very big gulp out of what taxpayers want to pass along to their heirs, but proper estate planning can often reduce that large gulp into a small sip. Implementing an estate freeze many years prior your final passing may be one way of making that happen. In my next article, I’ll discuss some ways to supercharge the benefits of a freeze to hopefully make that final sip of taxes into a mere moistening of the lips.

Apr 1

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Covid Contemplations: What to Do If You Have Been Socially Distanced by your Finances

Photo by cottonbro on Pexels.com

In this eerie time of social distancing, medical mayhem and financial carnage, I feel like a background character in a cheesy made-for-tv movie starring B-grade actors from the 70’s. Unfortunately, the chaos and risk are all too real, although the consequences and aftermath remain a riddle wrapped inside an enigma.

For those of you, however, who are trying make sense of their financial picture, I do have a few suggestions to lessen the financial pain and some things to keep in mind when you are deciding what to do next.

Consider Future Tax Issues When Making Your Financial Decisions Today

When reading some of the tax-planning options I discuss below, particularly those about harvesting capital losses, it’s also really important to consider how things might look a few years down the road when Covid19 is hopefully a distant and not particularly fond memory, like door-to-door salesmen and (fingers crossed) manbuns. I simply can’t imagine a future that doesn’t include significant tax hikes, particularly for those in the higher tax brackets or for most people in their year of death. I also worry if this might also include increasing the inclusion rate for capital gains from 50% or, for those of you not up on tax-speak, what percentage of any realized capital gains is actually included as taxable income and what part is tax-free. Keep in mind that this was something tax types were stressing about even before this all came down.

In the past, as much as 75% of capital gains were taxed on sale. If the inclusion rate goes to 75% again, this would mean paying 50% more tax on gains than we are right now! For example, if you had a $10,000 capital gain and were in the 40% tax bracket, you’d have to pay $2,000 in tax at the 50% inclusion rate ($10,000 x.50 x.40). If it goes to 75%, then you’re out of pocket $3,000 ($10,000 x .75 x.40). Hopefully, if the inclusion rate is increased, it’s not quite so drastic – I just used 75% as an example since it was a number our government had charged previously. Essentially, just like when setting any other tax rates, they can pick any number they want, limited only by the fact that they want to get re-elected and probably don’t particularly enjoy having their likeness burned in effigy.

A) Capital Gains

For those of you with unrealized capital gains from those bank stocks you bought in the days of disco, there are some planning opportunities available for you, particularly if you expect to be in a lower tax bracket than usual this year anyway. Here are some of the reasons why you might want to trigger some of those gains now:

Your other sources of income are also affected this year and you’ll be in a lower tax bracket than usual. Although paying taxes ahead of schedule is not something I love doing, you might be better biting the bullet now vs. selling in a few years during the new tax reality. It also may also mean not having as much money in the market to capture any future market recovery and receive dividend payments if you have to divert some of your capital to pay the tax bill next year unless you have offsetting capital losses so consider this carefully. On the other hand, it’s not like you need to pay the tax bill today – this is a bill you won’t need to cover until April 2021.
You have other stocks that are underwater and would generate capital losses upon sale. You could apply those losses against those gains so you won’t have to pay the tax man this year and can keep all of your capital invested to hopefully participate in any recovery and generate income while you wait.
You have losses from previous years already on the books to use up so you won’t actually be triggering a tax bill. Triggering gains at the current inclusion rate, even if you aren’t actually paying any tax on them because of your offsetting losses, will still save you tax in the future if inclusion rates change going forward as I explain later in this article.
You are worried and were going to take some money off the table anyway.
Your portfolio wasn’t properly diversified, previously, it would have meant paying too much tax to rebalance previously. Now that values might have declined, that tax bill isn’t so high and the tax pain isn’t too great. Although you are selling when markets are down, you will also be purchasing your new investments at a discount. This works even better if you have some of those offsetting losses we also discussed.
Your risk tolerance has changed, or you no longer like your current mix of investments anyway.
Your capital gains are inside your company and you are really worried about the inclusion rate for gains increasing going forward. If this happens, corporate investors will suffer another hit. Our tax system allows companies to pay out the non-taxable portion of capital gains tax-free to its shareholders (i.e. currently the 50% that isn’t taxed). If the inclusion rate went to, say, 75%, then shareholders would only be able to take out 25% of the gain tax-free, which is half of what they can do now. When coupled with the higher tax rates we’ll likely be paying in general going forward, this might be enough incentive to lock in those tax-free payments now, particularly if the business owner isn’t making as much money from other sources that year anyway. If this might be you, then you might hold off on selling company-owned investments that have losses, as realized losses offset how much of the gains you can withdraw tax-free.
You are looking at other uses for your money, such as permanent life insurance, income-splitting it with a spouse or through a family trust, paying down debt or perhaps helping the children out a bit more now than you’d previously anticipated.

