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Planning for Success: Coping with Adversity

By Susan Hudson, HBA, FLMI, CLU

June 24, 2009

Financial advisors and their clients are often challenged to be both conservative and creative, particularly when a situation calls for both security and growth potential in  their planning. The task of anticipating enhanced longevity while minimizing current and future tax consequences makes plan design tough enough, with the unsure economic climate adding to the degree of difficulty. In this article, Sue Hudson offers thoughtful and insightful consideration of three case studies which demonstrate the need for flexibility and the importance of relationship management through regular client reviews.

Table Of Contents


As life insurance professionals, and particularly when we work with affluent clients, we are often called on to be creative and pro-active. Our practice is evolving, and our profession as moved far beyond the days when a rate-book and a good supply of applications could suffice for most client situations. As well, the increasing affluence of our clientele, coupled with enhanced longevity, brings added complexities. Today's insurance practitioners are called on to know about income tax (and particularly minimizing both the current tax burden and the incidence of tax on transfer to heirs), family law impacts, the use of trusts, and the use of corporate structures, and a multiplicity of insurance and invest-ment product structures.

It's hard enough to weave together all these strands, but today's rapidly changing legislative environment, increasing globalization, and the current economic upheaval, have turned well-laid plans into potential time bombs. How, then, can or should we advise our clients?

Let's look at three case studies which demonstrate that having a good plan will not necessarily avoid issues and problems in the future. Plan design flexibility and regular client reviews are critical!

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Scenario 1: The Marriage Break-up

The Plan and Issues
Let's first consider George and Adele Worthy, a couple in their late 50s, who "froze" part of their corporate holdings eight years ago when business was booming, and the value of their company seemed to be increasing exponentially. It was a fairly straightforward freeze using a holding company and a discretionary family trust to hold the new common shares.

Their middle son's marriage broke down two years ago, and they've been drawn into a legal battle over disclosure of the nature and value of the trust assets. This feels to them like an invasion of their privacy, and they thought they had protected these assets from matrimonial law claims when they set up the trust.

Review and Analysis
Here's the problem: George and Adele and their advisors planned their estate freeze very carefully, and used a trust to hold shares for their children to avoid possible problems if a child's marriage broke down. Their lawyer told them that because the trust was set up after their son's marriage, and was fully discretionary, the provincial law (Ontario in this case) would help to ensure that the assets held in trust couldn't be attacked by a divorcing in-law.

But what they hadn't taken into account was the Federal Child Support Guidelines. The federal and provincial governments share responsibility for matters relating to child support. While provincial law generally applies to child support where couples have never married, or are separating without the intent to divorce, it is federal law that applies to those who are divorcing or who are already divorced. The Federal Child Support Guidelines are mandated in the Divorce Act.[1] These guidelines consist of rules and tables that are used in calculating the amount of financial support a divorced parent should contribute to the support of his or her children, and they vary by province (as tax rates vary provincially, and child support payments are not tax-deductible).

But the trust was discretionary if their son can't count on any particular income, why did the court ask for detailed information on the trust and its assets? The answer is that if their son is a beneficiary of a trust, and is or will be in receipt of income or other benefits from it, then the court has the power to take this into account in determining that person's child support obligations.

This issue was highlighted in a 2008 decision of the Ontario Superior Court of Justice in the case of Betel v. Betel.[2] The parents had frozen their estate and established a discretionary trust. The trust documents made it clear that Mr. and Mrs. Betel intended to benefit only their own issue, and while a portion of the trust's net income was to be paid out annually to their three children, the trustees had absolute discretion as to which child or children to allocate it to. Nonetheless, the lawyers acting for the son's estranged wife asked for full disclosure of the terms of the trust, and the value of the trust assets, and the court directed that this information had to be provided to the wife.

What the Court ruled, citing a prior case, was that "Section 21(1)(g) and section 21(2) of the Federal Child Support Guidelines,[3] as amended, require a spouse against whom a child support order is sought and who is a beneficiary under a trust to produce a copy of the trust settle-ment agreement and copies of the trust's 3 most recent financial statements. The court may order further disclosure. It is not restricted to the documentation detailed in the Rules or s.21 of the Guidelines."

