Chapter 6: Estate Planning

Question 1

What are the 5 types of gifts that can be made using a will?

Answer 1

1. Specific bequest - gift of a specific piece of property.
2. General bequest - gift of a specific amount.
3. Devise - gift of real estate.
4. Residual bequest - gift of residue amounts following all debts/taxes being paid.
5. Trust - gift in a trust arrangement.

Question 2

What are the 2 gift-over provisions?

Answer 2

1. Per stirpes distribution
2. Per capita distribution

Question 3

What is the term for when a gift in a will no longer takes place due to the property no longer existing?

Answer 3

Ademption, the gift is adeemed.

Question 4

What is the term for when there is not enough value in an estate to meet specific or general bequests?

Answer 4

Abatement, the gift would be abated (reduced)

Question 5

What is a hotchpot clause?

Answer 5

Addresses the possibility that an executor has decided to make some gift prior to death and that the property is no longer in the estate.

Question 6

What is exoneration?

Answer 6

An exoneration clause removes ambiguity from the handling of debts associated with specific assets. The clause would indicate whether the beneficiary of an asset should inherit the debt along with a property or if the estate should deal with the debt.

Question 7

When would executor compensation be appropriate?

Answer 7

If the executor is working on a complex estate where there are many beneficiaries. May not be appropriate if the executor is the sole heir.

Question 8

How are executor’s fees treated from an income tax perspective?

Answer 8

Generally taxable to the executor and deductible to the estate.

Question 9

What is a cy-près clause?

Answer 9

A clause used when making testamentary charitable donations to specify what should happen if a charity no longer exists.. Allows the executor to choose a suitable replacement charity, or similar charities, to a now non-existent charity.

Question 10

Why could a well-written tax plan for an estate backfire? What can be done to prevent this? What’s the downside?

Answer 10

If circumstances or tax rules change since the will was written, a complicated tax plan may not accomplish the desired income. Giving the executor flexibility in how and when gifts are allocated can be beneficial for that reason. However, the testator may have to sacrifice some certainty that their objectives will be met to achieve the desired outcome from a tax perspective.

Question 11

What can a testator do if they own exempt market securities to ensure the assets are sold in ideal circumstances upon their death?

Answer 11

They can have the will indicate that the estate is allowed to own and operate the assets. It may be necessary for the executor to hire professionals to operate a business or help with the sale of certain assets.

Question 12

Which types of documents (other than a will) could influence the outcome of an estate and potentially supersede a will (or vice versa)?

Answer 12

Buy-sell agreements, trust documents, family law agreements, insurance contracts.

Question 13

What are the 3 concepts that the capacity test for writing a will are based on?

Answer 13

1. Does the testator understand they are making a will?
2. Does the testator understand that they are distributing property?
3. Does the testator understand who property is being left to?

Question 14

When might an education trust be beneficial?

Answer 14

If a parent wants to set aside funds for a child’s education to a greater extent than permitted by the RESP.

Question 15

What is a spendthrift trust?

Answer 15

A trust established so the trustee is able to decide when and to what extent funds are distributed from the trust to the individual (often a child).

Question 16

What are commercial trusts?

Answer 16

A beneficiary purchases units of a trust, and the trustees use those funds to invest on behalf of the investor (beneficiary), such as REITs and mutual funds.

Question 17

What is a spousal trust and when might it be used?

Answer 17

Settlor settles a trust that would be for the benefit of their spouse during their lifetime, then for the benefit of someone else (typically children) when the spouse dies. This is often used in the case of second marriages and blended families.

Question 18

What is the alternative to a testamentary trust?

Answer 18

An inter vivos trust, which is settled when the settlor is alive.

Question 19

What is an alternative to leaving assets in a will that can help avoid probate?

Answer 19

Settling an inter vivos trust while alive so the assets do not form part of the estate and are not subject to probate.

Question 20

What are the 3 certainties (legal requirements) that a trust must meet in order to be a valid trust?

Answer 20

1. Certainty of intention - must be clear that the settlor intended to create a trust (whether formal or informal).
2. Certainty of subject matter - the trust must specify what property (subject matter) it deals with.
3. Certainty of objects - beneficiary must be identifiable. (Consider a couple who include a trust in their wills in favour of grandchildren they do not yet have, and they die before they have grandchildren. There would be a question around who the objects of the trust are.)