As a final point, it is also important to remember that if you do sell a stock that is in a capital gain position but you still love it, there is nothing that stops you from buying it back whenever your heart desires. Although you must wait 30 days after selling a loser before repurchasing it, there is no such rules when reconnecting with a former flame that you previously sold at a profit.

Capital Losses

When deciding whether or not to trigger capital losses, here are some of the things to keep in mind when making decisions:

If tax rates and the inclusion rate both increase in the future, triggering capital losses in later years to offset future gains might save you more money over time than triggering them now, particularly if you’re ultimately going to be in a higher tax bracket in the future anyway.

We talked earlier about how the inclusion rate works for capital gains and how an increase of the inclusion rate from 50% to 75% would mean including $7,500 of every $10,000 capital gain as taxable income rather than just $5,000. The same is true for capital losses – if the inclusion rate was increased from 50% to 75%, this means that you get to deduct $7,500 per $10,000 of bad decisions rather than only $5,000.

It all comes down to when you trigger the losses. Typically, when inclusion rates are increased, those increases don’t apply to losses already on the books. For example, if you trigger a $10,000 gain in a dystopian future reality where inclusion rates are 75% but had an unused $10,000 capital loss on the books from this year, the two would no longer cancel each other out. Because you triggered the loss at a time when the inclusion rate was only 50%, you would only get to deduct $5,000 of that total loss of $10,000 but had to include $7,500 of the $10,000 gain as income, meaning you would still need to pay tax on $2,500. It’s always possible that the government could increase the inclusion rate for past losses if they decide to increase the inclusion rate for new gains. Personally, I think it’s more likely to find discount hand sanitizer and toilet paper on sale next week than for that to happen.

If you want to trigger capital gains this year for some of the reasons discussed above, i.e. you’re going to be temporarily in a lower tax bracket and are okay paying some tax now at current rates, you won’t want to trigger any capital losses this year, as they have to applied against this year’s gains.
Triggering losses now will give you more flexible for rebalancing your non-registered portfolios going forward since you can apply these losses against future gains so that you can rebalance without tax consequences until those losses are used up.
You have some big capital gains from the last 3 years and want to carry back this year’s losses to get back some of last year’s taxes. You’ll have to wait until you file your 2020 tax return to do this, but it might be worth the wait if you were in a high tax bracket then and don’t expect to be in the same place going forward.
You adopt the bird-in-the hand approach and want to deal with today’s taxes and inclusion rates rather than guessing about how things might look in the future. Likewise, you might expect some of your losers to rebound and might want to just lock in the losses now for flexibility’s sake even if this means having more taxable capital gains in the future if your reinvested dollars make money.

As a final thought, it is important to remember that you, your spouse, your company, etc. must wait 30 days to repurchase any investments you sell in order to be able to realize your capital loss. If you are still really bullish on the investment’s long-term future, then you could look at similar alternatives, at least until the 30 days have expired, unless you’re happy to sit on the sidelines for the short term.

Find Some Balance

person in yellow protective suit doing a yoga pose

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Somewhat ironically, some of my client’s biggest financial planning headaches a few weeks ago was not being able to rebalance their portfolios without triggering big tax bills. In many cases, this meant having a disproportionately large share of their investments in perhaps a few stocks that had been in their lives longer than their children. Adding to the risk, many clients owned several similar stocks in the same sector with the same problem, such as perhaps 3 or 4 Canadian bank stocks they’d first started acquiring when the first Trudeau was doing his thing.

