Deceased mother’s codicil bites back

Client profile

deceased business owner left millions to one of her sons, leaving the remaining two with nothing. And though she’d planned to update her will so that each received an equal inheritance, she died before she got the chance. Her sons have complex legal and estate issues ahead of them.

The situation

Rainbow Harrison* was an accidental entrepreneur.

The daughter of a Vietnam-era U.S. expat and a Vancouver flower child, she started a family early and had three sons—Moonjava* (now 27), Karma* (now 24), and Wildwind* (now 22)—by the time she was 25 in 1993.

One year later, she opened a teashop in Vancouver because visiting friends consistently told her they’d buy the home-blended teas she served if they were available for purchase.

Her plan was to operate the shop, a sole proprietorship, as a lifestyle business so she could home-school her children while staying connected to the community. That didn’t work out. Enthusiastic word of mouth led to lines around the block, the opening of two additional locations in 1996, and 25 locations coast to coast by 2000. Rainbow was working a 60-hour week and turned the home-schooling over to her husband, who’d quit his landscaping contractor job in 1998 as the tea business took off.

By 2001, though, he’d found himself in the midst of a full-on mid-life crisis and left Rainbow to run a raw vegan retreat near Lake Louise in Alberta. The couple finalized separation from their common-law union in 2002.

After that, the business took off again, leading to a $28-million buyout from a major coffee house chain in 2005. The deal included a 5% license agreement on all future in-store sales and on sales of branded tea products distributed through grocery retailers across North America. Also, she’d been leasing the teashop locations, so the acquiring company took over those leases as part of the buyout.

Rainbow lives on the proceeds of the licensing agreement. The principal from the $28 million is in GICs because she’s afraid of what might happen if the money had been in stocks, and figures it’s such a large sum that she’d never need any more. And, of course, the events of 2008 confirmed her worst fears about the equity markets.

She’s never bought residential real estate, but has flirted with picking up “a little bungalow in West Van” and paying cash.

Not long after the deal closed, Moonjava and Wildwind asked for some of the sale proceeds to fund an entrepreneurial plan of their own. Unfortunately, it was a mobile-app software company, which led Rainbow to conclude her sons had sold out.

She refused to give them the money, called her lawyer the next day and drafted a holograph codicil to her will (which had been drawn up just after her separation and left equal shares to the three boys). The codicil disinherited Moonjava and Wildwind, leaving almost everything to Karma ($1 million would go to a charity that supports parents who home-school their kids). She also made Karma sole executor and included instructions not to share his inheritance with his brothers—going so far as to include metaphysical references to hauntings if he should go against these wishes.

The experts

• 

  Theresa Arsenault

  business and estate planning lawyer, Pushor Mitchell LLP

• 

  Cindy David

  CFP, CLU, FEA, TEP, president & estate planning advisor, Cindy David Financial Group Ltd.

• 

  Keith Vincent

  CPA, CA, taxation services at MNP

Over time, she softened her stance and told all three sons verbally that she intended to change her will to make the inheritance equal. But, since she was only 47, it seemed there was plenty of time.

Except that there wasn’t. Rainbow’s parents were anti-medical establishment, and refused regular physicals and diagnostic care. So a congenital ventricular septal defect was never diagnosed and Rainbow suffered a fatal heart attack in December 2015.

Karma, a critically acclaimed short fiction writer who just landed a $75,000 advance for his first novel, is deeply troubled by the situation. He doesn’t want to be sole heir, but feels bound by the will’s terms and codicil as written. He’s afraid to violate his mother’s wishes and wonders why she failed to make the changes.

This hemming and hawing has led his brothers to be suspicious of his motives, and Moonjava has gone so far as to suggest Karma would act unfairly even if he did decide to divide the inheritance. What should the brothers do?

Legal matters

TA: Karma has the ability to renounce his executor appointment if he would prefer not to be executor. If he does renounce, the court can appoint a different executor. So his brothers, or he and his brothers together, could apply to be appointed as executors or administrators.

