Pop Culture and the Trust by Bonnie L. Altro

By
Jacqueline Berman
April 27, 2012 | All, From the Blog, Publication



While reading a recent edition of O Magazine, I came across Suze Orman’s monthly column. For those who don’t know, Ms. Orman is a financial expert and has written many books on financial prosperity. She was a frequent guest on The Oprah Winfrey Show and now has her own show on Oprah’s network. The column addressed how to be smart about your assets by protecting your estate from unnecessary costs and delays when you pass away. And what was her suggestion to achieve this peace of mind? A trust.

For most Canadians, owning property in a trust is a new concept. They have never thought of holding property this way, and when they hear about all of the benefits, they have a number of reactions. Some love the idea and start to question why their Canadian estates aren’t organized in the way we suggest that their U.S. estate be arranged. Some are less enamored by the concept of a trust and worry that the trust will cause complications in connection with the purchase or may scare off the seller. I assure them that this won’t be the case. I explain that using a trust to hold U.S. assets is not something we recommend to solely to Canadians, but that this is the recommended approach for Americans as well. And to back me up on this, like I do with so many things, I quote Oprah. Ok, maybe in this case, it is not Oprah directly, but Oprah’s trusted advisor, Suze Orman.

I find Ms. Orman’s article compelling because it addresses a key myth when it comes to the way trusts are viewed in pop culture: that they are useful only for the wealthy, as vehicles for holding and controlling family money. This assumption can largely be blamed on the term “trust fund” and its use in TV shows and movies depicting a world of excess. That term has penetrated our collective vernacular and has made trusts synonymous with privilege.

The truth is that trusts can be more important for those of us who are not wealthy, as the costs of settling an estate without a trust in place are more painful when paid by those who have less to spare. Just to give you an idea of what I mean, probate costs in the U.S. can run between 3 and 5 percent of the value of the U.S. property depending on the state. Further, should a property owner not pass away, but become incapacitated instead, the cost of a guardianship procedure or a conservatorship to deal with the issue can cost about $10,000. You can see how the beneficiaries of those leaving less disposable funds in their estate will be even harder pressed to deal with the financial strain that such events can cause. Trusts are often the solution as they simply lessen cost and hassle on death or incapacity.

Usually clients feel comforted to know that trusts are highly recommended for both Canadians (a Cross Border Trust) and Americans (a Revocable Living Trust) as smart ways to hold U.S. real estate by experts that we trust such as Ms. Orman. I mean, a blessing from one of Oprah’s messengers! What could be better?

For more information, see one of Suze Orman’s articles on revocable living trusts here.

Bonnie L. Altro is a partner at Altro & Associates, LLP. Her practice focuses on real estate closings, U.S. probate and cross border tax and estate planning.

How Should Canadian Snowbirds Take Title to Arizona Real Estate? It Depends!

By
David A. Altro
April 26, 2012 | All, From the Blog, In the News, Publication



Canadians have long sought to escape harsh winters by spending time in the American Sunbelt. In recent years, with the dollar near parity, the depressed US real estate values, and a relatively strong Canadian economy, Snowbirds have shown stronger interest than ever in purchasing that winter get-away. The perennial question remains, however: what is the best way to own US real estate?

As usual, the answer is rarely straightforward. Each prospective buyer has a unique set of facts and different objectives to consider. Furthermore, the US real property laws, probate and incapacity are all governed at the State level, which means that the same strategy may not be appropriate in different States. This article focuses on Arizona law, and describes some of the options available to Canadian buyers of personal use properties, with a consideration of the advantages and disadvantages of each.

The Issues

A key issue that Canadians need to be aware of when buying real estate in Arizona are what happens to the property in the event of incapacity or death of an owner. Of course, the federal tax treatment of different structures under the Internal Revenue Code (the “Code”) is also a relevant consideration.

Incapacity

When Arizona real estate is owned in an individual’s personal name they may encounter problems in the event of incapacity due to illness or injury. Without proper planning, properties will be frozen if the owner or co-owner becomes incapacitated, and the family will have to apply to the court to have a Guardian or Conservator appointed to act on the incapacitated person’s behalf. This is an expensive and time consuming legal procedure that comes at a time when the family reasonably has more important matters on their minds.