Question 21

Who are the 3 parties to a trust?

Answer 21

1. Settlor - the person who creates a trust.
2. Beneficiary - person who has beneficial ownership of the trust assets.
3. Trustee - the party who exercises legal ownership, and therefore control, over the trust property.

Question 22

How is trustee compensation determined if it is not defined in the trust document?

Answer 22

Provincial trust law generally creates a formula for compensation where none is defined in the trust document, generally around 2%-2.5% of any assets flowing into the trust and the same amount for distributions from the trust.

Question 23

How does the flow-through structure of a trust work?

Answer 23

Income generated by the trust retains it character when passed on to the beneficiaries. However, losses generally cannot be flowed out of a trust to a beneficiary, but can be used by the trust itself if it has capital gains.

Question 24

What qualifies a trust to be a Personal Trust?

Answer 24

Essentially means the beneficiary did not pay to become a beneficiary, such as the case with a commercial trust.

Question 25

When could a trust use tax benefits like the Lifetime Capital Gains Exemption or Principal Residence Exemption?

Answer 25

If the trust qualifies as a Personal Trust, it MAY be able to use these tax benefits. However, it’s limited in the same way that an individual would be limited (trust cannot claim LCGE if individual has used up LCGE).

Question 26

Who owns (beneficially) the property owned by a trust?

Answer 26

The beneficiaries of the trust.

Question 27

How can trusts take advantage of rollovers when transferring property?

Answer 27

Property in a trust is beneficially owned by beneficiaries, so if ownership of property held by the trust is transferred to those beneficiaries, there is no change in beneficial ownership (and no disposition).

Question 28

What are the returns of property held within a trust referred to as?

Answer 28

The trust’s income

Question 29

What happens when a trust generates income?

Answer 29

The trust can either retain the income or allocate it to a beneficiary. If allocated to a beneficiary, the beneficiary receives the income and pays tax on it. A T3 tax slip would normally be issued.

Question 30

What are the 3 possible tax consequences for the settlor of a trust when the trust is originally settled?

Answer 30

1. Disposition - if there’s a change in beneficial ownership, the settlor must pay tax as if the property has been disposed of.
2. No change of ownership - if the settlor continues to own the property (such as an alter ego trust), no disposition is required.
3. Rollover - if the beneficiaries of the trust are parties to whom a rollover would normally apply, then the settlor can transfer property into the trust with no disposition.

Question 31

When would a rollover to a trust not apply and be considered a “tainted trust”?

Answer 31

The rollover beneficiary(ies) must be the only beneficiaries of the trust during the beneficiaries’ lifetimes. Would be considered a tainted trust if any other party could enjoy the use of the trust property during the beneficiaries’ lifetime.

Question 32

What rate is trust income taxed at?

Answer 32

If income is retained by the trust, it is taxed at the top marginal rate for their province of residence. If allocated to beneficiaries, the beneficiaries will pay tax at their marginal tax rate.

Question 33

What are the 2 exceptions (types of trusts) where a trust would not be taxed at the highest marginal tax rate?

Answer 33

1. Graduated Rate Estates (GRE)
2. Qualified Disability Trusts

Question 34

Are trusts able to use the $40K Alternative Minimum Tax (AMT) exemption?

Answer 34

No, unless it is a graduate rate estate (GRE).

Question 35

How does an estate differ from a regular trust for tax purposes?

Answer 35

An estate forms a trust known as a “Graduated Rate Estate (GRE)”. The trust that forms as part of an individual’s estate is subject to graduated rate taxation, like an individual taxpayer. This means the trust avoids taxation at the top marginal tax rate and has access to the $40K Alternative Minimum Tax exemption.

Question 36

At what point would a Graduated Rate Estate no longer be considered a GRE? What does this mean for the estate?

Answer 36

For the first 36 months, the trust is subject to graduated rate taxation like an individual taxpayer. After 36 months, it is taxed in the same manner as any other trust (at the highest marginal tax rate). A GRE can use any year-end, but a trust must use a Dec 31 year end. GRE has access to the $40K Alternative Minimum Tax exemption, trusts do not have access to this.

Question 37

How is a Qualified Disability Trust formed?

Answer 37

If a testementary trust with a disabled beneficiary (who qualifies for the DTC) is created, the trust and disabled person can file a joint election to qualify as a QDT. If qualified, it would become a graduated rate trust.