All that has now changed. Although you may still love your BMO or Royal Bank shares, it may now be possible to trim those positions in favour of a new infatuation. It doesn’t mean abandoning all of those legacy stocks, but merely hedging your bets. Although playing the field is not a great recipe for romantic success, investing is an entirely different kettle of fish. Rather than just looking at the tax side of things, you might be better off focusing on building a properly diversified portfolio that fits like a glove even if it means cutting an extra cheque to Ottawa in order to make this happen.

If you are looking to rebalance, perhaps this is the time to add a few new types of investments to your portfolio, particularly:

some that don’t trade on the stock market and hopefully haven’t taken as strong a gut punch to their prices as public market stocks have suffered;
expanding your portfolio geographically beyond just Canadian dividend payers and some companies from down in Trumpland;
investments that offer some downside protect through options or the ability to short-sell or which are designed to allegedly make money in any market conditions, although this doesn’t always happen.

The current buzzword is that people should “invest like a pension” and strive for less risk and smoother returns by expanding their mix of investments. Although even pension funds or companies that invest like them have taken a kick to the teeth this last month, their extra levels of diversification have generally helped them some of those extra body blows that the average Joe has endured.

Look to Refinance Loans

For those of us with mortgages, one of the consolation prizes (albeit one on par with a getting a participation ribbon for finishing 58^th place in a 5 km race) are much lower borrowing rates. If you have loans of any type, get professional advice regarding whether it makes sense to redo those loans at current rates despite any penalties that might apply. For those of us with variable loans, the monthly savings can be really significant and will hopefully help ease the pain for years to come.

For those of us with family trusts and loans at 2%, start planning to refinance those loans at 1% this July, as it appears very likely that the minimum loan rate will drop back to 1% at that time. This will also apply to spouse loans as well, so it’s worth looking at updating those too. Despite the hassle, it’s recommended that you actually physically repay past loans and then re-advance the funds.

This will allow more future investment income to be taxed in low-income family members’ hands and less in yours at your higher rates.

Consider Setting Up a Family Trust or a Spousal Loan

If the rates do drop to 1% in July (this will be clear by the end of April and is based on a government formula that suggests that this will happen with room to spare), then those of us with large unregistered investment portfolios have the opportunity to income-split a lot more successfully with spouses, children and other lower income family members. Noting the current yields on many investments and the hope of stocks eventually recapture some of their past glories, the tax savings from loans to family investment trusts or spouses are even more mouthwatering. Until now, the unrealized gains on the higher income spouse’s portfolios may have been a deal breaker, as it meant paying too much tax to free up the capital to loan to your spouse or trust. For better or for worse, this may no longer be the case, both because of reduced gains and perhaps if the higher income spouse is in a lower tax bracket this year.

Be Prudent If Investing New Money into the Market Today

Although current yields on many investments are (apologies to my vegetarian, vegan or pescatarian readers) as mouthwatering as prime rib on a cold winter’s day, there is still a lot of uncertainty in the market. Although it is a personal decision as to whether you wish to deploy any dry powder you may have to take advantage of these eye-popping yields, do keep in mind that we might not have seen the bottom and it’s hard to determine how the fallout will affect different stocks and industries. Consequently, you may wish to keep in mind some of the following if you’re contemplating dipping a toe back into today’s rather frothy investment waters:

Consider dollar cost averaging rather than trying to do market timing. We don’t know if we’ve hit the bottom so you may benefit from easing money bank into the market over a number of weeks or months rather than going “all in” on what your fortune teller says is your lucky day.
Yield is a wonderful thing. If you do want to put new cash into the market, take advantage of those high yields rather than counting on future gains. The income will reduce the risk and can be redeployed back into the market if you so desire or can be a way of providing more money for your family during a time when many family budgets will be stretched extremely thin. Because of the current calamity, even blue-chip stocks have yields formerly reserved for junk bonds. As a result, there is no need to travel too far down the risk spectrum just to get a few more percentage points when safer stocks are already paying you handsomely
Be sure that you have a sufficient contingency fund set aside to cover you and your family’s expenses so you’re not stuck having to sell some of those investments you just purchased at the worst possible time. If in doubt, bump up the size of the contingency fund.
Be even more conservative if you are borrowing to invest. Although rates are astonishingly low right now, leveraged investing only works if you can pay back your loans when the time comes. Accordingly, think long and hard before proceeding and reread my last three bullets at least twice. I strongly suggest staying away from margin accounts at this point as a margin call might ultimately be the financial kiss of death. If you do borrow to invest, carefully investigate the spread between secured lines of credits and borrowing using a traditional mortgage. Despite the decrease in rates, there can still be a big difference in cost between borrowing using a HLOC or using a mortgage. Although the mortgage option is less flexible and requires you to also pay down some of the principal with each payment, it might still be the way to go.
Diversify, diversify, diversify. Because the fallout is still so uncertain, spread your money over many different sectors and investments. It’s better to take some of the risk off the table by hedging your bets. Rather than waiting for fair weather and your ship to come in, consider funding a fleet of smaller boats that will see you safely into the future even if some of them don’t ever reach the shore.

