Do your clients - and their children - have an estate liquidity plan?

Earlier this year, the Canadian tax planning community received some welcome news from the CRA via two of its technical interpretations.¹ Although the newly revised general anti-avoidance rule (GAAR) introduces the concept that transactions significantly lacking in economic substance are likely to result in a misuse or abuse of Canada’s Income Tax Act, the CRA will not be changing its position on post-mortem “pipeline planning,” provided this planning meets existing CRA administrative guidelines.

The preservation of post-mortem pipeline planning brought a sigh of relief to the tax community. Still, estate planning remains a complicated exercise, and tax planning alone is not the only factor to consider. Another stage of planning is often needed—one I like to refer to as estate liquidity planning.

But first: What is post-mortem planning and why is it important?

Immediately before the time of death, Canadians are deemed to have disposed of and reacquired their assets at fair market value (FMV).² This includes a deemed disposition of corporate shareholdings, which can result in a hefty estate tax bill for business owners who have accumulated significant wealth in their corporations.

To add salt to the wound, there’s a double taxation issue that can arise when:

1. The FMV of a company’s shares is taxed on the death of a shareholder; and
2. The same corporate value is then subject to tax a second time on the eventual disposition of the underlying corporate assets and the extraction of the sales proceeds in the form of dividends.

Thankfully, there are two post-mortem tax-planning techniques that can be used to prevent this occurrence of double taxation, commonly referred to as “the 164(6) loss carryback plan” and “the pipeline plan.” The former typically involves paying tax at personal dividend rates, and the latter involves paying tax at capital gains tax rates. Without going into the specifics of each, depending on a client’s tax situation, one plan might be preferred over the other.

Post-mortem planning with a cherry on top?

Regardless of the post-mortem strategy undertaken to avoid double taxation, there remains at least one layer of tax for which estate liquidity is required. A common tax strategy for reducing and deferring the amount of capital gains tax exposure when passing wealth from one generation to another is an estate freeze,³ followed by a sensible amount of planned share redemptions to reduce the amount of tax exposure (referred to as a wasting freeze). To the extent that exposure to capital gains tax remains after a wasting freeze, taxpayers will need a financial plan or strategy to ensure that they have the liquidity required to pay the tax bill.

This is where tax planning for estates stops short. Although a wasting freeze combined with either of the two post-mortem plans described earlier will successfully reduce exposure to capital gains tax and eliminate the occurrence of double taxation, these kinds of tax plans generally do not create the liquidity needed to cover the tax bill. This is where estate liquidity planning comes in.

In my 2020 tax article, “Life Insurance Financing and the Great Wealth Transfer,”⁴ I discussed how corporate-owned life insurance can complement an estate plan in a tax-efficient and cost-effective manner, and how it will provide an estate with instantaneous liquidity to fund its capital gains tax bill. In terms of the financial return, corporate-owned life insurance can also make for a lucrative financial investment as well, especially when taking into account the tax benefits of funding policy premiums with cheaper after-tax dollars and tax-sheltered returns within the policy.

Additionally, in certain situations, life insurance leverage can further enhance returns and provide a means for companies to retain cash flow for use in their business and investments.

Also of significance in a post-mortem context, corporate-owned life insurance creates an addition to the company’s capital dividend account that will allow for the extraction of corporate surplus in the form of tax-free capital dividends, reduce overall tax exposure, and enhance net estate values—regardless of the post-mortem plan being contemplated. Combine the tax and financial benefits of corporate-owned life insurance with the liquidity created to cover the tax bill, and you have the cherry on top of your estate’s tax plan.

Don’t forget about the children

This issue is top of mind because, increasingly, we’re seeing boomer parents leaving their millennial and zoomer children with a hefty tax bill. Typically, these boomer parents are doing an excellent job with their own personal tax and liquidity planning—undertaking estate freezes and creating a plan to ensure that there’s a sufficient amount of liquidity in their estates to cover their future tax bill. The problem, however, is that all of this careful planning results in them transferring accrued gains to their millennial and zoomer children, and the ensuing capital gains tax bill is often significant—particularly given the rise in real estate values in British Columbia over the past decade.

For this reason, the inheritances being left to millennials and zoomers should be managed not only with tax and estate liquidity in mind, but also taking into account a number of other factors, including:

• Whether the children have proper wills;
• Whether the children have marital agreements in place that could exclude shares of the family corporation transferring to their partners;
  • If the answer is yes, they may need both an estate liquidity plan for their taxes and an estate liquidity plan to provide financial security to their dependants (their partners and children);
• Whether the children are interested in maintaining the family assets, continuing to run the business, and building on the legacy created by prior generations?
  • If the answer is yes, they will need to determine who will effectively manage and make the important decisions relating to the legacy assets;
• Whether any assets will be sold during the children’s lifetimes, thereby accelerating the occurrence of tax (to their lifetime rather than on death); and
• Whether siblings who will share in an inheritance are on the same page when it comes to growing the family assets versus cashing out;
  • If the answer is no, they must consider the liquidity plan to buy out those who do not wish to participate in the future growth of the business.

Final thoughts

Given the complexity of estate planning, as illustrated here, it is best to take a multifaceted approach when creating an estate plan—one that incorporates the expertise of tax, financial, and legal professionals working together.

Farzin Remtulla, CPA, CA, CFP, TEP, is an associate with ZLC Financial in Vancouver, where he specializes in providing customized life insurance and investment solutions to his clients.

This article was originally published in the May/June/2024 issue of CPABC in Focus.

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