Introduction
Succession planning involves careful strategies to manage and transfer wealth effectively while minimizing the tax burden. In Canada, although there are no federal or provincial estate taxes, income tax implications upon death or during the transfer of assets necessitate thoughtful planning to ensure family businesses and other assets are preserved for future generations.
Taxation on Death or Asset Transfer
When an individual passes away, they are deemed to have disposed of all their capital property at fair market value immediately before death, triggering capital gains tax. However, exceptions apply for property transferred to a spouse or a spousal trust, allowing tax deferral until the spouse’s death.
Key Tax Rules:
- Deemed Dispositions at Fair Market Value: Assets transferred inter vivos or at death to a non-arm’s length person or through a gift are taxed as if sold at fair market value.
- Family Business Transfers: Entrepreneurs transferring shares of a family business face inherent capital gains tax, which motivates strategies to manage this liability.
Estate Planning Methods
1. Gifts to a Spouse or Spousal Trust
A transfer to a spouse or spousal trust defers the tax on accrued gains until the spouse’s death. This approach ensures the family business remains intact but may not resolve the funding issue for tax liabilities upon the spouse’s passing.
Considerations for Spousal Trusts:
- Ensures ultimate transfer to children or other beneficiaries.
- Potential conflicts if the trust involves a second spouse and children from a prior marriage.
- Combining spousal and family trusts may optimize flexibility and minimize disputes.
2. Estate Freezes
An estate freeze locks the current value of a business and allocates future growth to the next generation. This defers capital gains tax on the increase in value until the succeeding generation’s death.
Types of Estate Freezes:
- Section 86 Reorganization: Converts common shares into preference shares (reflecting current value) and nominal-value new common shares, which can be transferred to the next generation.
- Section 85 Rollover: Transfers shares to a holding company, issuing fixed-value shares to the parent and new common shares to the next generation.
Advantages of an Estate Freeze:
- Defers capital gains tax on business growth.
- Parents can retain preference shares for income or spousal trust transfer.
3. Inter Vivos Trusts
Transferring assets to a trust during one’s lifetime triggers immediate tax on accrued gains but enables strategic long-term planning.
Benefits of Trusts:
- Common shares with minimal inherent capital gains can be held in trust and distributed tax-efficiently to beneficiaries.
- Trusts offer flexibility to manage ownership and involve minor children or unborn descendants.
- Trustees manage assets and can delay direct ownership decisions until children demonstrate capability.
Control and Transition
1. Operational vs. Legal Control
- Operational Control: Day-to-day management transitions gradually to children actively involved in the business.
- Legal Control: Rights to elect directors or make strategic decisions are transferred through mechanisms like:
- Retaining voting shares.
- Implementing unanimous shareholder agreements.
2. Ensuring Financial Security for Parents
It’s essential to structure succession plans to maintain the parents' lifestyle. Strategies include:
- Retaining preference shares for income.
- Using employment income or bonuses tied to business roles.
Other Estate Planning Considerations
1. Partial Estate Freezes
In cases of uncertainty about future financial security, a partial freeze allows parents to retain some growth potential in the business. Additional freezes can occur as the business grows.
2. U.S. Property
Canadian estates may face U.S. estate tax on U.S. property, including real estate, shares in U.S. corporations, and certain bonds. Proper planning is critical to mitigate cross-border tax implications.
Conclusion
Succession and estate planning require a balance between tax efficiency, operational continuity, and family harmony. Effective strategies like estate freezes, trusts, and spousal transfers allow for the preservation of wealth and smooth generational transitions. Working with tax professionals ensures compliance with legal requirements while addressing unique family dynamics and business goals.
If you own a family business or other significant assets and wish to plan for the future, consult a tax advisor or estate planning expert to create a strategy tailored to your needs.
This article is written for educational purposes.
Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at [email protected], or by visiting our website at www.taxpartners.ca.
Tax Partners has been operational since 1981 and is recognized as one of the leading tax and accounting firms in North America. Contact us today for a FREE initial consultation appointment.