Probate

Similarly, when the owner of Arizona real estate dies, his or her will must be approved by the County Probate Court in order to pass it along to the intended heirs. Even the simplest estates require at least 5 months to probate in Arizona, because the personal representative must wait for four months for any creditors to make claims against the estate; more often Arizona probate takes closer to a year when you factor in delays in the court system. Furthermore, unlike some other States, the costs associated with Arizona’s probate system are not tied to the value the estate. Therefore, when lawyers are retained to assist with the probate procedure, the client will often be paying on an hourly rate in addition to court fees and other disbursements.

US Estate Tax

A big surprise for many Canadian owners of US properties is that they may be liable for US estate tax upon their death. The rules for determining US estate tax liability for Canadians who die owning US real estate contain two tests: if the value of the US asset is less than $60,000, then no tax is payable; if the value of the US asset is more than $60,000, but the total net worth of the decedent is less than the ‘exemption amount’, then still no tax is payable. The current exemption amount is $5million, but is set to decrease to $1million on January 1, 2013. If the values of the US assets and worldwide estate are higher than these amounts, then there will likely be some tax to pay on death. Calculating US estate tax liability for nonresident Canadians involves consideration of formulas in both the Code and the Canada-US Tax Treaty (the “Treaty”), a detailed discussion of which is beyond the scope of this article.

A Variety of Solutions

Everyone’s situation is different, and the most appropriate strategies in any particular case are equally diverse. Some factors that are important in determining the best solutions include: the value of the Arizona property, the total net worth of the client, the clients’ family structure, the residency and citizenship of the clients and their intended heirs, and many more.

To illustrate the issues and options available, we will look at a hypothetical couple, Michael and Mary, whose facts we will change in a series of examples. Throughout the discussion, we assume that Michael and Mary are Canadian citizens and residents who plan to buy a property in Phoenix Arizona.

Example 1: the modest estate

In this example, Michael and Mary are looking at buying a house for $100,000, and have a total net worth in Canada of $4million, including their home, investments, RRSPs, and life insurance.

In such a situation, Michael and Mary may have little to be concerned about. The Arizona probate rules provide a fast-track process where the value of real estate is less than $75,000. A similar small estate probate exemption is available for personal property valued at less than $50,000. (A.R.S. §14-3971) If estate values are below these amounts, the executor only needs to wait six months and file an affidavit in the prescribed form at the courthouse, a copy of which can then be recorded at the land recorders office to transfer the property.

If they take title as tenants in common, then upon either of their deaths the value of their share of the Arizona house would be eligible for the small estate exemption from probate (assuming that the house has not appreciated in value by the date of death). Likewise, the value would be lower than the $60,000 initial US estate tax threshold, so this also does not present a problem. To manage the incapacity problem, Mary and Michael could execute durable powers of attorney and living wills to allow one spouse to act in the place of another in the event of incapacity.

Note that if Michael and Mary were to take title as joint tenants with a right of survivorship, the property would pass to the surviving spouse automatically on first to die. However, they would be required to prove to the IRS that the decedent had not paid for the entire property, or section 2040(a) of the Code would make the entire value includable in his or her taxable estate, which may give rise to estate tax liability. This fact illustrates the importance of getting good tax advice when purchasing US real estate to ensure that this presumption can be rebutted.
Proper estate planning would also be important in this example, because if Mary survives Michael and inherits his share of the Phoenix property, then upon her subsequent death she would be ineligible for the small estate exemption to probate and US estate tax.

Example 2: the bigger vacation house

Let’s now assume that Michael and Mary decide to purchase a house for $200,000, with the other facts staying the same.

In this scenario, their respective shares in the property would not qualify for the small estate exemption from probate. One option they could consider would be to execute a Beneficiary Deed. Arizona is one of twelve US states that offers this option, which allows a property owner to record a deed of transfer during his or her life that only becomes effective upon death. A validly executed Beneficiary Deed avoids the probate process, but does not address issues of incapacity or US estate tax liability.

Under these facts, the incapacity issue could be resolved with the power of attorney and living will mentioned above. However, the taxable estate of the first to die would be $100,000, potentially giving rise to approximately $6,500 in US estate tax. This could be eliminated if the survivor inherits the deceased spouse’s share, due to a marital deduction available to Canadians under the Treaty. However, that surviving spouse would then own the entire combined estate, and would be liable for approximately $37,500 in US estate tax on his or her subsequent death.

