ARTICLE: TAX AND FAMILY BUSINESS SUCCESSION PLANNING

Articles Newsletters Tax Newsletters		Tax and Family Business Succession Planning – A Checklist by David Louis, B. Com., J.D., C.A., Tax Partner Minden Gross LLP, a member of MERITAS Law Firms Worldwide. (This release is based on an article published in Tax Notes #545, June 2008, CCH Canadian Limited)* ___________ The following is a list of tax-related issues that should be considered in the formulation of a family business succession plan. Some of the issues raised are discussed in more detail in the endnotes. For a more detailed discussion of virtually all of these issues, see Tax and Family Business Succession Planning, 2nd edition (CCH Canadian Limited), by the author and Ms. Samantha Prasad. Estate Freezes · Review the advantages of an estate freeze. Note: the principal advantage is the deferral of “death tax” on future appreciation of the family business to the death of the next generation, e.g., by holding “growth shares” of a family business corporation. · Consider advantages/disadvantages of basic types of freezes: internal freezes (reconfiguration of shares of an existing corporation), holding company freezes, freeze of unincorporated assets. · Consider various estate freeze structures, e.g., partial freeze, gel (where future appreciation can be diverted back to freezor), reverse freeze (inter-corporate transfer of assets to frozen “Newco”). · Should income-splitting structures be implemented as part of the freeze? · Consider whether a family trust should be used for a freeze, or shares should be held directly by family members. · If a family trust is to be used, consider the choice of trustees, as well as trust provisions (e.g., the extent of indemnities to trustees, clauses prohibiting illegitimate children, special and residual beneficiaries, etc.). · Consider other uses of trusts (e.g., income-splitting, asset protection, etc.). · Review impact of estate freeze on associated corporation status.[1] · Consider other technical tax issues arising from the implementation of a freeze, e.g., conferral of benefit, kiddie tax, the attribution and reversionary trust rules, etc. · Review family law considerations. · Are US residents/citizens involved? If so, US tax/estate tax implications should be considered.[2] Capital Gains Exemption Review the availability of capital gains exemption. If it is not available, can the corporation be “purified” so as to qualify (this involves the removal of non-qualifying assets from the corporation)? · Consider the multiplication of the capital gains exemption, e.g., through a freeze into a family trust. This often involves purification structures to ensure that the corporation will continually qualify for the capital gains exemption.[3] · Consider whether the capital gains exemption should be “crystallized” (i.e., by purposely triggering a capital gain sheltered by the exemption to “bump” the cost base of the corporation’s shares). Income Splitting · Review advantages of income-splitting structures for a family business, e.g., with low-tax-bracket adult children/spouse, etc. Note: lower corporate tax rates on business income may favour the retention of profits at the corporate level rather than being “bonused out”. If so, taking full advantage of low-bracket family members as shareholders may become increasingly important.[4] · Consider carefully the various tax traps to income splitting especially where family members become shareholders, including the personal and corporate attribution rules, “kiddie tax”, rules relating to conferral of benefit, the general anti-avoidance rule, etc. · Should/can family members be put on company payroll? Life Insurance · Is life insurance necessary, e.g., to fund death tax or a buy-sell? · Have the tax advantages of corporate-owned life insurance been reviewed? · Has the role of life insurance in post-mortem estate planning been considered? · For existing corporate-owned life insurance structures, has “grandfathered” status been considered and reviewed? Note: This pertains to pre-April 27th, 1995 insurance or shareholders’ agreements. If grandfathering applies, post-mortem tax planning using an insurance-generated capital dividend account may be greatly enhanced. · Consider whether a buy-sell should be structured as a survivor buy-out or the redemption of decedent’s interest, including who gets the tax benefit of the life-insurance-generated capital dividend account. · Has the possible deductibility of insurance premiums been considered, as well as levered insurance structures? · Have alternative funding arrangements (other than life insurance) been considered? Asset Protection Strategies · Have corporate asset protection strategies been considered, including dividends to holding companies which are lent back on a secured basis? · Where corporate creditors are in issue, has consideration been given to maximizing distributions to individual shareholders that can be made on a tax-effective basis, e.g., through the payment of capital dividends, reduction of stated capital, or ordinary dividends which generate a dividend refund? · Consider asset transfers in favour of spouse or other family members (one example being a freeze in favour of a discretionary family trust). · Consider “spin-outs” of assets from corporations which may have creditor issues. · Consider segregating real estate, e.g., in a Holdco. · Consider the use of a bare trustee corporation, e.g., to hold title to real estate. · Explore asset protection for retirement plans and life insurance. · Are more “exotic” asset protection structures advisable, e.g., offshore asset protection trusts? Wills, Will Substitutes and Probate Planning