The royal pain (a case study, part 1)

Liz and Phil Royal are a typical Canadian entrepreneurial couple: Close to retirement, oodles of retained earnings and no coherent plan for retirement. They are the prototypical case offered to the 100 registered financial planners who gathered for the sixth annual Institute of Advanced Financial Planners (IAFP) conference in September in Regina.

To understand some of the nuances in developing a financial plan for a successful business owner, the IAFP provided speakers and experts on a variety of topics, including: tax and estate issues, legal ramifications of business succession, insurance options and family dynamic coaching.

The result was a three-day analysis of the Royal family – affectionately known as “The Royal Pain.”

In PART 1 of AER’s coverage, we outline the case study and explore retirement planning solutions. Next month, in PART 2, we cover business succession planning and the options the Royals could choose for their legacy. In PART 3 we will publish the remaining facets of the Royal’s financial plan, along with your responses to the case study.

PART 1: THE WONDER PLOW CASE STUDY SET UP Liz and Phil Royal, together, have built a successful manufacturing business based in Dog River, Saskatchewan. Over the years, these high-school sweethearts transformed a small backyard business, based on an invention by Liz’s father, “The Wonder Plow,” into a mid-sized farm machinery manufacturer with a 150-employee factory in Dog River and a U.S. distribution facility in Minot, North Dakota.

Close to retirement, the Royals approached their advisor in an effort to understand what plans they needed to make and implement to comfortably retire.

During the initial conversations, the advisor learned:

• They recently turned down an offer of $10 million for the business from the “Jack Moose Implement Co.,” a large multinational manufacturer of farm and industrial machinery. • They have always concentrated on the business and have done little in the way of estate planning except for a will that leaves everything equally to their children. • They wish to pass the company and their estate to their children and “natural” grandchildren. • They wish to treat all of their beneficiaries equally. • Their biggest fear is that the assets they have accumulated through a lifetime of hard work and frugality will end up in the hands of ungrateful in-laws. (This is an understandable concern as three of their four children are divorced.) • They also want to leave a significant legacy to their community, ideally something that would pay homage to the early settlers and pioneers of the prairies. • They want to minimize taxes, preserve assets and distribute wealth while protecting the estate.

Now, their advisor’s job is to develop a comprehensive financial plan that takes into consideration the wishes and desires of Phil and Liz, while accounting for the tax, legal and familial implications that may be involved.

FAMILY FLOWCHART – THE CONCERNS AND DESIRES The first step is to develop a comprehensive picture of the family dynamics, which includes a list of goals and dreams, and a list of concerns, from Phil and Liz.

Through a few probing questions, the Royals’ planner ascertains the following:

• Liz is 80 and Phil is 82. Both are in generally good health although Phil has had a recent health scare. Liz has genetics on her side: her mother lived to 101. • Chuck Royal, age 54, is the oldest son and runs the day-to-day operations of the family business, Britannia Ltd. Chuck has been a success as an executive but his personal life has been a disaster. He and his first wife, Deedee, had a very public and embarrassing divorce. Together they have two sons, Billy, age 30 and Hal, age 27. • Billy is his grandparents’ favour ite, and is already working in a mid-management position in the family firm. Hal has been in and out of trouble and was always a bit of an outsider (and he bears a remarkable resemblance to his mother’s tennis pro). • Chuck remarried a few years ago to Cammi who has two grown children of her own. • Annie, 52, is the only daughter. She is divorced and has battled alcoholism all her adult life. She has not worked for years and her divorce settlement is fast depleting. Her son, Ted, 26, is a social worker and is married with one child. Her daughter, Mary, age 24, has Down Syndrome and lives in a group home. • Andy, age 50, manages the family’s U.S. distribution centre in Minot, North Dakota, where he lives. He is divorced with two daughters, aged 10 and 12, who live with their mother, Sara, in Denver, Colorado. • Eddie, age 42, is the youngest. He has pursued a career in theatre and lives in Vancouver with his partner, Steve.

Their advisor also learns about a few more family issues. For instance, Liz and Phil confess that their eldest son, Chuck, is under the assumption that he is entitled to the largest share of the family business. By working for less than market wage for years in the family business and dedicating 20 years of his professional life to the corporation, Chuck believes his retirement should be secured by his inheritance – the business. However, Liz and Phil are worried. Chuck still makes support payments to Deedee, his first wife, and she appears to be counting on Chuck’s inheritance as a way to make a claim for larger support payments if Chuck’s financial fortunes improve.

Liz and Phil also know that their second eldest son, Andy, believes himself entitled to the U.S. operations, at the very least. His argument is that he established the U.S. market for Britannia products and has recently become a U.S. citizen. While his parents acknowledge that Andy has also worked hard on the business, they know that he is also heavily involved in his own career and that his daughters attend a very expensive private school in Denver, making him financially strapped. They are worried that these financial pressures may prompt Andy to liquidate any portion of the business he may receive from his parents in order to capitalize on the retained earnings and pay off his bills.

When asked about their eldest daughter, both Phil and Liz let out a great big sigh. They are already quite aware of how much money they have provided Annie, and, over the years, have tried to help her battle her addictions. Yet, their daughter can only talk of “retiring” to Hawaii once she receives her inheritance. While Phil and Liz want to be able to provide for their daughter, they are worried that she will spend all the money too quickly and not leave enough to take care of her own children.