A better option for this scenario could be for Michael and Mary to purchase the property in twin Cross Border Trusts (CBTs). This structure consists of revocable living trusts for each of Michael and Mary, which would own the Phoenix home as tenants in common. To be effective for Canadian Snowbirds, CBTs must have special clauses to ensure tax compliance in both Canada and the US. The trust instrument also specifies who would be the decision maker in the event of incapacity, so that issue is covered. Because trusts never die, probate would be avoided. Upon the death of one spouse, his or her interest would be passed to the survivor in a form of trust that would defer any US estate tax owing on the estate of the first decedent, be shielded from US estate tax on second to die, and protected from creditors. In this way, the CBTs serve the function of the last will and testament, power of attorney and living will in one trust package.

Example 3: the risk averse buyers

Let’s extend the facts in Example 2 such that Michael and Mary are concerned about potential liability from lawsuits in the US. Perhaps they intend to rent the house out for part of the year, or have guests stay there often. If someone were to slip and injure themselves, then they, as property owners, could be sued. With property in their personal names or in CBTs, creditors can reach beyond the Arizona real estate to enforce judgments against other personal assets.

In this scenario, a possible strategy would be for Michael and Mary to hold the Arizona house in a form of limited partnership (“LP”). A partnership is a business entity where at least two parties are working together with a view to profit. An LP is a special form of partnership consisting of at least one general partner, who has managerial control, and at least one limited partner, who has an equity stake, but cannot participate in the management of the entity.

LPs provide good tax advantages in that net revenue flows through to the individual partner to report as personal income. For Canadian Snowbirds this ensures that foreign tax credits are available under the Treaty to prevent double taxation on rental income or capital gains upon sale. Limited partners are also shielded from potential liability as property owners, risking only their stake in the partnership not their other personal assets. The general partner, however, has unlimited liability in respect of creditors of the partnership, so we often recommend setting up a corporation to serve as the general partner.

If an LP in Arizona makes an election under A.R.S. §29-367, it may be convertible into a Limited Liability Partnership (LLP), and even the general partner can limit its liability to the equity stake in the enterprise. This would alleviate the need to establish a corporate general partner. Note that conversion to an LLP gives rise to annual filing requirements with the Arizona government, and potential penalties for failure to file.

Incapacity of a partner does not present difficulty from an entity perspective, as Arizona law allows a partner’s legal representative to step in to exercise the rights of an incapacitated partner (A.R.S. §29-343).

However, LP structures do not address issues of probate or US estate tax. In Arizona, an interest in a partnership is personal property (A.R.S. §29-339). This means that if Michael or Mary die owning a partnership interest valued at more than the $50,000 small estate exempt ion, it would be considered a probate asset. No Beneficiary Deed is available to pass personal property upon death. That partnership interest would similarly be includable in the taxable estate of the deceased, potentially giving rise to US estate tax liability.

More fundamentally, however, for personal use properties that are not rented out for income, it is questionable whether the Canadian government would recognize a valid partnership, since the motivation to earn a profit is arguably lacking (see Backman v. Canada, 2001 SCC 10).

Example 4: The large estate

For this example, assume that Michael and Mary are looking to purchase a $500,000 home in Phoenix, and have a combined net worth of $10million. This scenario presents more challenges, especially in terms of US estate tax liability.

Assuming the purchase was structured to avoid the s.2040(a) presumption of full ownership in a joint tenant, the US estate tax liability on the first spouse to die would be approximately $36,000 if the surviving spouse inherits the property outright. On the second spouse to die, US estate tax would be an additional $138,000.

It is important to note that none of the ownership structures discussed so far are effective in avoiding US estate tax liability. The CBT structure retains sufficient control over trust property to make it included in the estate of the owner of the trust. A properly structured CBT can defer estate tax on the first spouse to die, and split the value of the taxable portion to achieve a lower rate of tax, but US estate tax is not eliminated. Likewise an interest in a LP that holds US real estate is taxable upon the death of a limited partner.

Therefore, if Michael and Mary hope to avoid US estate tax, they must not own the property in a structure that the IRS will look through. One such structure is the Cross Border Irrevocable Trust (“CBIT”), which addresses all the issues discussed above: incapacity, probate and US estate tax. Similar to the CBT, the CBIT must contain language to ensure compliance with the tax regimes on both sides of the border. When properly drafted, however, this can be a very effective structure for Canadians to own US real estate.