Question 38

Can multiple beneficiaries be on a Qualified Disability Trust?

Answer 38

Yes, but only the disabled beneficiary(ies) can have any entitlement to capital of the trust. If trust capital is distributed to a non-disabled beneficiary, all tax savings would be undone.

Question 39

What year-end does a Qualified Disability Trust have?

Answer 39

Must have a Dec 31 year-end.

Question 40

What happens on the 21st year of a trust’s existence?

Answer 40

The Income Tax Act provides that most trusts will be subject to a deemed disposition of all capital property every 21 years.

Question 41

What are the 5 types of trusts that are not subject to the 21-year rule?

Answer 41

1. Alter Ego Trust
2. Spousal Trust or Common-Law Partner Trust
3. Joint Spousal Trust or Joint Partner Trust
4. Commercial trusts
5. Charitable trusts

Question 42

What is an Alter Ego trust and when might it be used? What rule does not apply to Alter Ego Trusts?

Answer 42

An Alter Ego trust is one in which the settlor and beneficiary are the same person. This is normally done to protect assets, such as if the settlor is concerned about the effects of dementia or potential elder abuse. The settlor may name a trustee to take care of her assets as they age. The 21-year rule does not apply to Alter Ego Trusts. Must be age 65 or older.

Question 43

What is a Spousal/Common-Law Partner trust? What is a Joint Spousal/Partner trust? What rule does not apply to these types of trusts?

Answer 43

Like an Alter Ego trust but settled for the benefit of a spouse. The settlor must be 65+ (no consideration given for the age of the spouse). The spouse must be the only beneficiary during their lifetime. 21-year rule does not apply.
The Joint Spousal trust combines the Spousal and Alter Ego trusts, bringing both the settlor and the spouse as beneficiaries.

Question 44

What can be done to deal with the 21-year rule for trusts?

Answer 44

1. Transfer property in the 20th year or earlier to the beneficiary.
2. Hold property with no capital gains liability.
3. Plan to pay the taxes.

Question 45

If a trust is holding property with a capital gains liability and is in its 20th year, what can be done to avoid paying tax on the capital gains liability? How does the LCGE play into this?

Answer 45

Any capital property owned within a trust can be transferred to the beneficiaries prior to the 21st year and avoid a deemed disposition.

The LCGE is not available for a deemed disposition while in a trust. However, if the property is transferred to the beneficiaries and they dispose of the property, the LCGE can be used.

Question 46

Which type of trust does not need to have a December 31 year end?

Answer 46

Graduated Rate Estate (GRE) can have any year end.

Question 47

What tax slips do trusts use?

Answer 47

T3 for their own income tax filing and T3 slips to any beneficiaries who have taxable income associated with the trust.

Question 48

How does attribution work with trusts?

Answer 48

Trusts do not circumvent normal attribution rules. Any income earned within a spousal trust for example is still attributed back to the settlor.

Question 49

What is a revocable trust?

Answer 49

Any trust where the settlor can resume ownership of the assets in the trust, such as a settlor acting as trustee and beneficiary.

Question 50

What are the 2 general types of trusts in terms of how trust income is dispersed?

Answer 50

1. Discretionary trust - trustee has decision-making authority to decide when, to whom, and how much is paid out.
2. Fixed trust - provides some terms or conditions under which income or capital is paid to the beneficiaries of the trust.

Question 51

What is a contingent trust?

Answer 51

A trust with conditions attached.

Question 52

How much discretion does a trustee have with a discretionary trust?

Answer 52

They have unlimited discretion. They do not owe any particular duty to one beneficiary and could pay everything out to one and ignore all others, as an example. They can pay out as much as they want, when they want, to whom they want.

Question 53

What are the types of interests that a beneficiary could have in a trust?

Answer 53

• Income interest
• Capital interest
• Life interest
• Remainder interest

Question 54

What does a “capital interest” refer to (specifically for trusts)?

Answer 54

Gives a beneficiary the right to capital held by the trust. Often used where the beneficiary doesn’t have ongoing needs, but the settlor wants to enrich them at some future date.

Question 55

What does a “life interest” refer to (specifically for trusts)?

Answer 55

Means the beneficiary has access to the funds in the trust while alive, but not in death.

Question 56

What is a “remainder interest” in a trust and what is it also referred to as?

