Send to a friend
Print this page

Estate planning pitfalls

Advertisement The best laid schemes o’ Mice an’ Men, Gang aft agley, An’ lea’e us nought but grief an’ pain, For promis’d joy! So wrote Robert Burns, Scotland’s poet laureate in the 18th century, after routing a mouse in a farm field. He might well have been writing about estate planning in the modern world. People without estate plans, or those whose plans were prepared with the best of intentions but without proper advice, can create legal and financial nightmares for their families and other survivors. Poorly devised estate plans often result in the opposite of what was intended, with the taxman getting the lion’s share of the estate while surviving family members and business partners are left to squabble over what remains. What follows are examples of common estate-planning missteps, the problems that resulted and ways these problems could have been avoided. The house and the RRIF Ken Hawley, a financial advisor and vice president at The Rogers Group Financial Advisors Ltd. in Vancouver, has witnessed the unfortunate results of estate plans prepared without professional advice. He tells of Ward (all client names have been changed), an aging widower who had a house worth $300,000 and a registered retirement income fund worth about the same. He wanted to ensure his two grown sons, Wally and Theodore, would benefit equally from his estate when he died. But the two sons’ situations were not the same. Theodore was married and lived in a house of his own; Wally, a bachelor, still lived in the family home with his dad. Ward came up with a simple plan. He made Wally and himself joint owners of the house so when he died, Wally would become the sole owner. And he left the RRIF to Theodore. “People don’t envision what’s going to happen when they do things like that,” Hawley says. What Ward didn’t know was that when he died and passed the RRIF on to Theodore, there would be taxes due on the beneficiary payout, according to RRIF rules. The estate became liable for those RRIF taxes, which, in this case, were almost 50% — the father’s marginal tax rate at the time of his death. The estate had no other cash — only the house, now owned by Wally — so Theodore had to pay $150,000 to the Canada Customs and Revenue Agency from the RRIF. Theodore ended up with only half of his $300,000 inheritance — not the result Ward had envisioned. “He thinks he’s giving them equal treatment, but because of tax issues he gave substantially less to one son than the other,” Hawley says. What could Ward have done to ensure a more equitable result? There are a number of possible solutions. Most simply, Hawley says, Ward should have split both assets — the house and the RRIF — between the two sons. “He could have made both sons equal beneficiaries of the RRIF, and just left the house in his own name,” Hawley says. Both sons would get an equal stake in the house upon Ward’s death. “If he wanted to, the son who was living there could buy his brother out,” Hawley says. “But that could be dealt with separately.” Avoiding probate at any cost Probate is a fee paid to the provincial court when the will of a deceased person is verified in court as authentic. Assessed as a percentage of the estate, fees vary from province to province and are usually tiered according to the size of the estate. They never exceed 1.5% of the estate and are generally much lower than income tax and capital gains tax rates. For example, in Ontario, probate fees are 0.5% of the first $50,000 and 1.5% of the remainder. In British Columbia, there is no fee on the first $25,000; the fees is 0.6% for the next $25,000 and 1.4% for amounts in excess of $50,000. Probate fees are regarded by many as a nuisance, and by some — judging by the lengths to which they will go to avoid them — as the end of the world. “I’ve seen many situations in which people have avoided the Ontario 1.5% probate fee but incurred 25% capital gains taxes as a consequence,” says Heather Evans, a partner with Deloitte and Touche LLP in Toronto. Hawley knew a widow named Endora, who wanted to pass her estate on to her grown daughter, Samantha, without paying probate fees. Endora learned that people can avoid probate fees by placing assets in joint ownership with a family member. When the first person dies, full ownership of the assets passes to the survivor outside of the will, free of probate. Endora decided to put all her assets into joint ownership with Samantha, so when Endora died, Samantha would take full ownership of the estate. But Samantha and her husband, Darren, owned a business. While Endora was still living, the business went under and Samantha and Darren wound up owing a considerable sum to a bank and other creditors. When the creditors came to seek repayment, Samantha had a significant portfolio of investments that she owned jointly with her mother. These were considered Samantha’s assets, and the creditors were able to demand payment from those investments. “The moral of the story is a lot of people do everything they can to avoid probate fees and do other things that