For all its benefits, the CBIT is not perfect in every scenario. In order to avoid US estate tax, Michael and Mary must not own the property, which necessarily results in an element of lost control over the asset. Selection of the trustee is always a delicate issue when dealing with the divergent issues of control and tax compliance. Michael and Mary would need to seek advice from a cross border expert to determine whether the CBIT is appropriate for their family situation and future plans and, if so, how it should be structured.

Good advice is Key

The take home lesson from these examples is that Snowbirds who want to enter the US real estate market are well advised to take the time to seek advice from a qualified professional before plunging in. In this case, a solid understanding of how the Canadian and US laws interact to affect rights is the key to the quality of advice sought or received.

There is no universal solution for Canadians purchasing US real estate, and each option has its advantages and disadvantages. The professional must also take the time to gain an appreciation of the particular circumstances of the client in order to provide the most appropriate advice and structures to fit their goals and objectives. With the right advice, however, Canadians can take advantage of the opportunities in places like Arizona.

This article is intended for information only, and should not be relied upon as a legal opinion. Anyone considering making a purchase of US real estate should contact a qualified cross border professional.

Ask the Experts – April 14, 2012

By
Jacqueline Berman
April 19, 2012 | All, On the Radio


On the April episode of Ask the Experts on Newstalk1010, Managing Partner David A. Altro and Chief Operating Officer Matt Altro speak about the many issues that Canadians need to be aware of when considering buying property in the U.S. and moving to the U.S.

Host Iain Grant speaks with Matt about the 5th Annual RBC Squash Crohn’s Tournament taking place on May 20, 2012 in Montreal and the important cause that the event benefits.

Listen to the program below and don’t forget to tune in the show, the first Saturday of every month at 5 PM EST on Newstalk1010.

Part 1


Part 2


Part 3


Part 4


Part 5

Ask the Experts – March 3, 2012

By
Jacqueline Berman
April 19, 2012 | All, On the Radio


On the March episode of Ask the Experts on Newstalk1010, Managing Partner David A. Altro and Chief Operating Officer Matt Altro discuss David’s book, Owning U.S. Property – The Canadian Way, 2nd Edition, share real-life scenarios from Canadians who own property in the U.S., take caller questions and more.

Listen to the show below and join us the first Saturday of every month on Newstalk1010 at 5 PM.

Part 1


Part 2


Part 3


Part 4


Part 5

Introducing: Ask the Experts on Newstalk1010 in Toronto!

By
Jacqueline Berman
April 18, 2012 | All, On the Radio


Altro & Associates, LLP is excited to introduce their new radio show, Ask the Experts on Newstalk1010 in Toronto. Hosted by Iain Grant, the show features Managing Partner David A. Altro as the resident cross border expert and Chief Operating Officer Matt Altro as the expert on moving to the U.S. David and Matt discuss common issues Canadians face when purchasing property in the U.S. and moving to the U.S. and offer solutions to listeners.

Tweet your questions to @mattaltro and David and Matt will answer them LIVE on the air the first Saturday of every month at 5 PM EST.

Listen to the debut show below and don’t forget to tune in!

Part 1


Part 2


Part 3


Part 4

Dollars and Sense Radio Show – January 26, 2012

By
Jacqueline Berman
April 13, 2012 | All, On the Radio

Montreal, Quebec – January 26, 2012

On the January 26th episode of Dollars and Sense on CJAD 800 AM, host, Matt Altro and legal expert David A. Altro discuss all the important issues surrounding Canadians buying property in the U.S. and moving to the U.S.

They discuss renting vs. buying property in the U.S., the questions to consider when choosing the right structure to hold title of your property, the state of the real estate market in Florida, how to protect yourself and your family from the U.S. probate procedure, creditors, taxes and much more.

David takes caller questions about inheriting U.S. property, starting a business in the U.S. and moving to the U.S.

Part 1


Part 2


Part 3


Part 4

Life Insurance Tax Free? Not so Fast!

By
Jacqueline Berman
April 13, 2012 | All, From the Blog



HOW TO PREVENT YOUR LIFE INSURANCE FROM TRIGGERING U.S. ESTATE TAX

In Canada, life insurance is often used as an effective estate planning strategy to ensure family protection, estate preservation and investment solutions. Although these advantages are indisputable, many Canadians with U.S. assets and U.S. citizens living in Canada may be shocked to learn that owning life insurance may expose their estates to U.S. estate tax upon their death.

