A succession plan, or two

In PART 1 of AER’s coverage, we outlined the case and explored retirement planning solutions. In PART 2, we cover the business succession planning and the welter of options the Royals could choose in relation to their legacy. In PART 3, we will publish the remaining considerations for the Royals’ complete financial plan and include options, ideas and solutions submitted by readers (if interested in commenting or providing a solution to the Royals’ financial plan dilemma, please email: editor@advisorsedgereport.com).

BUSINESS SUCCESSION PLANNING Despite the plethora of solutions already offered to Liz and Phil, a few pressing matters still have not been addressed. The first is how to deal with the succession of the business – where the majority of their wealth is accumulated. The second is how to plan the transfer of wealth to their heirs.

In initial conversations, Phil and Liz expressed a desire to divide all assets, including the business, equally among all beneficiaries.

“This could be disastrous for Britannia Manufacturing,” explains Gregory Swanson, partner at the Saskatchewan-based law firm of McKercher LLP. He quali- fied his remarks as being restricted to Saskatchewan law, given that the corporation is located in Dog River, Sask.

Swanson suggests that a better solution is for Liz and Phil to agree that the business not be divided, but rather have a trustee appointed to make all the decisions. Then the shares could be distributed evenly among the 10 beneficiaries – four children and six grandchildren.

“Having a trustee or two trustees make all the decisions will help avoid the problems that may arise if 10 individuals try and run a company,” says Swanson. The two most obvious trustee choices, according to Swanson, are Chuck and Andy, based on their knowledge of the business. Swanson also points out that the company assets will require a Canadian lawyer and an American lawyer, in order to ensure that all decisions are within legal parameters of both countries.

Swanson explains that if Liz and Phil opt to take this business succession and wealth transfer solution, there will be immediate tax consequences if they create the trust and move all the shares into that trust while they are still alive. “The trust, then, could be responsible for paying the tax on the capital gains accrued on the transfer from owner to trust.”

Another option, if Liz and Phil did not want to pay the tax would be to create an alter-ego trust, which would defer the tax, consequences but enable the structure of the business succession and wealth transfer to take place. Also any future growth of Britannia would belong to the trust.

“We would also suggest that Chuck receive a greater share of the income and capital distributed by the trust, based on his contribution to the business,” says Swanson.

Swanson believes that this is a viable business succession option as everyone shares in the growth of the company and those that have and are contributing to the growth of the company are also adequately compensated.

However, Swanson cautions that the Royal family will need to address the U.S. estate tax issue. With a company and property in the U.S., the Royals would be subject to the tax on all facets of their estate – a cost that can be quite substantial, explains Swanson.

“To avoid the U.S. estate tax, the Royals could roll the U.S. shares into the Canadian company,” says Swanson. “U.S. estate tax arises only when an entity dies and a corporation never dies,” he explains. “By rolling the U.S. shares into the Canadian operation, the Royals could avoid these taxes. However, we would caution them to seek out specific legal advice to ensure there are no tax consequences in Canada for this action and to ensure that this is acceptable under U.S. law.”

The Royals need to realize that leaving equal parts of the business to each child could result in the demise of the family business, explains Elaine Froese, a certified coach based out of Boissevain, Man. Yet, Froese cautions that the discussion about how to pass on the family business needs to come after the discussion on which child contributes to the business and what division of assets is fair in relation to these contributions.

“Only 30% of family businesses make it to the second generation,” explains Froese, who, coming from a second-generation farming family, has direct experience in business succession planning. “This is because the work ethic of the founder of a business often differs from the work ethic of the successor. This difference is amplified when there is more than one successor in a family.”

Froese believes the Royals will run into work-ethic problems, among other issues.

“Who said Phil and Liz had to leave anything to their kids?” queries Froese. “But this type of question gets the conversation started, particularly on the topics that are taboo, topics that are considered undiscussable.” This discussion also allows the advisor to determine necessary planning points, such as: how much money is required for their retirement lifestyle; what long-term care planning do they have in place; and whether or not they should sell their business, instead.

Froese also believes that the advisor may need to call in additional help and expertise.