Answer 56

Beneficiary has access to the funds in the trust only when the beneficiaries with a life interest have died. Also referred to as a “residual interest”.

Question 57

What type of trust is a Henson Trust and what does that mean?

Answer 57

It’s an absolute discretionary trust, which means the trustee decides when and how much is paid to the beneficiary, the beneficiary has no fixed interest at all.

Question 58

What gives a Henson Trust its advantage?

Answer 58

The absolute discretion the trustee has, which means the beneficiary has no fixed interest in the trust assets.

Question 59

What are the tax advantages for a Henson Trust?

Answer 59

A testamentary trust with a disabled beneficiary can use graduated tax rates.

Preferred beneficiary election can be made (if the settlor is related to a disabled beneficiary).

Question 60

How does the Preferred Beneficiary Election work?

Answer 60

If the settlor of a trust is related to a disabled beneficiary, they can make a preferred beneficiary election. The beneficiary does NOT necessarily have to qualify for the DTC as the definition is broad for this purpose. The trustee can then allocate the tax consequences of the trust to the beneficiary and retain the income in the trust, which would then become tax-paid capital. This allows the trust to continue to grow its asset base and give the disabled beneficiary access to more income at some future date.

This is attractive if the beneficiary has low taxable income but doesn’t need much financial support from the trust.

Question 61

What is the Rule in Saunders v Vautier?

Answer 61

This restricts someone from using age as the sole limiting factor in paying proceeds of a trust to a beneficiary.

Question 62

If someone establishes a testamentary trust with $1000/month income and the remainder paid at a certain age, what types of interests are those?

Answer 62

The monthly income is considered a fixed interest while the lump-sum distribution is a contingent fixed interest.

Question 63

What can be done to get around the rule in Saunders v Vautier, regarding restrictions on the use of age as the sole limiting factor in paying proceeds of a trust to a beneficiary?

Answer 63

Placing additional non-age related restrictions on access to the funds.

Question 64

Why is a trust simpler than a corporation?

Answer 64

Although an annual tax return must be filed, there is no legal documentation that must be filed each year.

Question 65

What are the broad reasons why a trust may not be an appropriate planning tool?

Answer 65

Cost and complexity.

If the trust is poorly implemented, if the trustee is not trustworthy, or if tax law changes, the trust could end up causing more frustrations than benefits.

Question 66

What are important considerations if it’s necessary to have separate wills for different jurisdictions?

Answer 66

It’s important that the wills not revoke each other, and that they’re clear as to what property they deal with.
May be necessary to have the wills probated in each jurisdiction separately.

Question 67

Which countries use trusts in a similar way as we do in Canada?

Answer 67

Only countries that follow the British legal tradition.

Question 68

What does a US citizen who is a Canadian Resident have to consider when planning for their estate?

Answer 68

US estate tax if estate is worth $13.61M (for an individual).

Question 69

How does the US estate tax rollover work?

Answer 69

For married persons, the first to die can use a rollover, and the second will have an exemption based on the sum of the two amounts.

Question 70

Given US estate tax, why can US citizens not gift property prior to death?

Answer 70

There is also a US gift tax for gifts in excess of $18,000 (2024) each year. The gift tax is essentially the same as the estate tax.

Question 71

What type of insurance will US persons sometimes purchase using the gift tax exemption to help pass down their estate more efficiently?

Answer 71

Life insurance through a special trust known as an irrevocable life insurance trust (ILIT).

Question 72

What rule does an irrevocable life insurance trust (ILIT) avoid?

Answer 72

The “incident of ownership” rule. For those with US interests, a life insurance policy with an “incident of ownership” is considered property for estate tax purposes, unlike in Canada where the death benefit is tax-free.

Question 73

What does “situs” mean when referring to US situs assets?

Answer 73

Situs is a technical term meaning “located in”.

Question 74

What are the 2 thresholds a Canadian has to meet to owe US estate tax?

Answer 74

1. Canadian owing US situs property in excess of $60,000 (excluding US bank accounts, US T-bills, American depository receipts)
2. Worldwide assets in excess of $11,580,000 (2020).

Question 75

How is jointly held property treated for US estate tax purposes when calculating worldwide assets?

Answer 75

Jointly owned assets are considered to have their full value on death of each owner. For example, if a couple owns a $500,000 property jointly, the property would have $500,000 added to the estate tax calculation upon the first death, and another $500,000 upon the second death (rather than $250K each).