U.S. ESTATE TAX

According to U.S. estate tax law, Canadians are subject to U.S. estate tax upon death on the fair market value of their U.S. situated (situs) property (such as U.S. real property or U.S. securities) when the following two conditions apply: First, that such U.S. property exceed a value of $60,000 and second, that the individual’s worldwide assets exceed a value of $5,000,000 indexed for inflation (hereinafter the “World Wide Asset Exemption”). In 2012, the U.S. estate tax rate caps at 35%.
Unlike Canadians, U.S. citizens (including those residing in Canada), face up to 35% U.S. estate tax on the fair market value on their worldwide assets at the time of death. In 2012, as a result of the current World Wide Asset Exemption, the first $5,000,000 indexed for inflation is excluded from tax. After December 31, 2012, the World Wide Asset Exemption will be reduced to $1,000,000 and the maximum tax rate of 35% increases to 55%.

When calculating the value of an individual’s worldwide assets, the value of life insurance that was owned by the individual and payable at his or her death is included. Consequently, a worldwide estate that would have otherwise been below the World Wide Asset Exemption may be pushed over such threshold with the inclusion of life insurance and cause a U.S. estate tax liability or if the estate is already taxable, it will increase the U.S. estate tax by reducing the Canada-U.S. Tax Treaty credits. As life insurance policies often pay out considerable sums of money in the hundreds of thousands of dollars, it is likely that such policies will have a significant impact on the deceased’s exposure to such tax.

INCLUSION IN A DECEASED’S WORLDWIDE ASSETS

To determine if life insurance proceeds are included in the value of the deceased’s worldwide assets for the purposes of calculating his or her U.S. estate tax liability, one must examine if the deceased was the owner of the life insurance policy and who are the named beneficiaries of the life insurance proceeds.

Pursuant to section 2042 the Internal Revenue Code (IRC), an individual demonstrating “incidents of ownership” to a life insurance policy shall have the proceeds of such policy included in the value of his or her total worldwide assets for the purposes of calculating U.S. estate tax. Incidents of ownership to a life insurance policy is based on an individual’s right to name or change a beneficiary to the policy, the right to borrow against the policy and the right to cancel, surrender or exchange the policy. As a general rule, individual shareholders who have a controlling interest in their corporations are deemed to have incidents of ownership over the corporately owned life insurance on their lives and will have to include the proceeds as part of his or her worldwide assets for the purposes of calculating U.S. estate tax. However, the Code of Federal Regulations (26 C.F.R. §20.2042-1(c)(6)) does not apply this general rule where the value of the insurance proceeds are payable to the corporation or to a third party for valid business purposes. Unfortunately, such individual shareholder will nevertheless will have to include this amount in his or her worldwide assets for the purposes of calculating U.S. estate tax as the value of his or her shares at death reflect the insurance proceeds received by the corporation.

IRREVOCABLE LIFE INSURANCE TRUSTS

Canadians and U.S. citizens with a potential U.S. estate tax liability may find an Irrevocable Life Insurance Trust (ILIT) to be a very effective tax savings solution.

An ILIT is typically a trust for the benefit of one’s spouse or children that is named beneficiary of a life insurance policy on the life of an insured individual. For U.S. estate tax purposes, the assets included in the ILIT will be removed from the estate of the insured, thereby reducing the insured’s estate tax liability.

In order to achieve the optimal tax strategy, the ILIT must be properly crafted to avoid any adverse gift, estate, generation-skipping and income tax consequences in the United States. In this context, the ILIT must be irrevocable (i.e. that the insured not retain the right to revoke, alter, amend or terminate the trust, nor that the insured retain the power to modify the interests of the beneficiaries). Additionally, the ILIT must own all of incidents of ownership in the policy and that the insured not retain any control that would demonstrate incidents of ownership that would cause the policy to be included in his or her estate. In order to demonstrate that the trust owns all incidents of ownership, a third person (other than the insured), bank or trust company should be appointed as trustee to administer its assets and have the power and authority of all decision making.

When considering how the ILIT should be funded, it is more advantageous if a new life insurance policy can be applied for and issued directly to the life insurance trust, rather than transferring an existing policy to it. The proceeds from an existing life insurance policy that are transferred to a newly formed ILIT are deemed to be included in the estate of the insured should he or she die within three years after the transfer is executed (IRC 2035). Furthermore, for U.S. citizens and U.S. residents, the transfer of an existing life insurance policy with a cash value to an ILIT may be considered by the IRS as a “taxable gift” levied against the insured or donor.

