Businessman calculating and checking articles of agreemen

An estate plan has gone askew, and, consequently, a surviving spouse may be unable to afford payments for her retirement home and be forced to move in with her children.

In this real client scenario, the family’s financial advisor had no idea that the surviving spouse was in a desperate situation despite the family owning a business that was valued in the tens of millions of dollars pre-pandemic. The situation reinforces that advisors need to query clients about assets that they do not directly oversee.

For example, if seniors rely on a family business (even though they have no effective control of the business) to support their lifestyles and retirement plans, the advisor should know how that business is performing and its ability to support the client. These discussions should also address ongoing cash flow assumptions and contemplate an inflationary environment.

In the scenario referenced above, the couple’s biggest asset was a family business. The principal shareholder (husband) and spouse (wife) began thinking about a business succession plan a few years back. They contemplated selling the business on the open market or transferring the business to family members. They decided to transfer the business to family members via an estate freeze, which would permit the principal shareholder to transfer control to the family members and provide the couple with financial stability in retirement. The estate freeze would also help in determining the principal shareholder’s tax liability at death, which could be covered by a life insurance policy.

With an estate freeze, the value of the business is “frozen,” and any appreciation in the business value post the freeze transaction date is enjoyed by other taxpayers (in this case, family members). Estate freezes make sense when there is an expectation that the business will grow in value, and there is a clear understanding of who the next generation of owners are.

An estate freeze can be complex and requires costly tax and legal expertise to ensure tax rules are followed and pitfalls avoided. The principal shareholder was cognizant of ongoing legal and accounting costs and wanted a simple corporate ownership structure. He chose to have his family members directly subscribe for the common shares, as opposed to using a trust or holding company.

Accordingly, the principal shareholder and his spouse exchanged the common shares they owned in the business for fixed-value preferred shares. The family members effectively became the new owners of the business and directly subscribed for new common shares. The future growth in the business would accrue to the family members via their common shares.

During execution of the estate freeze, the principal shareholder and his spouse were denied life insurance coverage because of medical conditions. Thus, the opportunity to leverage life insurance to deal with the tax liability at death was lost. They decided they would self-insure and rely on the business as the funding mechanism.

As the principal shareholder stepped back from running the business, it began to suffer, as most of the family members didn’t have the competencies or business acumen to run it.

Financial institutions recognized the operational void and financial challenges, and were unwilling to provide any incremental capital. To keep the business afloat, the couple sold their home, moved to a retirement home and injected the proceeds of the principal residence sale into the business. Their investment and pension portfolio supported the retirement home payments. To maintain their lifestyle plus their current and pending tax liabilities, they relied on loan repayments, salary and dividends from the business.

The injected capital brought some stability to the business. But then Covid hit, and the business suffered. The loan, salary and dividend payments stopped as did any significant remuneration to the family members. The principal shareholder died, and the tax liability was paid via the capital in the investment and pension portfolio.

Meanwhile, the couple’s advisor was unaware of the business’s issues. When the advisor received notification that their address had changed, he reached out and asked what happened to the home sale proceeds. At that time, the couple told him the proceeds were loaned to the business with very favourable terms. The family didn’t want anyone to think the business was struggling, and they were fearful that if the market learned of their financial peril, any remaining business value would be lost.

Eventually, the family shared the situation with the advisor. By that time, the remaining investment portfolio had endured a substantial market hit. The portfolio couldn’t support the retirement home payments, and the surviving spouse’s lifestyle needed to be reined in.

An advisor must collect details about all their client’s assets, including small business ownership details, to meet their KYC obligations. They need to review these details with the client at regular intervals and update them if they become aware of a significant change.

In this case, the sale of the principal residence was a significant change, requiring additional discussion.

The advisor should have ensured that the clients understood this need for information regarding all assets, and addressed any confidentiality concerns. The advisor should also have participated in the estate planning process, being mindful of the need for contingency plans and challenging cash flow–related assumptions.

As this case shows, an advisor’s care and diligence can be the very thing that saves the day.

Michael Kulbak, MBA, CPA, CMA, TEP, is principal of Kulbak Trust Solutions in Mississauga, Ont.