Question 76

What is the unified credit for US estate tax?

Answer 76

The unified credit is a basic amount ($4.425M in 2020), of which only a portion can be qualified for if not a US resident and they only hold some US situs property.

For example, if $15M worldwide assets are owned and US property is $1.2M, then 8% of the credit can be used.

Question 77

What happens if Canadians own US property and they meet the 2 thresholds for calculating estate tax?

Answer 77

If they own US property > $60,000 and meet the US worldwide asset threshold, their US situs assets are subject to a 40% estate tax.

They also have access to a unified credit based on the proportion of their worldwide assets that are located in the US.

Question 78

What is the tax rate for US estate tax?

Answer 78

Marginal tax rate ranging from 18-40%. However, for Canadians owning US situs property who meet the estate tax thresholds, the rate is a flat 40%.

Question 79

Can a spouse or common-law partner elect out of the rollover of REGISTERED property upon the death of their spouse?

Answer 79

Yes, they can elect out of the rollover entirely or a partial rollover can be elected.

Question 80

Can a spouse or common-law partner elect out of the rollover of CAPITAL property upon the death of their spouse?

Answer 80

Yes, but a partial rollover is not available for certain property. For example, a rental property would need to see either a full rollover or no rollover. Shares could have a partial rollover.

Question 81

Why would an executor choose to elect out of a rollover of property at the death of a testator for unused capital losses (or capital losses generated at death due to disposal of assets) when there are no capital gains?

Answer 81

Capital losses can normally only be used against capital gains, but they can be used against any type of income in the year of death.

Question 82

What are the 3 optional tax returns that can be filed as part of the terminal tax return? What is the effect of doing so?

Answer 82

1. Rights and things return
2. Return for the beneficiary of a testamentary trust
3. Return for a partner in a partnership

Have the effect of multiplying access to lower marginal tax rates and certain tax credits. When used properly, this can substantially reduce the tax burden in the year of death.

Question 83

Why would an executor be more likely to opt out of rollovers if a testator dies earlier in the year rather than later?

Answer 83

The person is more likely to die with a low tax bill. If the executor opts out of rollovers, they can create taxable income in the low tax brackets.

Question 84

Are children eligible for rollovers of registered property upon the death of a parent?

Answer 84

Yes, either minor children or disabled children of any age.

Question 85

What happens to HBP and LLP balances outstanding at death?

Answer 85

These amounts are normally added to income in the year of death, but a surviving spouse can take on those liabilities.

Question 86

How does a post-mortem spousal RRSP contribution work?

Answer 86

If the testator dies in a relatively high tax bracket and there’s cash available to make a contribution (and available contribution room), doing a spousal RRSP contribution can make sense. The executor and surviving spouse have until the normal RRSP contribution deadline (60 days into the following year) to make the contribution on behalf of the testator.

Question 87

When can a charitable donation made by an estate be applied?

Answer 87

In the year of donation, any earlier tax year of the estate, the year of death, or the year prior to death.

Question 88

What happens to unused Alternative Minimum Tax credits at death?

Answer 88

If there is an AMT credit still available (within the 7-year span following the AMT being levied), the last chance to use the credit is on the terminal return. The executor may elect out of rollovers if that creates income to use up the AMT credit.

Question 89

How much of a tax-free death benefit (separate from any life insurance) can an employer provide? (Generally supported by a written policy)

Answer 89

Up to $10,000 tax-free.

Question 90

What is “purifying” the LCGE and how is this different from “crystallizing” the LCGE?

Answer 90

Purifying refers to taking a business that may be “offside” and making it “onside” so it qualifies for the LCGE. Purifying is typically done by reducing passive assets in 24 months prior to sale by either paying out passive assets or turning passive assets into active assets (typically use cash to purchase active assets). Could also implement an IPP which would turn corporate passive assets into personal assets.

Crystallizing the LCGE generally means you’re using the LCGE prior to selling a business.

Question 91

What is an estate freeze?

Answer 91

Any of a variety of techniques that can be used to ensure that the value of an estate at death will be known. This generally involves giving away assets while alive or transferring future growth or gains to another party.

Question 92

What is the easiest method of “freezing” an estate?

Answer 92

Inter vivos gifting. By giving away assets prior to death (typically over several years) and leaving just enough to fund retirement and other goals, many common estate problems can be solved.

