Case study: Estate freeze trims entrepreneur’s tax bill

Client profile

Last month we met Jerrod, 58, and Penelope, 54,* co-owners of a clothing distribution company (Opco). A bitter divorce made it impossible to continue as business partners, so they tried selling to a competitor. But the deal fell through.

*This is a hypothetical scenario. Any resemblance to real persons or circumstances is coincidental.

Read: Co-owners’ divorce leaves business in limbo

The experts

Jordan Caplan

Partner, Audit & Advisory, Crowe Soberman LLP in Toronto

Neil Maisel

Partner, Valuations, Forensics & Litigation, Crowe Soberman LLP in Toronto.

The situation

Jerrod wants to retire early, while Penelope still craves the fast pace of entrepreneurship. They reach an agreement: Penelope will buy out Jerrod, and fund the deal through a bank loan. She wants to plan for the eventual transfer of wealth to her children, and needs advice on how to do it tax-efficiently.

Penelope has three children: Cecilia, 30, and Edmond, 26, both from her first marriage, and Sam, 16, whom Penelope and Jerrod had together. Cecilia’s a sales manager and Edmond’s a warehouse supervisor at Opco; neither are married, but both are in serious relationships.

The solution

There are two main aspects to the solution:

• an estate freeze and trust structure to transfer Penelope’s wealth tax efficiently; and
• trust document clauses and marriage contracts to protect Penelope’s wealth from potential ex-spouses (her own and her children’s).

Estate freeze and trust structure

Jordan Caplan, a partner at Crowe Soberman LLP in Toronto, says an estate freeze is the best way for Penelope to create funds for retirement and pass her company’s growth on to her children.The freeze locks in the current value of Penelope’s Opco common shares by converting them to preferred shares.

Without this conversion, the common shares would increase in value as Opco grows. On Penelope’s death, her estate would pay tax on the deemed disposition of those common shares; if their value increased 30% between today and her date of death, for example, that growth would be included in the tax payable by her estate.

When Penelope started Opco with Jerrod, she subscribed for half of the company’s common shares with a nominal $100. Her original 50% stake is now worth $5 million, so that’s effectively a $5-million gain. Converting the common shares to preferreds caps that $5-million gain; new common shares are issued (again for a nominal amount) to capture Opco’s anticipated future growth. That growth will accrue in the hands of Penelope’s children.

Read: 5 tax tips for business owners

8

Degree of difficulty

8 out of 10.

The holding company and trust structure is highly complex. There are no templates: the nuances of each client’s situation evoke the finer points of tax law and, in such cases, there’s a thin line between maximizing tax efficiency and being offside with CRA. Penelope’s advisors consult several accountants and tax lawyers to craft the solution.

Converting Penelope’s common shares and creating new ones requires an elaborate holding company and trust structure to maximize tax efficiency and achieve her estate planning objectives.

Another important factor is how to take possession of Jerrod’s Opco common shares tax-efficiently. Caplan explains what Penelope should do.

Step 1: Create a discretionary trust with Cecilia, Edmond, Sam and Penelope as beneficiaries. Penelope should be a beneficiary, just in case the $5 million she freezes doesn’t cover her spending needs through retirement. The trust’s settlor must be someone who isn’t a trustee or beneficiary, such as a friend or uncle, to avoid negative tax consequences.

Step 2: Create an incorporated holding company (Holdco).

Step 3: The trust subscribes for 100 common shares of Holdco for a nominal $100.

Step 4: Holdco borrows $5 million from a bank.

Step 5: Holdco buys Jerrod’s Opco common shares for $5 million.

Step 6: Penelope transfers her common shares of Opco to Holdco in exchange for voting preferred shares of Holdco.

Step 7: Opco borrows $5 million from a bank to pay dividends to Holdco. (We assume Holdco has retained earnings of at least $5 million.)

Step 8: Holdco repays the bank debt incurred to purchase Jerrod’s shares.

Read: 9 considerations for successful business owners

Result

• Borrowing occurs at the corporate level, with the interest deduction sheltering operating income. Debt repayment is with pre-tax corporate funds.
• Holdco’s shares in Opco have a fair market value of $10 million and an ACB of $5 million. That high ACB reduces Holdco’s capital gains tax in the event Opco shares are sold.
• Opco’s future growth accrues to the family trust, meeting Penelope’s estate planning objective.

Trust document and marriage contracts

Neil Maisel, a partner at Crowe Soberman LLP in Toronto, says the trust should have three trustees (see “Structure family trusts properly”). Since Sam’s still a minor, the trust document should include a clause preventing him from receiving distributions until he’s 18.

Maisel says the trust document should also indicate that beneficiaries who marry cannot receive distributions unless they have marriage contracts, which must stipulate that, in the event of separation, trust property is excluded from net family property calculations. Opco’s value, as well as the value of all trust property, must be fully disclosed in the beneficiaries’ marriage contracts.

Say Edmond and Cecilia get married two years apart. A new valuation may be necessary before each marriage contract is finalized. Maisel adds that, even if their marriages are only a few months apart, it could still be necessary to get a valuation on Opco before each marriage. A major corporate event, such as the loss of a major client, could occur between the marriages and have a dramatic impact on the company’s value.

“You can’t release your rights to property until you know what’s there,” he explains. Without proper disclosure, an ex-spouse may claim he would never have signed the contract had he known his former wife was so wealthy.

Read: Is owning a business worth the financial struggle?

Client acceptance

8/10

While some may view Penelope as young for an estate freeze, she has no plans for lavish spending during retirement, so it makes sense for her to use the strategy now. As Opco’s CFO, she has the technical background to grasp the strategy’s components, and she’s satisfied it’s the best way to manage her tax situation and leave as much as possible to her children.

Dean DiSpalatro is a Toronto-based financial writer.