really aren’t significant in the whole picture. They wind up exposing themselves to all kinds of other nightmares along the way,” Hawley says. “So it’s often better just to pay the little bit of probate fees in the estate, where it’s protected.” Evans recalls June, an elderly widow, whose principal residence was a pricey house in Toronto. She also owned a cottage, which had been in the family for 30 years and was now worth more than $300,000. June decided to do her own estate planning. She attended a couple of seminars about probate fees and decided to put the cottage in joint ownership with her daughter, Sally, figuring that when she died, Sally would acquire full ownership of the cottage, which would pass outside the will free of probate fees. But the transfer of ownership raised questions with the CCRA. Did June give a gift of half the cottage to Sally? The CCRA saw this as a deemed disposition, through which June triggered a capital gain. As a result, June would have to pay capital gains taxes at the time of the change of title on that portion of the cottage given to Sally. “It would be as if she made a gift of half the value of the cottage to her daughter. There would be capital gains taxes on half of it then, and the balance when she died,” Evans says. How could June have avoided this potential tax bill? If June is bent on avoiding probate fees, Evans says, one solution would be to create an alter ego trust. The property comes under the ownership of the trust, with June named as beneficiary of the trust for her lifetime; upon June’s death, her children become beneficiaries. Cottages Cottages result in many estate-planning nightmares. If they are not subject to the principal residence exemption, which they rarely are, the death of the owner triggers capital gains taxes. Because of a growing demand for property in resort regions throughout Canada, many cottages purchased 40 years ago for $15,000 or $20,000 are now worth $500,000 or more. The CCRA regards such increases in value as capital gains, and the taxes become the liability of the estate of the deceased owner. One common way to deal with the taxes is to take out life insurance on the aging cottage owner, with the owner’s children paying the premiums. When the owner dies, the insurance settlement pays the taxes. The capital gains liability can be reduced by offsetting the increases in the cottage’s value with expenses. If a client bought a cottage in 1970 for $20,000 and it is now worth $200,000, did the client really realize a $180,000 capital gain? Probably not, says Warren Baldwin, an advisor with T.E. Financial Consultants Ltd. in Toronto. Baldwin points out that most cottage owners neglect to subtract the costs of all the upgrades they made to the property, such as new sunrooms, new porches, extensions and other renovations. “They should have a record or, better yet, receipts,” Baldwin says. “This is an almost universal oversight.” If the client keeps a record of these expenses, they can be deducted from the capital gain. So if the client can document $75,000 worth of improvements to the cottage, the capital gain can be reduced by that amount. Businesses Estate planning is especially important for business owners. Failure to plan properly can cause problems for surviving business partners as well as for family members. Hawley tells of Bob and Ray, two partners in a business who never got around to mapping out what would happen if one of them should die. One of them, Bob, did die. Ray was left in dire need of a qualified partner to replace Bob and enough money to keep the business operating. At the same time, Bob’s widow, Elaine, felt entitled to some of the money from her late husband’s business. “Their goals were totally opposite,” Hawley says. “One wanted to keep the business running and keep reinvesting in it, and the other wanted income from the business or her money out.” This lack of planning caused grief for both Ray and Elaine. The grief could have been easily prevented, Hawley says, if Bob and Ray had put together a legal buy/sell agreement when they formed their business. The buy/sell agreement would spell out the terms under which one party would buy out the other in the event of certain triggering events, such as death, disability and conflict in the business. At the same time, the company takes out life insurance on both partners. Upon Bob’s death, Ray would have bought Bob’s stake in the company, using the proceeds of the life insurance. The cash would have gone to Bob’s estate and, in effect, to Bob’s widow, Elaine. There are different ways to design the agreement, depending on the structure of the business. If it is a corporation, the agreement is made between the shareholders and the company. The company would agree to buy back the partners’ shares, so the company would own the insurance on their lives. Another way to use insurance to prepare for the worst in a business partnership, Hawley says, is through a “criss-cross arrangement.” Each partner insures the other’s life, and the purchase of the other’s shares takes place outside the company. If Bob and Ray