An ILIT will also provide U.S. citizens or U.S. residents with the ability to qualify for the annual gift tax exclusions should they make annual contributions into the ILIT (up to $13,000.00 per beneficiary) for the purposes of providing the trustee with funds to make the life insurance premium payments.

Also, an ILIT gives the insured tremendous amounts of control over how the insurance proceeds will be used by the beneficiaries. For example, insured Canadians with sizable insurance policies who wish to pass on the insurance proceeds to their adult children residing in the U.S., can structure the ILIT so that the insurance proceeds once funded into the ILIT can then be distributed into a Cross Border Dynasty Trust in order to shelter their U.S. resident children’s assets from U.S. estate tax across multiple generations.

CONCLUSION

For individuals exposed to U.S. estate tax or individuals likely to be exposed to U.S. estate tax in the future with the expected reduction of the World Wide Asset Exemption from $5,000,000 indexed for inflation to $1,000,000, an ILIT is an effective estate plan to reduce or even in some cases eliminate one’s U.S. estate tax liability.

David A. Altro featured in the Montreal Gazette Monday, February 20, 2012

By
Jacqueline Berman
April 13, 2012 | All, Publication

Tax Strategy: Marriage affects tax exemption on principal home

David A. Altro is a frequent contributor to Paul Delean’s business column in the Montreal Gazette. Click here to view the article online or scroll down to read David’s answers to the second and third questions.

PAUL DELEAN
The Gazette
Monday, February 20, 2012

The impact of marriage on the principal-residence exemption and tax obligations in the U.S. for Canadian citizens were among the topics raised in the latest batch of reader letters. Here’s what they wanted to know.

Q: “If two people who own their own homes get married, how does the principal-residence exemption apply?”

A: A couple can designate only one property as principal residence, so marriage has the effect of eliminating the exemption for one of the two properties. If you keep both and real estate continues appreciating, the increase in market value of one property from the time of the marriage has tax implications. If you sell one property before the marriage, that’s not an issue since each partner is entitled to claim the principal-residence exemption for the years they were on their own.

Q: “I have a daughter who is a Canadian citizen but has permanent residency in the U.S. and is married to a U.S. citizen. She’s currently at home raising a daughter, but when she gets employment will she have to pay U.S. taxes and report her income in Canada as well?”

A: No. Cross-border tax expert David Altro says that if she isn’t a resident of Canada, she won’t pay tax to Canada unless she has certain types of Canadian-sourced income.

Q: “About seven years ago, I inherited a home in San Diego where I spend my winters. Am I affected by changes in the maximum tax rate on U.S. property to 55 per cent from 35 per cent?”

A: The tax you are referring to is U.S. estate tax, which applies to your U.S. property upon death. “Under current U.S. law, if you are Canadian, there will be no tax if the property market value is under $60,000 on death,” Altro said. “If above, there will still be no tax if your worldwide estate is under the exemption of $5 million. But on Jan. 1, 2013, the exemption drops to $1 million and the tax rate on U.S. property increases to a maximum of 55 per cent from 35 per cent.” Altro said it could be advantageous owning the property in a cross-border irrevocable trust to avoid taxes and probate costs.

Q: “I have an adult son with Tourette’s and severe OCD (obsessive-compulsive disorder) for whom it was recommended, by a specialized team, to hire a behaviour therapist to work with him at hospital and at home. He is under public curatorship and receives welfare. Since I paid all expenses, can I claim a deduction on my tax return?”

A: The first step should be asking the Canada Revenue Agency for a ruling. Because of the public curatorship, he may or may not meet the definition of dependant. If he does, costs would be deductible (allowable medical expenses for other dependants). There might also be eligibility for the disability tax credit.

The Gazette welcomes reader questions on tax and investment matters. If you have a query you’d like addressed in this column, send it to Paul Delean, Montreal Gazette Business Section, Suite 200, 1010 Ste. Catherine St. W., Montreal, Que., H3B 5L1, or by email to pdelean@montrealgazette.com

© Copyright (c) The Montreal Gazette

Cross Border Series EP 1 – Robert: Cross Border Irrevocable Trust (CBIT℠)

By
Matt Altro
April 13, 2012 | All, Cross Border Video Series



Video Series

Robert – Cross Border Irrevocable Trust (CBIT)℠

Robert is worth $20,000,000 and is considering buying a condo in Arizona. Is he subject to U.S. estate tax upon his death?

