First and foremost, the key to any successful estate plan is communication among those interested parties. I have seen the most astute of businessmen plan both his estate and the succession of his business to his children or other prodigy without having gone through the exercise of actually discussing it with them. As simple as that might seem it happens everyday. Somehow there is a presumption that leaving any business to an heir is something an heir will be all too happy to take on. Unfortunately the human dynamic comes into play. All too often family members are involved in businesses but their hearts are not in it or they really have other goals. Before you start planning inter-generational transfers on your retirement, sit down and speak with those affected, both those that may be the actual hands on operators and those that might have a more silent interest, such as children that you wish to provide for but may not be directly involved in the business. I cannot emphasize this point enough. All estate succession planning and the mechanisms for implementing it are only the tip of the iceberg. The human dynamic is the nine-tenths below sea level. This is the first and foremost issue to be addressed. The process for addressing it can be as individualized as the individuals involved.

Normally, I find that the patriarch or matriarch of this business usually attend at the lawyer’s or accountant’s office and starts the process. They give an idea of what it is they would like to accomplish, seek advice and determine a sort of preliminary plan on how best to carry it out. At that point, with a preliminary plan, they sit down with their children or heirs and discuss it with them, obtain their input and, based on their response, go back to try and finalize a plan. I find that the key to successful succession planning is involving all of the parties, ensuring that those that you wish to leave in charge are left in charge and are protected and those that you wish to be participants, but not be in charge, also have their interests protected. This avoids the ultimate family squabble or war that erupts after mom or dad have passed away and left the children fighting. Any plan worth its salt has to address the human dynamic.

The second part of any appropriate estate plan is retirement planning. What the principals of any business must do is evaluate their personal assets, both inside and outside the business, and decide what level of assets and income are necessary to maintain a comfortable living while they are alive. It is this decision that will often determine to what extent future growth of the business may be passed onto the next generation. It is not necessary to pass on the entire future growth at any time and of course, it is this decision that may determine what income, bonuses, dividends, or other remuneration a principal must continue to derive from the business while he or she is alive.

There are all sorts of mechanisms to ensure satisfactory income ranging from salary, bonus, dividend income, repurchase of shares creating dividend income, fixed or flexible dividends, and so forth but the actual mechanism chosen will of course depend on your own personal circumstances and that of the business.

Thirdly, your tax liabilities, now existing and resulting on death, must be examined. Most small businesses maintain large accrued capital gains as often times they, or the company in which they own shares, have large holdings of property that have increased in value or large retained earnings. On death, a taxpayer is deemed to dispose of his capital assets, such as property, and trigger a capital gain regardless of whether they have actually sold the property or not. This often creates a large tax call on the estate. Planning for the payment of this cash call is often what insurance agents and securities advisors undertake through the provisions of various types of life insurance and/or investment income to satisfy the tax hit.

There are however other matters which must be looked at. Too often principals of small businesses fail to utilize their $750,000.00 (formerly $500,000.00) small business capital gains deduction and accordingly, part of any plan would be to utilize that deduction before changes in the Income Tax Act (the “Act”) remove it. This way, any capital gain that may accrue on death or disposition will be reduced by the amount of that deduction. Of course, often times businesses retain non-qualifying assets in their corporations resulting in the shares of the corporation not qualifying for the small business capital gains deduction and often purifying steps need to be taken to make sure the corporation qualifies.

In addition to the income tax, there is also planning for probate taxes. Probate planning is often overemphasized from my experience. Too often the emphasis on this 1-1/2% tax on the value of your probatable assets seems to dominate estate planning, particularly the will planning portion of the estate plan. Often times, we see the use of alter-ego trusts or other trusts to avoid this; however, when one looks at the costs of creating and maintaining these trusts versus the relative costs of the actual probate tax, some times the benefit is not there. That is not to say that that is always the case. Again, one has to evaluate any probate tax savings and one of the mechanisms often used is the use of dual wills where those assets, such as shares of a private corporation, which do not need probate fall under one will and hence do not attract probate taxes, while those assets which do require probate fall under a separate will. This is a mechanism that is often available to those business owners that operate under a corporate structure. For those operating as proprietors or partnerships, mechanisms exist to incorporate their business and provide ready access to this benefit.