The Royals face various, multidimensional problems; an advisor can bring in a family therapist to help facilitate communication. The benefit of calling in a therapist who specializes in family dynamics is that this expert can sort out the non-financial planning problems within the family, thereby enabling the advisor to focus on their job of financial planning. (One good resource, says Froese, is www.crnetwork.ca). “The Royals are like any other farm-type family,” says Froese. “Less than 20% of farm family businesses have a written succession plan.” If the therapist works on the lack of communication in the family and the advisor works on developing a written succession plan, as part of a formal financial plan, the Royal family and their business may actually survive the succession process, says Froese.

ESTATE PLANNING: TRANFER OF WEALTH But only if Phil and Liz are able to see that there is nothing more “unfair than treating un-equals equally,” says Froese.

“Those who contribute to wealth and the protection of that wealth should be given consideration for their ‘sweat equity’.”

Froese suggests splitting the estate on a 3 to 1 basis: $3 to every business contributor, such as Chuck, Andy and Billy, versus $1 to every non-business contributor, such as Annie and Eddie. Hence, if Chuck were to receive $3,000 as inheritance, Annie would receive $1,000.

“If Phil and Liz do not take into consideration Chuck’s sweat equity, he may be able to rely upon the doctrines of unjust enrichment and constructive claim against his parents’ estate to bring him up [his inherited portion to] fair market value based on all the work he has done,” explains Kim S. Korvan, a Regina-based lawyer with McKercher LLP, specializing in elder law issues. “Chuck could have worked for XYZ Company but stuck it out with the family business instead of making more money because he expects his due to be reflected in the inheritance. The courts may recognize the validity of his claim if Chuck brings an action against the estate for these reasons.”

Korvan suggests Liz and Phil sit down with a mediator to discuss and explain their intentions with Chuck and then with the entire family. While a bit more dif- ficult, Korvan also suggests that Chuck talk to Deedee, his ex-wife, in an effort to bring her on board with the plan so she does not take a run at any increase in income he may receive from his inheritance. “This form of communication is often all that is required to prevent family members from contesting a will.”

For his part, Swanson suggests that the Royals implement strategies that would prevent family members from selling the shares of the business, thereby diluting family control.

This is of particular concern to those siblings in financial strife, says Swanson. For example, Annie may be desperate enough to sell her existing shares to a family member at below market value. Not only would Annie lose out but this type of action could dilute ownership or create power struggles within the family. The easiest way to handle this type of concern is to set up a discretionary trust that holds the shares for the heir. This trust could stipulate stringent selling terms, or could prevent a sale unless voting members approve.

The Royals have also indicated a desire to exclude their children’s current and former spouses from benefiting from their estate.

In Saskatchewan all property received during a spousal relationship in which an adult child has an interest – including inter vivos and trust gifts – is property subject to division pursuant to The Family Property Act. Thus, the Royals decision to try and protect their children’s inheritance is a very real concern, says Korvan.

“Their best option is to call a family meeting and discuss their intentions and the legal ramifications of their decisions,” says Korvan.

In the matter of Annie – the daughter who struggles with addiction and who has received fi- nancial contributions from her parents – Korvan suggests including a hotchpot clause in the will.

A hotchpot clause would take into consideration all assets provided to Annie during her parents’ life and addresses the parents’ need to account for the difference in compensation their daughter will receive in relation to her siblings.

According to Korvan, an example of a hotchpot clause is: No gift of money or property made by me and no obligation entered into by me for the benefit of Annie Royal is to adeem any gift to her in this Will nor is it to be compensated for by way of hotchpot.

Korvan did not address whether or not Annie’s inheritance and the hotchpot clause should take into consideration accrued interest of monies advanced to her during her parents’ lifetime – a consideration financial planners at the sixth annual IAFP symposium suggested.

ESTATE PLANNING: CAN’T BUY HEALTH While on the subject of trusts, Jamie Golombek, managing director, Tax & Estate Planning, CIBC Private Wealth Management, suggests the Royals examine the use of testamentary trusts.

“This type of trust protects the assets for the kids, grandkids, from any future re-marriage by the surviving spouse.”