Have wills been updated (especially if there has been a change in personal circumstances, such as a marriage or divorce)? · Consider special factors in wills pertaining to business owner-managers (e.g., are there shareholders’ agreements in which designations must be made in the will; does the shareholders’ agreement restrict the manner in which a will can be drafted; consider associated corporation issues). · Consider special life insurance and retirement plan designations, e.g., to provide asset protection, reduction of probate fees. · Consider spousal rights under family law and other legislation (e.g., in Ontario a spouse can opt for an equalization of net family property in lieu of taking under the will). · Consider also the rights of dependents under provincial dependant’s relief laws. · Consider the choice of executors, including tax consequences, such as associated corporation status.[5] Note: in some cases a change of executors in an estate could have adverse tax consequences.[6] · Where possible, take advantage of the ability to defer of death taxes where the spouse is beneficiary. · Should a spouse trust be used (e.g., could the surviving spouse leave assets to undesired beneficiaries; does the spouse require business/investment assistance from trustees)?[7] · Is maximum advantage taken of low-bracket beneficiaries? · Have multiple testamentary trusts been considered in order to gain income-splitting advantages in the estate? · Consider testamentary tax planning strategies involving charitable donations. · Consider probate issues and strategies to reduce probate fees, especially in high-fee jurisdictions (e.g., multiple wills in Ontario, alter-ego or joint partner trusts in British Columbia). Note: Beware of joint tenancy arrangements.[8] · Consider whether there are advantages of using an alter ego or joint partner trust. (Besides probate reduction, considerations may include marital and creditor protection features, dependants’ relief protection, confidentiality, etc.) · If an alter-ego or joint partner trust is to be used, consider special tax and other issues.[9] · Has consideration been given to whether special post-mortem estate planning procedures will be necessary? Should there be specific provisions and directions in the will? Other Succession Planning Strategies · If a family trust is in place, consider whether a letter of wishes/revised letter of wishes should be prepared. · Should a family constitution-type shareholders’ agreement be entered into? (This could address matters such as governance by family members, liquidity, distributions, management issues, participation of family members in the business, special majorities for sale of the business, etc.). · Consider disability provisions for a family shareholders’ agreement, including issues relating to advanced age of the founding shareholder. · Consider the tax consequences of a family shareholders’ agreement, e.g., the result of buy-sell/call/put rights, in terms of change of control, association, etc.[10] · Consider the 10-year capital gains reserve for qualifying inter-generational share transfers. Alterations to Estate Plans · Do changing circumstances require the alteration or variation of an estate freeze? If so, consider methodology, e.g., thaws (i.e., unwinding an estate freeze), refreezes (modifying an estate freeze), refreeze at lower value, etc. Note: marriage may be a triggering event, e.g., the marriage of a beneficiary or remarriage of the freezor – family law rights should be carefully considered. · If a family trust is in place, consider the tax consequences of a change of trustees, particularly if the trust controls a corporation.[11] · If an estate freeze or other family trust structure is in place, is the 21st anniversary of the family trust approaching? If so, a distribution of appreciated assets should be seriously considered. · If an “asymmetrical” distribution is to be made – i.e., favouring some beneficiaries over others - consider taking steps to minimize the possibility of legal actions against the trustees and others, including revisions to the letter of wishes, trustees’ minutes (documenting that they considered only relevant issues), indemnities to trustees, resignations of “outside trustees”, etc. Note: trustees’ actions can be challenged notwithstanding the fact that a discretionary trust is used. · Consider the tax consequences of a distribution to a non-resident beneficiary. · If there is to be a distribution from a family trust, consider the implementation of a protective shareholders’ agreement, e.g., prior to distribution. (Consider also the inter-position of a holding company, with “thin-voting” shares held by parent(s).) · If there are differing assets within a freeze or other structure a spinout reorganization (e.g., where some assets are spun out to a “Newco”) may be desirable as the family business matures, e.g., if the freezor wishes children to take over part or all of the family enterprise. · If a shareholder has passed away, has there been a deemed sale of shares or other personally-held assets at fair market value? (Typically, this occurs on the death of the surviving spouse.) If so, consideration should be given to post-mortem estate planning strategies. Note: It is important to address this well within the first year after death. David Louis wishes to thank Mr. James Wong, Director of Succession at BMO Harris Private Banking, who suggested this checklist. [1] Pursuant to paragraph 256(1.2)(f), each beneficiary of a discretionary trust is deemed to own all of the shares held by the trust. Paragraph 256(1.2)(c) establishes a control test based on greater than 50% of the fair market of all