The fourth aspect of the plan is determining the right mix of “Equity”, “Control” and “Management” that the principals wish to retain or pass on to the next generation. Here we are dealing strictly with the succession planning part of the exercise. It should be clear that none of these three items are necessarily tied to the other. They can be mutually exclusive. For instance, through the use of appropriate voting preference shares, a principal can retain control over the business until he passes away and yet pass on all future growth of the business to the next generation. Likewise, although retaining control, the use of shareholders agreements amongst both the principal, the active children and the non-active children will ensure that the management be appropriately directed by the heirs specifically chosen by the principals. The silent heirs, if you will, will participate to some extent, if that is the desire, in the business without managing; however, to protect their interests, the same shareholders agreement can give them certain outs or rights to put their shares to the active shareholders of the corporation if they are unsatisfied with the future direction of the business or simply want out.

Next is the actual implementation of the plan. The mechanisms to create the plan are many and diverse; the most common being the “estate freeze” referred to later. This allows a tremendous amount of customization in most plans. This is where we can now contact your insurance agent and buy the appropriate life or term insurance to fund the tax liability and/or create sufficient cash equity in the estate to satisfy a bequest of the non participating child. This is where dual wills can be used to minimize probate taxes or the use of alter-ego trusts. This is where discretionary family trusts can be used when we are not sure what portion of future growth we want to pass on to what children and want the right to change our mind and/or pass it onto second and third tier generations.

There are many many different parts to consider under the umbrella of successful estate planning. Any comprehensive estate plan for the substantial business will include powers of attorney, wills, estate freezes, trusts and shareholders agreements. To what extent each of these items will be involved will of course depend on the plan. Planning is the key! Estate planning and succession planning contain the word “planning”. Planning by its nature has a temporal aspect. Planning ahead is the way to do it. The flexibility the principals of a business have when they plan ahead far exceeds the flexibility available to an estate after the principal has passed away, particularly in the use of corporate divisive reorganizations or “butterflies” contemplated under Sub-section 55(3) of the Act. So encourage your clients to plan ahead, meet with their advisors and consider an appropriate plan. The more successful plans I have been involved with are those where the client assembles the players, including the lawyer, accountant, insurance agents, banker and investment counselor at one meeting. At that meeting, a quarterback is chosen (normally the lawyer) for the plan who ensures that the client is getting a plan with the right mechanisms to carry it through instead of just buying product.

Now let us take a look at the most common planning mechanism in use - the “estate freeze.”

In general, an estate freeze is a series of transactions that results in the financial interest of the existing owners of a business to be “frozen” in value. Most businesses are corporations, so what we normally do is take the shares of the existing owners and exchange them for another class of shares having their fair market value at the time fixed. In other words, the interests of these existing owners cannot by the ownership of those shares grow in value any further. The Act allows the transfer of these shares to accommodate an estate freeze to occur on a tax deferred basis. Normally when you transfer your shares at fair market value, you are deemed to dispose of them for purposes of capital gains tax and pay the resulting capital gains tax. There are, however, provisions in the Act that allow the transfer of these shares at fair market value without triggering an immediate capital gain. The shares taken back in return, i.e. the “fixed-value” shares, are deemed to be acquired at the same cost as the original shares, but the capital gain is deferred until disposition of the new shares.

So far, we have addressed the interests of the owners, who get the frozen value. The next step in an estate freeze is always the issuance of new “growth” shares, usually known as “common shares” to other parties who will then participate in future growth of the corporation’s value. These may include either some of the existing owners themselves to some extent, but more likely their children and grandchildren. You can see where intergenerational transfers come into play.

Obviously, the estate freeze raises many questions that the parties have to address. For example:

(1) How do we determine the value of the owner’s existing shares?