Considering that Phil has already suffered a series of strokes, Golombek believes the testamentary trust to be an ideal solution for the protection of assets, the mitigation of taxes and the ability to control who, in the future, has a right to the estate.

“It’s a classic problem: One spouse leaves everything to the other and then dies. But what if, after the death, the other spouse decides to remarry? If the surviving spouse were to die, while married to someone else, then the new spouse may be entitled to the estate and could, potentially, leave the kids with nothing. That’s a serious problem.”

Golombek suggests that both Phil and Liz set up testamentary trusts that give each spouse limited access to the encroachment of the capital. He suggests the Royals see a lawyer in order to set this up, as both will have to take into consideration that their spouse is, at the very least, entitled to what they would receive if there had been a divorce.

“Still, if the spouse who remarries dies, only his or her portion of the estate would pass to the new spouse, leaving the remainder to the surviving children.”

The other benefit to the testamentary trust is the ability to income-split post-mortem, says Golombek. Because the testamentary trust is not taxed at the highest rates, as an inter vivos trust would be taxed, but at graduated rates, this allows for the postmortem income-splitting by having income taxed inside the trust post-death instead of in the hands of a high-income beneficiary.

“The Royals could set up four testamentary trusts and could potentially save over $12,000 in taxes annually, per trust,” says Golombek. “Plus Phil and Liz could limit the amount the kids have access to, thereby ensuring that their kids do not spend all the money at once.” Even if some of the children, like Eddie, can be trusted to be responsible with the inheritance, Golombek suggests the Royals still use a trust. “The potential to reduce the tax on the future income from the inheritance through post-mortem income-splitting is huge!”

ESTATE PLANNING: LEGACY GENERATIONS While Liz and Phil are under no obligation to leave their estate to nonminor children, their intentions need to be clear and should be expressed in their wills, says Swanson.

This issue, however, prompts a more fundamental issue Phil and Liz will need to address: Their desire to “control the distribution” of their estate to only “natural heirs.”

Both Swanson and Korvan believe potential problems will arise if this desire is pursued.

“The Royals could include provisions for DNA testing or they could specifically spell out in the will instructions for the executor to divide the estate only among natural heirs, but this puts the executor in the hot seat,” and leaves the will open to being contested, says Swanson. “Hal has been treated like a grandson so to stop treating him as such would prompt problems. My advice is that Hal should be included as a beneficiary regardless of lineage.”

If the Royals refused to acknowledge Hal as a grandson, Swanson suggests that the couple “not use words to legally exclude children born out of wedlock, [but rather] use words to direct” the inheritance.

“I would not encourage people to state reasons, in their will, for their intentions,” says Swanson, as the burden of proof then is on the estate to prove the reasons are accurate. “Instead, I would encourage them to acknowledge that they are not leaving money to a particular person without stating a reason, particularly since the will is a public document.” If the Royals insisted that their potential heir should know the reason for the exclusion, Swanson suggests asking Phil and Liz to compose a private letter to the heir. “Put the reasons in a separate document;” one not considered a public document and, thus, need not be submitted into court.

Yet, one grandchild that does appear to cause Liz great concern is Mary – Annie’s mentally disabled non-minor child.

Liz, in particular, is very concerned that Mary is taken care of even after she and her husband are gone. In her efforts to gain some clarity on what to do for Mary, Liz is told that she may be able to roll her RRSP into the recently created registered disability savings plan (RDSP), which will solely benefit Mary. As of December 2008, approximately 10 financial institutions will launch the RDSP. Another means of ensuring that Mary receives the benefit of her inheritance, without incurring clawbacks from government assistance, would be to use a Henson or discretionary trust, either completed on an inter vivos basis or included in the wills.

Liz and Phil also need to consider that any money left to a minor grandchild residing in the U.S. will require a trustee to oversee the estate. “It is unlikely that Andy can be the trustee because he lives in a different state than his children,” explains Korvan. “That requires Liz and Phil to find another trustee or a professional fiduciary if they do not want Andy’s ex-wife, and mother to the children, to control the portion of the estate left to the grandkids, which could include shares of the business.”