Question 93

What are the methods of freezing an estate (4)?

Answer 93

1. Inter vivos gifting
2. Section 85 rollover
3. Section 86 rollover
4. Establish a trust

Question 94

What is a section 85 rollover?

Answer 94

Transferring assets into a new corporation on a rollover basis, taking back shares in exchange. The transfer could happen at FMV where taxable gains would be triggered, or can be done as a section 85 rollover.

Question 95

How can a section 85 rollover be used as an estate freeze technique?

Answer 95

Property can be rolled over under s.85 into a corporation on a tax deferred basis. For an estate freeze, the property donor will normally take back preferred shares with a fixed value (generally equal to the value of the property transferred) and usually include the largest proportional share of voting rights for the new company.

The heirs would then buy the newly issued common shares of the new company, generally for a nominal amount. If the company grows in value, the transferors wouldn’t see their preferred shares grow in value, but should generate dividend income to support the lifestyle needs of the older generation.

Question 96

Why could personal assets (like a cottage) not be used under a S.85 rollover for an estate freeze?

Answer 96

The tax consequences of personal assets being owned in a corporation can be extremely detrimental, as each use of the cottage by the shareholders would have to trigger a taxable shareholders benefit.

Question 97

What is a Section 86 rollover and how is it different from a section 85 rollover?

Answer 97

Section 86 is a reorganization of an existing company, so the shareholder is going to swap one class of shares for another. Section 86 involves a complete rollover with no tax triggered, so there is no opportunity to apply any LCGE or other measures to step-up the ACB.

Question 98

How can a trust be established as an estate freeze technique?

Answer 98

Similar to the inter vivos gifting option, but the assets are settled into an inter vivos trust. Unless it’s a spousal/partner joint trust, there will be a disposition. Any future gains would be dealt with in the trust. While there are essentially no tax advantages to this strategy, it gives the trustee the discretion to distribute assets as appropriate at an undetermined point in the future.

Question 99

What does a typical “wasting freeze” involve?

Answer 99

Typically involves a structured purchase agreement in which the donors of property to a corporation (section 85/86 rollover) get rid of a small number of preferred shares each year, gradually running them down to nothing (or near nothing) by the end of their lives by either having a trust buy their shares (if a trust was used), having their kids buy their shares, or having the corporation redeem their shares.

Question 100

Where can a company’s buy-sell agreement normally be found (if there is a formal agreement in place)?

Answer 100

Normally a part of the Unanimous Shareholder Agreement (USA) or the Partnership Agreement.

Question 101

What happens if there is no formal buy-sell agreement in place?

Answer 101

Normally default to the province’s Business Corporations Act or Partnerships Act.

Question 102

What is the standard buy-sell agreement that is generally used called? How does it work?

Answer 102

A “shotgun clause”, which generally sees one shareholder (in a 50/50 situation) decide they want out (or they want the other person out) and initiates the buy-sell without a triggering event. Often will make a blind offer for the other party’s shares.

Question 103

Why is a shotgun clause buy-sell agreement a cutthroat arrangement?

Answer 103

It favours the party with greater financial resources. If one party is in a bad financial position, they likely can’t come up with enough cash to make a purchase and may be compelled to sell their shares at an artificially low price as their ability to negotiate is limited.

Question 104

What is the “right of first refusal”?

Answer 104

The right of one party to enter into a business transaction before any other party can.

Question 105

Why is it often important for owners of partnerships or other business to have a right of first refusal?

Answer 105

Especially important to protect against situations like bankruptcy or divorce, where a spouse/creditor could end up in possession of shares and ownership interest in the business. Instead, the co-owner has the right to purchase those shares off the owner going through the divorce/bankruptcy and offer cash to settle the divorce/bankruptcy.

Question 106

How could a buy-sell agreement with a pre-determined price (such as based on the amount of insurance in force) result in double taxation?

Answer 106

This may not result in a Fair Market Value and if non-arm’s length parties purchase capital property from one another using a price other than FMV, this can result in double taxation.

Question 107

Why would it be important to use FMV for a buy-sell agreement?

Answer 107

If the owners don’t deal with each other at arm’s length, using another value could result in double taxation.