I don’t think they’d want to leave it in the hands of the public guardian and trustee, who’s the default person if they don’t look after it themselves.

Either way, it could take time. If Karma renounces, his brothers need to apply to be appointed, and it would be a several-month process. From an expediency point of view, it would make more sense for him to continue on and be executor, but work out a deal with his brothers. Also, when the codicil was originally made, it had to be in writing and signed by two witnesses. Under the new Wills, Estates and Succession Act in B.C., there is the opportunity to rectify a will that does not meet the requirements of having two witnesses. “Holograph” generally means a handwritten will signed by the testator. If it was just a handwritten will signed by the testator, it would not have been valid when it was made, which means her previous will that divides her estate among the three boys would apply.

CD: And that would save Karma a lot of headaches.

TA: Indeed, it would. But if he chooses to probate the codicil, then his brothers can apply to vary the will and demand that it provide for them. In B.C., the courts are pretty generous about varying wills to make sure that people are fairly treated.

And as executor, Karma needs to account to the beneficiaries for anything that he’s done with the estate assets. Right now the other sons are not beneficiaries, but they will likely become beneficiaries. The accounting he gives must include the value of the assets at the time of death, any income or capital received by the estate after death, any outflows from the estate and what’s available to distribute.

KV: Is there any opportunity to not have the will probated, and save the almost $400,000 of probate fees that are going to come off of this?

TA: If the GICs were in Rainbow’s name alone, there is no opportunity to avoid probate because she’s dead. The holders of the GICs [i.e., the financial institution] will not allow them to be transferred without probate.

CD: Unless they were life insurance GICs with named beneficiaries. If she purchased them from an insurance company, for instance, versus a bank, there’s a potential for beneficiary designation.

TA: Yes, if the GICs were in a life insurance product with named beneficiaries, she could have arranged this estate to make it more effective from a probate fee and estate-planning standpoint.

Taxing issues

KV: The biggest asset in her estate is the $28 million in GICs. There wouldn’t be any tax on that, because that’s all tax-paid money (i.e., an asset that someone owns where tax has already paid). There might be some accrued interest that would get taxed, but I don’t see much tax there.

What I do wonder about is that she had a 5% license agreement on future sales. There could be some tax depending on what the terms of the deal were. Did it only apply while Rainbow was alive? Does it carry on after she passes away? If it ends at her death, then there’s no value to that license agreement, so there’s no disposition to report on her tax return because it’s now worthless.

If it continues on, it’ll be divvied up three ways among her sons. The executor works with professionals to come up with a value, which would be based on future estimated cash flow.

Let’s assume the license agreement carries on after death. Then that’s the value of some kind of intellectual property, some kind of intangible.

It would be treated as a disposition of eligible capital property. Let’s say it’s worth $1 million. Half is taxable, so that’s $500,000. With the present value of that license deal, the payment stream coming out of it and her GICs, she’s likely in the top tax bracket. She’d be taxed at the top B.C. rate (currently 45.8%). So she’d pay tax of about $229,000.

CD: Would you recommend they incorporate and accumulate retained earnings?

KV: Presumably, they’d have put a value on it when Rainbow passed away. They’re going to have a tax cost equal to that value (i.e., the cost we use as a basis when comparing the value of the property on the sale less what you have acquired it for), so they should be able to transfer it into a company. That kind of income is going to be a passive income stream, not active business income. Investment income is taxed at a higher rate initially, because there’s a component of the tax that’s refundable for Canadian-controlled private corporations.

As the income is earned, and dividends are paid out to shareholders, a portion of that tax is refunded. So, that is certainly one option. It might make things easier, as opposed to having a license deal owned three ways by three individuals.

Create a holdco?

KV: We might consider having the inheritance invested through a holding corporation, where we can split income with other family members. Typically, they would take the funds and transfer them to their holding company by way of a loan or some kind of preferred share, for example, and have other family members either directly, or through a trust, own shares in that company.