Look into Estate Freezes

An estate freeze is a strategy that involves owners of private companies swapping their common shares for fixed value preferred shares. New common shares are then issued to other family members or to a family trust and all future increases in company value will be taxed in their hands. Private business owners do this sort of thing this for a couple reasons:

To increase how much capital gains can be sheltered from tax if the business is sold. If the existing shareholders won’t be able to shelter all the gains from tax upon sale under their own lifetime capital gains exemptions, having new growth taxed in other’s hands allows these other family members to dip into their own exemptions to increase tax sheltering at that time.
To minimize the tax bill on their deaths by capping the value of their shares and transferring future growth to younger generations.

Despite not owning a private company, are you the proud owner of a non-registered investment or real estate portfolio that you want to pass along to your kids, grandkids or favourite financial planner? An estate freeze might still be the thing for you. Transferring those assets into your company on a tax-free rollover basis in exchange for fixed value preferred shares lets any future growth accrue inside a family trust or in your heirs’ hands rather than yours. As a result, when your time comes, you can pass into the great beyond knowing that your final tax bill is a lot smaller and your heirs’ inheritance that much larger than might have been the case.

In most of this instances, estate freezes only work if the new common shares subsequently grow in value. Accordingly, doing a freeze this year when share prices for most private and public companies are at Black Friday prices can mean tremendous tax savings in years to come if values do bounce back, particularly if tax rates and the inclusion rate are both higher in the future.

Learn About Your Options

Keep informed about government programs and tax changes that might help you and your family, such as EI, reduced RRIF withdrawal requirements, extensions to tax filing and installment payments, changes to your bank rates, mortgage or loan deferral options and so much more.

Conclusion

I am hoping that one day, hopefully soon, we can look back on today’s events in the same way many of us look back on 2008 and 2009 and perhaps how my parents viewed my teenage years – incredibly trying and stressful, but something we all survived and put behind us. I’ve tried to give you a lot to think about but there are so many moving parts and uncertainty that this is probably a good time to get professional advice before taking any big steps. In the meantime, let’s just focus on being good to each other and realizing that we’re all in it together.

Mar 18

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A Voice from Beyond the Grave: Providing Guidance to the People Listed in Your Will and Related Documents

Most people quite rightly feel pretty good about finally signing their Wills and related documents such as Powers of Attorney and Representation Agreements. They have taken a huge step toward making sure the right people get the right assets at the right time, that the right people are empowered to make the appropriate decisions, and that their healthcare choices are clear, all the while hopefully ensuring that those left behind are still able to sit across the table from each other at family gatherings without needless bloodshed. On the other hand, as I generally point out in my egregiously long reporting letters after the fact, their work may not be quite done. Read more

Jan 7

RRSPs 102 – Beyond the Basics

I don’t want to insult your intelligence or induce a potentially fatal sense of post-holiday boredom by repeating what a lot of you already know about RRSPs. On the other hand, you know what they say about “assume” and what it makes of “u” and me. Accordingly, this is what I propose: I’ll run through a basic summary as quickly as possible and will ever try to sprinkle in a few jokes to liven your day before getting to some of the (at least to me), more interesting stuff. I’ll then describe a couple more advanced planning techniques to reward you for making to the bitter end but will hold back the rest until my next article in the hopes that this will both leave you clamouring for more and reduce your eyestrain in the meantime. Read more