Solving estate problems with careful planning

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Last week, I shared the story of a family who is dealing with the estate of their deceased husband and father. William leaves his second wife, Jane, and children Wayne, Wendy and Warren. William left his business, worth $5-million, to his son Wayne. Jane is to inherit $1-million, William's favourite charity is to receive $500,000, and the residue (the rest) of the estate is to be split between Wendy and Warren (who has a mild cognitive disability). After paying taxes of about $1.8-million, Wendy and Warren will only receive about $500,000 each.

No one in the family is content with this outcome. Wendy and Warren feel short-changed, and Jane simply isn't going to receive enough to help meet her needs. Some families would find themselves in court in a situation such as this.

The solutions

There are some simple steps in winding up William's estate that could ease tensions in the family. Jane could receive enough to help her make ends meet, Wayne can still inherit the business, and Wendy and Warren could end up with a more meaningful share than they would otherwise. Here are some ideas the family should consider.

• Life insurance. I mentioned last week that there was a $2-million life-insurance policy purchased by the business on William’s life. When life insurance is paid to a corporation on the death of the insured, the value of the insurance (net of the adjusted cost base of the policy) is credited to the “capital dividend account” (CDA) of the corporation, which can then be paid out tax-free as capital dividends to the shareholders. In this family’s case, the full $2-million could be paid out tax-free to the estate where the proceeds could be used to cover the taxes owing on William’s death, leaving a greater residue for Wendy and Warren.(As an aside, the proposed tax changes introduced by the Department of Finance on July 18, 2017 do propose certain changes to the CDA, but no mention was made of making changes in situations where the proceeds of life insurance are paid to a corporation, so the type of planning I’m suggesting for the family in this story remains effective.)
• Lifetime capital gains exemption. William’s shares in his corporation qualify for the lifetime capital-gains exemption, which can be claimed on his final tax return and will save $223,550 in taxes.
• Principal residence. William owned a home worth $1-million and a cottage worth $800,000 at the time of his death. The cottage has the bigger capital gain, and so it makes sense to use the principal-residence exemption to shelter the cottage from tax on William’s death. As for the city home, it would make sense for Jane to inherit the property, in addition to $1-million of other assets that William wanted her to have. This does two things: First, it defers the taxes owing on the home since an asset inherited by a surviving spouse is deemed to have been sold for its cost amount, not fair market value, which means no taxes will be owing on assets that Jane inherits, until she passes away or sells the assets. Second, it provides Jane with a place to live, which will make it possible for her survive financially.
• Charitable gifts. William wants to help his favourite charity. It makes sense for his executor to donate some of his non-registered investments that have appreciated in value. Our tax law will eliminate the taxable capital gain on those investments when they’re donated, in addition to providing a tax credit for the value of donated, which will reduce the tax burden on William’s death.
• Registered plans. As part of the $1-million to be inherited by Jane, the registered retirement savings plan assets could be transferred to Jane’s plan, avoiding tax at the time of William’s death on those assets (Jane will pay tax on withdrawals she makes from her registered plan).
• Taxable assets. The balance of the $1-million paid to Jane can be paid using some of the non-registered assets in William’s estate. These assets had appreciated in value significantly, but there will be no tax to pay on William’s final tax return on those assets left to her.
• Qualified disability trust. Since Warren has a disability, the assets being left to him could be placed in a trust for his benefit, which would enable him to save tax by splitting income with the trust annually.

These ideas reduce the taxes owing on William's death by about $800,000. In the end, Jane will inherit $2-million of the estate, Wayne receives $5-million (the business), Wendy and Warren each receive about $1.65-million, and the taxman gets about $1-million – a big improvement for everyone (except the taxman).

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.

(Editor's note: An earlier version of this story suggested potential CRA changes to how life insurance is credited to the CDA could jeopardize the ability of business-owing families to solve serious estate problems, however we received clarification that the changes are not related to situations where the proceeds of life insurance are paid to a corporation.)