Question 108

What are funding options for a buy-sell agreement? (5)

Answer 108

1. Insurance
2. Promissory note
3. Personal assets
4. Business assets
5. Loan

Question 109

When would a promissory note be used to fund a buy-sell agreement?

Answer 109

When a purchase is required, but the owners don’t have the full amount of cash on hand. This should be referred to directly in the buy-sell agreement so the owners are compelled to accept the promissory note, as owners would not be likely to accept this as a means of payment without being compelled to.

Question 110

How can business assets be used to fund a buy-sell agreement? What is the tax consequence of doing so?

Answer 110

If the assets are liquid, they can be loaned out to the owner making the purchase or paid out as a dividend.

This is considered a shareholder loan, and shareholder loans outstanding beyond the year-end following the year of the loan become taxable.

Question 111

Why would a loan typically not be used to fund a buy-sell agreement?

Answer 111

Small business credit is extremely difficult to qualify for even at good times. Banks would likely be hesitant to lend money to businesses undergoing a transition like a business would be in a buy-sell arrangement.

Question 112

What are the 3 most common types of buy-sell agreements? What are the 4 other types?

Answer 112

1. Cross purchase or criss-cross buy-sell.
2. Promissory note buy sell.
3. Share redemption buy sell.
4. Insurance share buy-sell
5. Spousal roll and redeem
6. Hybrid wait-and-see arrangement
7. Put/call arrangement

Question 113

What must be in place for a cross purchase/criss-cross buy-sell arrangement?

Answer 113

Owners must have insurance.
LCGE is useful, but not necessary.

Question 114

How does a cross purchase buy-sell arrangement work?

Answer 114

Upon the death of one owner, the other owner receives insurance proceeds. The decedent shows a capital gain on their terminal tax return and can apply the LCGE if available. The decedent’s estate inherits the shares and the surviving owner uses the insurance proceeds to buy the shares from the estate. There are no tax consequences to the estate (if the shares are purchased at the ACB, which they should be), and the surviving owner now owns 100% of the company with an ACB equivalent to however much was paid for the shares.

Question 115

How does a basic promissory note buy-sell agreement work?

Answer 115

The corporation owns insurance on all owners. When one owner dies, the corporation receives the death benefit and has a CDA credit. The decedent’s estate will inherit their shares and there could be a capital gain on the decedent’s terminal tax return, so the decedent can use the LCGE if available. The surviving owner(s) can then use a promissory note to buy the shares from the decedent’s estate. There are no tax consequences to the estate and the surviving owner will now be sole owner(s). The corporation can then pay a capital dividend to the shareholder(s) and the surviving owner can use the capital dividend to redeem (pay off) the promissory note.

Question 116

How does a Share Redemption Buy-Sell work?

Answer 116

Corporation insures the owners and receives the death benefit at death of an owner. Terminal return can use LCGE against any capital gains (if available). Deceased owner’s estate will inherit the shares and be subsequently redeemed (paid as a dividend as the estate is a shareholder) by the corp. Due to stop-loss rules, the dividend is half capital (tax-free) and half taxable (either eligible or ineligible), so the estate will need to pay tax on half the dividend.
Due to this, the decendent’s estate has disposed of $X of capital property and received $0 of proceeds of disposition, meaning there will be a full capital loss. The capital loss can be carried back and applied against the past capital gain (or others).
The surviving owner doesn’t buy any shares. When the corp redeems the shares, they are no longer issued and paid-up shares, they return to treasury. The surviving owner will now own 100% of the company again but has not increased their ACB.
There is still a CDA credit from the death benefit less the capital dividend paid out to the decedent’s estate.

Question 117

When would a share redemption buy-sell agreement be appropriate?

Answer 117

• If the values are in excess of available LCGE
• Insurance not needed, works with any corporate redemption
• Works well for multiple shareholders

Question 118

When would a Cross Purchase buy-sell agreement be appropriate?

Answer 118

• For partnership structures
• For other temporary arrangements
• Only two owners
  This is the simplest buy-sell structure but only works for 2 partners.

Question 119

When would a promissory note buy-sell agreement be appropriate?

Answer 119

• Corporation with multiple shareholders
• Value of no more than around $1M per shareholder
  This has a relatively simple structure but only works for smaller businesses.

Question 120

What are some potential issues with a cross purchase buy-sell agreement?

Answer 120

Funds flow personally to the insurance owner, so they may be used elsewhere if the owner desires. This would leave the shares in the decedent’s estate and could potentially cause problems. It’s also only tax efficient if the LCGE is available.