This usually necessitates appraisals on the property and/or valuations on the existing shares. The Act allows you to transfer those assets at their market value but at an “elected amount” for deferral of the capital gain at between their cost amount and their fair market value. You are still however transferring those shares at fair market value for the purposes of freezing the value. Accordingly, if you arbitrarily take a value that is too low, you are passing on future growth at a faster pace and this is a “no-no”. If you choose a value that is too high, you are effectively delaying the passing of future growth, which is not only a “no-no”, but of course defeats the purpose of the estate freeze. The rollover provisions available under different sections of the Act to effect a freeze usually contain parameters or rules on the choice of “elected amounts” or impose penalties for taking back inadequate consideration and, accordingly, trying to “gift” away value without corresponding tax liability is prohibited.

Accordingly, it is important to have a reasonable fair market value that you can justify to the tax authorities if need be. Bear in mind that it is not usually at the time of transfer that the valuation issues come into place, but down the road somewhere when the original owner dies and the tax authorities question the value of the shares transferred and hold up issuing a tax clearance certificate to the estate and hence, the distiibution of the assets under the will.

(2) If we freeze the values of our existing shares, how do we get that value out and what rate of return can we expect?

Generally speaking, the shares taken back have a dividend rate. This is akin to earning interest on your investment and you must decide what rate to consider. Normally, you have to think in terms of how much money does a client need to live on if they are not drawing a salary from the operation or do not have other investments and secondly, depending on who will participate in future growth, you may have to set the rate at a rate prescribed by the government to avoid the attribution rules, i.e. having the income that the children earn taxed back to you or worse, being taxed on an imputed income regardless of whether any was paid out. Again, an issue that has to be addressed.

(3) One of the biggest issues is “who participates in that future growth”?

Bear in mind that there are various answers to this question. However, the parties can include the original business owners, which is usually the case if they are concerned that the value of the shares that they froze may not be sufficient or want their options open in the event that their financial circumstances change or can include spouses, children, and other generations. Of course, if minors are involved in growth, the attribution rules of the Act may kick in, causing any income earned on these growth shares to be taxed back to the original owner. There are, of course, ways of avoiding this through payment of an appropriate dividend on the frozen shares or by having the shares for minors held by a trust with provisions that the trust cannot distribute any income to these minors until they are of the age majority. This is known as an anti-attribution trust.

(4) What is the method for passing on future growth?

This can be as simple as having the parties who wish to participate subscribe for new common shares for $1 after the freeze takes place. Think about it. Since the original owners froze the fair market value at that instance, then at that point in time, the corporation has no additional value and hence subscribing for growth shares at $1 makes economic sense.

An alternative is to have a trust subscribe for shares. A trust is an arrangement whereby someone settles a trust, usually a grandparent or other relative who will not participate in the growth and can never benefit from it and designates certain beneficiaries, i.e. the business owners and/or their children and grandchildren as the beneficiaries. A trust is usually a discretionary trust such that the trustees can decide to allocate all or any portion of the income or capital of the trust to any one or more of the beneficiaries to the exclusion of others. Normally, trustees are people who are aware of the family situation and are aware of the ultimate desired disposition. Thus the trust can provide great flexibility in putting funds to the right parties, i.e. if one of the children or grandchildren is incapacitated, then additional funds can be allocated to such child to provide for their special needs. Obviously if certain beneficiaries fair better in life, you may wish to give a little more to those that have been less fortunate.

And finally, the use of a trust also allows, to some extent, a “thawing” of the estate freeze. The thawing of an estate freeze is where, in a sense, we undo the estate freeze. In many cases, the original business owners of the shares realize that their financial requirements have increased. While their goal may have been to pass on future growth to their children and grandchildren, they realize that they did not leave themselves enough.  By being a beneficiary to a properly constructed trust, they can end up with a percentage of that growth that they originally sought to pass on and hence, the thawing of the freeze.

The estate freeze is the most commonly used mechanism in inter-generational planning because of its tax benefits, and flexibility. There are however other mechanisms used in conjunction with freezes or on their own to effectively split up corporate assets or different businesses run from a corporate entity for the ultimate benefit of children or a spouse, commonly known as the “butterfly” rules under Sub-section 55(3) of the Act. They however are extremely complex, laden with traps and pitfalls and should only be undertaken with the assistance of qualified tax accountants and counsel.