had had a buy/sell agreement funded by life insurance, Ray would not be in conflict with Elaine after Bob’s death over money from the business. But Ray would still have a business problem; he would need to find a qualified replacement for Bob. That’s where another type of insurance comes in. Key-person insurance provides cash to help the company get through the difficult period following the death of a key person and while searching for a replacement. Like a cottage that rises in value over the years and attracts taxes upon the owner’s death, so can a business, Evans says. A business owner who started the company from scratch finds that, as he or she approaches retirement age, the stake in the company is worth $10 million and growing. That business person might be advised to cap the value of that stake in the firm while the company continues to grow. That way he or she knows the estate will be worth at least $10 million upon death, regardless of growth in the company until then. The process, called an “estate freeze,” usually involves exchanging the business owner’s common shares for a class of preferred shares that will not increase in value. The owner’s stake in the company — essentially, the estate — is capped at $10 million. A trust, for the benefit of the heirs, becomes the owner of the new common shares, which are value-less at inception but will be entitled to all future growth in the company. If, when the founder dies, the company is worth $20 million, his or her estate will pay taxes on a capital gain of only $10 million. “He [or she] has said: ‘OK, I’m not going to be worth any more than $10 million when I die, in respect to this company. I know what my taxes will be. I have bought insurance, my kids will have all the future growth and they’re going to inherit the business and run it anyway’,” Evans says. But she has had a number of clients come to her after their estate-freeze plans have experienced a meltdown. In one example, Conrad — for 10 years the client of a colleague of Evans — set up an estate freeze to cap his stake in his company at $10 million. “Oh, by the way,” he told his lawyer one day, “did I ever tell you I’m an American citizen?” No, he hadn’t. But he should have. Although he had lived in Canada since infancy, Conrad’s citizenship had a drastic effect on his estate plan. A Canadian estate freeze is tax-deferred; taxes are payable only upon death. But as a U.S. citizen, Conrad triggered U.S. gift taxes when he implemented the estate freeze. “He made a gift to his children of the entire value of the company,” Evans says. Those taxes are payable to the U.S. government at the time of the transaction. The moral of the story: always confirm your client’s citizenship status. A typical garden-variety Canadian estate freeze doesn’t work for U.S. citizens. Estate plans must be tailor-made to accommodate issues of citizenship. Another potential estate-freeze problem: a couple performs an estate freeze when they are in their 50s. But they live into their 80s and the money starts to run out. Their other investments don’t perform as well as expected and they are forced to return, cap in hand, to their children, asking for help. “When you do an estate freeze or any estate plan, you have to take into account unanticipated events,” Evans says. “Are Mother and Father going to have enough capital? Is there an income stream that’s sufficient? What happens if they live longer than expected? What if their other assets don’t perform?” Where is the money? While the families of business owners at least know where their loved ones’ assets are, some people die leaving assets in places known only to them — assets that might never be recovered. George, for example, had assets spread throughout a number of products and institutions. As he approached age 60, he decided it was time to get his finances in order. He had an initial meeting with Baldwin, his financial advisor, and shortly afterward died suddenly of a heart attack. George hadn’t informed anyone about what his assets were or where they were held. “The family members were at their wits’ end, trying to figure out where things were,” Baldwin recalls. “They had experienced the traumatic and sudden loss of a close family member, and they were trying to figure out something they had no clue about. Talk about making a bad situation really awful.” But things took a turn for the better. While going through his papers, George’s family discovered the initial report Baldwin had prepared for him. Baldwin had made a net-worth inventory for George, listing all his assets, such as life insurance, bank accounts, pensions plans and investments. It didn’t list the details of each asset, such as policy numbers or account numbers, but it provided amounts, institution names and issuer names, giving the family a starting point in locating the assets. George had left a will, Baldwin says, but it was “quite rudimentary” and needed updating. “The will probably would have been one of the next items on the agenda,” Baldwin says. “But we didn’t get there.” IE Read other news from our Building your Business Section