David A. Altro addresses Robert’s concerns by directing him to the Altro & Associates online estate tax calculator and explaining the advantages of a Cross Border Irrevocable Trust℠.



David A. Altro Published in STEP Journal – February 2012

By
Jacqueline Berman
February 16, 2012 | All, In the News, Publication



Frozen Over
By David A. Altro and Ben Jeske

Estate freezes have been in Canada since the introduction of federal capital gains taxation 40 years ago. Along with the capital gains tax (CGT) on properties sold by taxpayers, the so-called death tax was also brought in. Essentially, when a taxpayer dies, they are deemed to have sold all their assets at fair market value, and will be assessed for CGT on all accrued gains. The estate freeze, in essence, is an attempt to cap the value of the assets owned by a taxpayer that would be subject to the death tax. Therefore, the estate freeze generally involves the conversion or exchange of assets susceptible to capital appreciation for assets that retain a fixed monetary value.

Capping CGT

In the context of a closely held private corporation, the estate freeze consists of the well-known mechanism of the taxpayer exchanging common shares (susceptible to capital appreciation) for fixed-value preferred shares. Immediately thereafter, the taxpayers’ children, or a trust established for their benefit, subscribes for new common shares. Following the completion of the estate freeze, all the corporation’s assets continue to generate income and/or growth for the family – at the level of the shareholders the shares to which such future growth is attributed are the common shares, which are now no longer part of the taxpayer’s property, but are safely in the hands of the next generation. Thus, unless the shares of the corporation are sold to a third party, accrued gains on these shares will not be subject to CGT until the death of the taxpayer’s children. The taxable capital gain being realised on the taxpayer’s death is now capped at today’s current value of the taxpayer’s shares.

Market value

Any one of a number of provisions in the Income Tax Act placed at taxpayers’ disposal allow such share exchanges to take place on a fully tax-deferred basis, but for such common-to-preferred share exchange to be tax-deferred, the taxpayer must ensure the frozen preferred shares they receive have fair market value equal to the value of the exchanged common shares. The safest and surest way of ensuring the frozen preferred shares have the correct value is to:
- obtain an independent valuation of the corporation
- provide an adjustment clause whereby the value of the frozen preferred shares will be adjusted if the tax authorities disagree with the taxpayer on the value of the common shares prior to the freeze; and
- provide that the frozen preferred shares are redeemable at the option of the shareholder.

Where shareholder effectively has a ‘put’ option on the shares, the shares are referred to as being retractable. Canada Revenue Agency is of the view that preferred shares lacking a retraction feature are not worth their stated value.

Accrued gain

When the freeze is complete, the taxpayer’s exposure to the death tax is capped. Now you can look at ways of reducing or eliminating the death tax by reducing the value of the frozen preferred shares held by the taxpayer. Often a taxpayer who implements such a freeze still wishes to draw income from the corporation through either salary or dividends. If the corporation is a Canadian-controlled private corporation and earns investment income, a portion of the corporation’s tax payable on such investment income is added to the corporation’s refundable dividend tax on hand (RDTOH). When a corporation with RDTOH pays taxable dividends to its shareholders, it receives a tax refund of one dollar for every three dollars of dividends paid. Finally, if the corporation sells any of its capital property and realises a capital gain, one-half of the gain is added to the corporation’s capital dividend account and is available for tax-free distribution to the corporation’s shareholders by way of dividends.

Golden opportunity

A well-known provision of the Income Tax Act stipulates when a corporation redeems shares of its own capital stock from a shareholder, the amount paid to the shareholder (less the stated capital attributable to the redeemed shares) is treated as a dividend for all purposes of the Act. This provision affords taxpayers who have implemented estate freezes a golden opportunity to reduce the frozen preferred shares’ value, reducing the eventual death tax.

Whenever the taxpayer would otherwise wish to draw dividends from the corporation, either to extract the corporation’s tax-free capital dividend account, to allow the corporation to obtain its RDTOH refund, or simply to provide personal funds to the taxpayer, redeeming some of the frozen preferred shares is recommended. The taxpayer will be treated as having received dividends, but the value of the frozen preferred shares will be diminished and the eventual death tax reduced.