To balance out their concern for Annie’s lack of self-sufficiency is the delight the Royals have for their youngest son, Eddie. On his own since 21, Eddie is content with his life. He and his live-in partner, Steve, have a real talent for flipping real estate. Despite not making a great deal of money, their son and his partner own a condo in Vancouver and a 12-suite apartment in Surrey. The most notable difference, however, is that Eddie is the only child not vying for a piece of the family pie. Instead, he actively encourages his parents to give their fortune to charity (specifically recommending charities with an environmental focus).

THE NEXT GENERATION: LOOKING OUT FOR THE ROYAL GRANDCHILDREN Aside from their children, Liz and Phil have expressed concern about whether their “favourite” grandson, Chuck’s eldest son Billy, will be adequately compensated for his contribution to the family business. Liz is also concerned for Mary, her granddaughter with Down Syndrome. Mary works in the local recycling facility and is happy in the group home, where she resides, but Liz knows that her granddaughter is not capable of handling money. Still, Liz would like her to be able to have “nice” things.

Finally, Liz is concerned about her husband. While both are close to retirement, Phil has been quite forgetful as of late, partly due to a series of mini strokes he suffered this winter while in Arizona. Since this medical mishap, Phil has been muttering about leaving his entire estate to the church and has been spending a significant part of every day at the local casino. Worried about his behaviour, Liz hopes that by concentrating on retirement planning, she and her husband will be able to comfortably move into the next phase of their life.

Part of the role of the advisors is to unpackage what aspects of their estate and their business will impact the Royals’ retirement.

RETIREMENT PLANNING One key aspect of their retirement planning, however, is to determine how they will realize the retained earnings in their business. By their own admission, the Royals have little money invested in external sources; instead, most of their net worth resides in the business they patiently built upon over the years.

While their advisor was told that the Royals had declined a $10 million offer on their business, it is still unclear why this offer was declined.

For example: Did the Royals decline the offer because the business was worth more? If so, how much is the business worth and how do they know this? Did they decline the offer based on their desire to leave a legacy, rather than for financial reasons? Or were they concerned for their son Chuck, since he has spent so much time in the family business?

The easiest and probably most profitable solution, in the short term, would be to sell the family business, explains Jamie Golombek, managing director, CIBC Private Wealth Management.

However, if the advisor learns the Royals refused the proposed offer of $10 million because of their desire to pass on their legacy through the family business, Golombek suggests that the advisor construct the financial plan so that growth of the company, not the control of the company, is transferred to the heirs while Phil and Liz are still alive (and not yet retired). This can be done through the use of a family trust and an estate freeze. The trust holds the shares on behalf of the beneficiaries and can accommodate voting and non-voting shares – so that the future growth of the company can be divided up among those siblings involved with the business and those that are not.

“If you issue the shares directly, absent a shareholder’s agreement, the children can run off… sell them, whatever,” says Golombek. “If you use a trust they can’t do that and the Royals can retain control of the business until they choose to officially retire. It’s built-in protection,” while establishing a CRA-friendly transfer of wealth and business succession plan.

Also, the condominium in Arizona needs to be dealt with, says Golombek. Both the condo and the U.S. business assets will be subject to U.S. estate tax upon death, says Golombek. “This could result in a substancial U.S. estate tax liability. Add this to the potential capital gains tax and the Royal family could end up in a cash crunch. They need to plan their estate in order to avoid having to pay these expenses.”

CONSIDERING THE SOUTHERN SIDE OF THE ESTATE Golombek explains that if they sold the condo in Phoenix, given the current glut of residential real estate in the U.S. market, the family could not claim the loss as the condo is considered a personal use property.

“While the family could take advantage of the U.S. estate tax exemption ($2 million in 2008 and $3.5 million in 2009), the exemption must be prorated by the U.S. situs assets divided by the worldwide estate. But considering that a family’s worldwide estate is usually so large, and the U.S. portion of an estate is usually so small, this prorated rate means little in terms of exemption from the estate tax. For the Royals, this means they will have substantial U.S. estate tax to pay and they need to address this while Liz and Phil are alive.”

Assuming that no one is a U.S. citizen, Golombek suggests that the Royals take one of a few approaches in order to mitigate estate and capital gains taxes.

The first is to purchase life insurance to cover the estate tax sum. The next option, which is generally not recommended, is to have the Canadian company purchase the U.S. real estate.

“If they opt to have the property purchased by Britannia, they need to be aware that the CRA will assess a shareholder benefit for equal to the fair market value of the rent that could be charged on that property,” explains Golombek.

Another option is for the Royals to establish a trust and have the trust purchase the U.S. property.

“Before selling and then purchasing [either another property or the same property] the Royals could consider creating a Canadian trust and ensure that a non- U.S. resident is established as the trustee,” says Golombek. “Since the trust owns the property upon death, the Royals could save a significant amount of estate tax.”

Golombek does forewarn, though, that the Royals would lose control of the property, as it would legally be owned and controlled by the trust. “Expert legal and U.S. tax advice here is, of course, a must,” quips Golombek.

ASSETS: LIZ AND PHIL, OWNED 50/50

THE "ROYAL" FAMILY

GENERATIONAL DIFFERENCES

GENERATIONAL DIFFERENCES

We encourage readers interested in commenting on any of the suggestions provided, or offering alternative solutions to the Royals’ financial plan dilemma to email their suggestions or comments to: editor@advisorsedgereport.com.