Question 121

What are some potential problems with a promissory note buy-sell agreement?

Answer 121

If the CDA or LCGE become available, it’s not going to be efficient.

Question 122

What are some potential problems with a share redemption buy-sell agreement.

Answer 122

It’s a very complex strategy. In addition, the capital loss cannot be used if the transaction takes more than a year. While this strategy does not require insurance, the surviving owner/the corp would still need to come up with the cash if insurance is not available.

Question 123

How does an insurance share buy-sell agreement work?

Answer 123

Very similar to the promissory note arrangement, except that its underlying mechanism relies on a special class of common shares that would only ever pay dividends based on the events described in the buy-sell agreement.

Question 124

How does the spousal rollover and redeem buy-sell strategy work and how does it differ from the share redemption strategy?

Answer 124

The spousal rollover and redeem strategy is slightly more complex than the share redemption strategy. It’s used when shareholders have spouses who are not shareholders in the business.
At exit, the spouses take advantage of the spousal rollover to avoid a capital gain. The corp would then instead redeem shares from the surviving spouse.
The full redemption can be done using CDA as there is no concern about a capital loss carry back.

Question 125

How does a hybrid/wait and see buy-sell arrangement work?

Answer 125

The promissory note structure is used up to the available LCGE. If the purchase price is higher than the LCGE, the share redemption structure is used (for shares in excess of LCGE).

Question 126

How does a put/call buy-sell arrangement work?

Answer 126

The shares have attached a put option where a purchase can be compelled and a call option where a sale can be compelled. The options would b exercisable under events described in the buy-sell agreement. This is a useful way of multiplying the LCGE between spouses because it allows for share ownership without concerns about indefeasible vesting requirements.

Question 127

What are indefeasible vesting requirements?

Answer 127

If an asset is to vest indefeasibly to someone, it means the interest must not be subject to a condition precedent or subsequent the asset being gifted.

Question 128

What happens if somebody who is the beneficiary of a trust transfers assets into the trust?

Answer 128

They might be deemed to be the new settlor, and income of the trust will be deemed as theirs.

Question 129

How does attribution work with regards to minor beneficiaries who are children of the settlor?

Answer 129

There is attribution of interest and dividend income, but not of capital gains.

Question 130

What happens if minor children receive dividends from CCPCs?

Answer 130

They are subject to “kiddie tax” and are taxed at the highest tax bracket on those dividends.

Question 131

What are concerns when a trust is revocable?

Answer 131

If the settlor of the trust is also a beneficiary, the trust is revoocable.

This can defeat income splitting benefits and any legal protections. A lawsuit could cause the whole trust to be exposed to creditors’ claims.

Question 132

What is a family trust often referred to as?

Answer 132

A sprinkling trust or an income splitting trust.

Question 133

Do personal trusts have access to the LCGE?

Answer 133

Only if the beneficiaries are willing to give up their LCGEs via a joint election with the trustee. Then, the trust can potentially dispose of qualifying property and allow the trust to reduce the consequences of its capital gains. Alternatively, the trust can simply distribute the property to the beneficiaries and later dispose of that qualifying property and use their LCGEs.

Question 134

How does income splitting within a family trust work?

Answer 134

Income generated by the property owned by the trust can be distributed among the beneficiaries. If the trustee has discretion, then the income can be distributed in any manner desired with no consideration to fairness or consistency.

Question 135

What are the 6 possible outcomes for the succession of a business?

Answer 135

1. Die in the chair
2. Wind up the business
3. Pass to the next generation
4. Sell to a 3rd party
5. Sell to employees
6. Take the company public

Question 136

What is an earn out for business transition and how does it work?

Answer 136

There’s a phase-in period during which time the vendor often becomes an employee and the vendor sticks around for a pre-determined transition period. Often instead of the vendor becoming an employee, a portion of the proceeds of sale are withheld and are dependent on the business’ ability to generate revenues.

Question 137

In which situation is a share redemption commonly used to sell a business? How does it work?

Answer 137

Most common in family business succession. It allows the vendor to retain some shares - usually preferred shares with most of the voting rights and a fixed dividend and value. Over time, the business redeems those shares for value, allowing the vendor to enjoy a steady stream of income, supplemented by occasional share redemptions.