Price adjustment

While redeeming frozen preferred shares is an excellent strategy for reducing the death tax, if not structured properly, it is fraught with difficulty. For the freeze to be tax-deferred, it is always advisable to include a retroactive price adjustment clause in the valuation of the frozen preferred shares. Although the price adjustment clause ensures a fully tax-deferred freeze, it is dangerous to redeem shares whose value could be subject to retroactive adjustment.

To illustrate this danger, take the example of a taxpayer who holds 100 per cent of a corporation valued at CAD 10 million. To freeze this taxpayer’s estate, they convert their common shares of the corporation into 10 million preferred shares, each redeemable for CAD1, subject to the aforementioned adjustment clause. When the taxpayer wishes to receive a CAD 1 million dividend, it is tempting to have the corporation redeem 1 million frozen preferred shares, reducing the taxpayer’s shareholdings to 9 million preferred shares, and reducing the eventual death tax.

But if the tax authorities subsequently intervene, and successfully assert that the pre-freeze value of the corporation was not CAD 10 million but CAD 14 million, to retain the tax-deferred nature of the freeze, the retroactive price adjustment would be invoked and the frozen preferred shares would be retroactively valued at CAD 1.40 per share. Now, although the taxpayer receives only CAD 1 million on the redemption, they are deemed to have retroactively received the new fair market value attributable to the redeemed shares, namely CAD 1.40 per share. The result is tax on an extra CAD 400,000 dividend that the taxpayer didn’t even receive.

Negative tax consequences also flow if the value of the frozen preferred shares is overstated. Suppose that in the earlier example, the tax authorities successfully assert that the pre-freeze value of the corporation was only CAD 7.5 million, not CAD 10 million – and, therefore, pursuant to the adjustment clause, the frozen preferred shares are retroactively valued at CAD 0.75 per share. When you reconsider the redemption of 1 million preferred shares, the taxpayer was entitled to receive only CAD 750,000. But as they received CAD 1 million they run the risk of being taxed as if they appropriated CAD 250,000 of corporation assets.

Thus, the garden-variety estate freeze, involving the exchange of common shares for frozen preferred shares subject to a typical price adjustment clause, is effective in capping a taxpayer’s CGT on death exposure. If you want to do better, if you want to allow the taxpayer to erode their potential death tax exposure, and if you want to do so without tax risk, a properly structured estate freeze will involve issuing at least two separate classes of preferred shares to the taxpayer on the exchange, one class of which would expressly not be subject to the price adjustment clause.

So, while the Income Tax Act offers an interesting planning opportunity to reduce or eliminate exposure to estate CGT, it also contains traps that could translate in high-tax liabilities if affairs are not carefully arranged.

Creditor protection

Now consider another client concern: protection from creditors. As mentioned, one of the requirements to effect a tax-deferred estate freeze is that the frozen preferred shares must be retractable. While this achieves tax objectives, it places the taxpayer at considerable risk should they subsequently face action from personal creditors. While the constituting documents of all private corporations contain provisions restricting the transfer or seizure of shares, the effectiveness of such restrictions to defeat a creditor is far from certain; and if a creditor succeeds in seizing retractable preferred shares, the creditor can demand payment from the corporation.

As all bankruptcy and insolvency lawyers agree, the time to plan creditor protection is when there are no known creditors, so the implementation of a tax-driven estate plan is the ideal time to plan for protection against future unknown creditors.

Although you cannot remove the retraction feature attached to the frozen preferred shares, other structures can be put in place. One possible solution is to interpose a new holding corporation (Newco) between the taxpayer and the original corporation (Oldco). The taxpayer would own Newco, and Newco would now hold the retractable frozen preferred shares. Generally, as long as the common shareholders of Oldco are related to the taxpayer, the retractable frozen preferred shares could be redeemed in the hands of the Newco on a fully tax-free basis in exchange for a demand note. After the demand note is issued, Newco would recapitalise the note’s value in non-retractable preferred shares. Therefore, while the taxpayer would continue to hold all the Newco shares, its only asset would be the hard-to-realise-upon non-retractable preferred shares of the original corporation.

© Copyright (c) Society of Trust and Estate Practitioners. Article first published in STEP Journal Volume20/Issue1.

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