shares, or 50% of the fair market value of common shares only. Subsection 256(1.3) deems shares to be owned by a child under 18 to be owned by a parent unless the child manages the business on an independent basis. [2] A typical Canadian estate freeze structure can give rise to serious adverse US gift and income tax consequences. For gift tax purposes, a preferred interest is valued at nil unless it earns a cumulative return. Retractable preferred shares will typically be treated as non-qualified preferred stock (i.e., boot), which can cause the estate freeze reorganization to be taxable under US rules. [3] For discussion of purification methodology, see “The Capital Gains Exemption: Keeping it Pure” by Michael Goldberg, Tax Notes, No. 541, February 2008. [4] A number of anti-avoidance provisions must be considered, including the attribution rules. Perhaps the most problematic of these rules are the so-called “corporate attribution rules” in section 74.4. Since this provision is potentially triggered when an individual transfers or loans property to a corporation, estate freezes potentially trigger the corporate attribution rules, since a share reorganization (e.g., where common shares are changed into freeze shares) is usually considered to be such a transfer. (See, in particular, subsection 84(9).) [5] The CRA’s position, based on MNR v. Consolidated Holding Company Limited, 72 DTC 6007(SCC), is that, in the absence of evidence to the contrary, there is a presumption that all of the trustees of a trust constitute a group that controls the corporation. Query, however, whether the CRA would take this position if some of the trustees were related, e.g., where two of the trustees were siblings, with a third “outside” trustee. In addition, for the purposes of the association rules, the look-through rules in subsection 256(1.2) must be considered. Finally, subsection 256(1.4) and paragraph 251(5)(b) should also be considered. These provisions speak to associated corporation and CCPC status (respectively) where a person has right (whether absolute or contingent) to shares. Although there is an exception in respect of rights that are contingent on death, once the shares pass to the estate, this contingency may no longer exist. See also Technical Interpretation No. 9235395, which involved a situation where shares in question were specifically bequeathed to a particular beneficiary. Query whether a non-specific bequest would make a difference. [6] At time of writing, the CRA’s policy is that an acquisition of control will not occur if an executor is replaced as a result of that person’s death or inability to fulfill his or her functions. See paragraph 10 if Interpretation Bulletin IT-302R3. [7] One of the requirements of a spouse trust is that no other person can receive or obtain the use of capital during the spouse’s lifetime. Doc. No. 9627345 and paragraph 16 of IT-305R4 indicate that a loan to a non-spouse on commercial terms (e.g., with commercial interest rates) would not taint a spouse trust. Doc. No. 2003-0019235 indicates that where the trust permits funds to be loaned (or other forms of assistance to be provided) to anyone other than the spouse for inadequate consideration, this would disqualify the trust, whether or not such a loan was actually made. Doc. No. 2006 – 0185551C6 indicates that a rollover to a spouse trust would not be available if the trustee is required to pay life insurance premiums. [8] In Pecore (2007 SCC 17), the Supreme Court indicated that the presumption of resulting trust (i.e., the presumption that there is no gift intended), rather than the presumption of advancement (i.e., the presumption that there is a gift intended), applies to gratuitous transfers to an adult child, while the presumption of advancement applies to a transfer to a minor. Further, if a gift is intended, it can be a gift inter vivos of the property at the time the joint tenancy is created (i.e., the transfer of beneficial ownership), or a gift only of the right of survivorship. A number of potential adverse tax consequences can arise from the creation of a joint tenancy, including the loss of the ability to “estate split”, and so on. [9] A good example relates to charitable donations. Although subsection 118.1(5) deems gifts made by an individual by will to have been made in the year of the individual’s death, this rule does not apply to an alter ego or joint partner trust. The ability to use a charitable tax credit against the deemed realization on death appears to be available only if the gift is made in the taxation year of the trust in which death occurs. Further, depending on the drafting of the trust, issues may arise as to whether the transfer to the charity is voluntary or is a distribution in satisfaction of the charity’s capital interest in the trust, governed by subsection 107(2), rather than treated as a charitable donation. [10] Some of the issues include acquisition of de jure control, if a unanimous shareholders’ agreement is used, de facto control, and the application of paragraph 251(5)(b) and subsection 256(1.4). As the various exceptions in proposed section 56.4 depend on a disposition to an arm’s length person, the use of a restrictive covenant in a family business succession planning shareholders’ agreement appears to be problematic. [11] See Doc. No. 2004-0087761E5. As noted earlier, the CRA’s position is that, in the absence of evidence to the contrary, there is a presumption that all of the trustees of a trust can constitute a group that controls the corporation. Consequently, the replacement of a trustee potentially constitutes an acquisition of control as a new group may control the corporation.