There are tax rules called the corporate attribution rules—if you don’t follow them, it can result in some income being attributed to the person who transferred the property. Let’s say Karma puts $5 million into a holding company to reduce his income. The company either pays an interest rate on the loan owing to the child, at the prescribed rate (currently 1%), or a dividend rate on the preferred shares. The corporation is earning the investment income. It can pay dividends out to the other family members, and use their lower tax brackets.

CD: If there’s any liability in a company, it’s always a good idea to incorporate. It could protect them, and they have access to tax planning as Canadian-controlled private corporation business owners. They have the ability to retain earnings at low income tax rates. So, it creates a tax deferral, and income splitting, as Keith mentioned.

KV: Yeah, they’d get the low-rated tax on the first $500,000 of active business income, which is currently 13.5%, as opposed to 26%.

If you compare that to what they would pay in tax personally, if they ran this business as a partnership, the rate is 45.8% in B.C. Further, as long as the company qualifies as a small business corporation, they have the ability to shelter $814,000 of capital gains on the sale of their shares from income tax.

CD: If they get married and have kids, they can also create a corporate structure around that business to have tax-effective income go to the spouse or kids. And they have access to group dividends.

TA: Also, when they incorporate, we’d recommend they have a shareholders agreement to specify things, like what happens if they need more money.

Would they borrow it from themselves or from financial sources? Who’s going to be the director(s) of the company? What happens if one party wants out? Do the others have a right of first refusal? What happens if one party can’t stand working with another? Do we put in a shotgun clause to provide that one party can force the sale one way or the other? Do we allow this family business to be sold to a third party? It would be important to put an agreement in place at the beginning, while they’re all still happy and getting along.

Planning for the inheritance

CD: The mom had toyed with the idea of buying a primary residence. I’d suggest all the kids think about maximizing the value of the primary residence because it’s a tax shelter.

Also, they should maximize TFSAs and use any unused RRSP room. I’d wait until the income actually lands on their tax returns, so they can get a big refund from making use of RRSP room. If they haven’t made any money at their jobs, they wouldn’t have any room. Karma did just get that book deal, so he would have some room.

Aside from that, it would be about investing wisely—focusing on growth, capital gains and dividends being better than interest. There’s a lot of money at stake here, and they wouldn’t want to necessarily put the money at risk in the markets without a really good stop-loss strategy, and a plan to protect the original capital. A lot of what would be recommended depends on what their lifestyle needs are. I’d encourage them to look at their picture globally, and have a balance between real estate and investments that don’t attract a ton of tax.

KV: An option is to invest in a life insurance policy.

CD: I would definitely look at that strategy: their ages are perfect, and we can lock in age and health while they have it. Borrowing to invest would work well because it would create interest expense and NCPI (Net Cost of Pure Insurance) deductions that wouldn’t be available otherwise.

To be clear, the borrowing to invest is not done in the policy. The policy is assigned as collateral for a loan, and the loan proceeds are used to invest in a taxable non-registered investment. Eventually, they can build up some significant deductions against their income to help them with the tax bill they’ll face every year. Because they have such a large pool invested, it’s going to land them in the highest tax bracket.

Further, the cost of insurance is irrelevant given that it’s a deduction. What matters is net annual cash flow. The after-tax cost of borrowing and paying for insurance is less than the cost of paying tax on investment earnings, which is why this plan works. The break-even period can be anywhere from three to 10 years, depending on age and the plan structure. Given their young ages, the break-even period would be very short.

And we have a smoking gun. Access to tax sheltering using universal life plans is going to change dramatically after January 2017. Whole life plans won’t be affected as much, but the strategy of borrowing to invest is going to be hindered with the new legislation.

The change is to the maximum tax actuarial reserves, which limits the amount of deposit room in the investment portion of the contract.

After January 2017, we still have access to it, but these kids would have to buy a whole lot more insurance to get the same amount of money tax sheltered. The point is that we’re trying to beat the cost of tax. When you have to buy more insurance we’re going in the wrong direction. So, right now, they could get really cost-effective insurance plans.