The judgement also stated that in deciding whether to order the production of documents from a third party (such as a trustee), the importance of the documents to the litigation had to be considered, and that in this case, the wife was entitled to "meaningful disclosure that allows her to assess whether the husband's interest in the trust has any value."

What lessons are there to be learned from this situation? First, no matter how "discretionary" the trust, under federal law its value and income are factors that must be taken into account in determining a parent's support obligations to his or her children. And secondly, this obligation takes precedence over the concerns of the trust settlors for their privacy and confidentiality.

There's a third observation that needs to be made here. The trust will be deemed to have disposed of its capital assets 21 years after it was settled. If the trust reaches this milestone, the trustees will be faced with a choice: pay the tax liability, or distribute the assets to the capital beneficiaries prior to that 21st anniversary on a tax-deferred basis. Many such trusts are designed to offer the trustees the flexibility to distribute trust capital before this time, as the tax burden can be onerous. If the assets had already been distributed to the children, then the income from those assets would have to be taken into account in determining child support obligations. End result? Whether the assets were still held in the trust, or were in the son's hands, the potential income from the assets has to be considered in determining his support obligations.

The discretionary nature of the trust still helped preserve some degree of control over the assets and left the proverbial door open for some judicious sharing of income and future growth among the children. And it did, in this instance, afford some protection against possibly losing control of some shares to their son's ex-wife. In fairness to the Worthy family's legal advisors, George and Adele probably could not have done more than they had done, without keeping all the shares in their own names and foregoing an estate freeze. And that lack of planning could have resulted, ultimately, in ruinous income taxes on their eventual deaths, or the purchase of ever-increasing amounts of life insurance to cover those taxes, subject to remaining in good health.

Preserving control within the family cannot be done through a trust deed alone, and the Worthy family members (and particularly those of the second generation) would be well-advised to consider entering into a buy-sell arrangement amongst themselves and with the trustees, giving each of them the right to buy shares that are subject to a negotiated or court-awarded transfer to anyone other than them-selves and their own children. And that agreement should of course be backed up with insurance funding.

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Scenario 2: U.S. Tax Issues

The Plan and Issues
George and Adele's neighbours, Frank and Hope Power, are both in their mid-40s. They are successful professionals with established careers and two teenagers at home. Frank's father, a widower, died three months ago, leaving Frank and his two sisters the controlling interest in a real estate holding company, which owns apartment buildings and a small commercial property. Frank had purchased corporate-owned insurance some years ago to help fund the tax liability arising from the shares on his death.

One of the sisters has already told Frank she wants to be bought out so she can finally buy a home in Arizona, where she's been living and working since moving there five years ago. While there was adequate company-owned life insurance on Frank's life to fund the tax liabilities when he died, it will not be sufficient to enable Frank and Dot to buy out their Arizona sister, Ginnie.

Review and Analysis
At first glance, the estate planning work that was done eight years ago seems to have provided well, but a closer look reveals that there are unanticipated problems. Initially, Frank's main concern was finding the funds to buy out Ginnie's interest in the company. As his parents also had some investments, he thought he might be able to use some of them as a down payment. Alternatively, he could suggest that Ginnie exchange her common shares for voting preferred shares, to be redeemed out of profits over the next five to 10 years. But as his other sister, Dot, pointed out, the investment funds in the estate would not be sufficient, especially as they had tumbled in value in the recent market downturn. They might be better off trying to persuade their Arizona sibling that she should consider redemption over time.

But the bigger and more immediate problem here is the impact of the U.S. income tax rules on residents who hold shares in foreign companies that earn passive income, directly or through trusts, or who have interests in foreign (i.e. non-U.S.) trusts. Simply put, the United States (much like Canada) is concerned that taxpayers might try to avoid taxation in the United States by having investments owned through a non-resident trust or a holding company, and artificially suppress income. And so (again, much like Canada), they have tax rules that will impute income from certain non-resident trusts or corporations to the U.S. resident beneficiary or shareholder, and impose tax on that imputed income.

And in spite of the fact that we share the world's longest border, many television shows, and a language, our tax laws differ in ways that not even a tax treaty between our two countries can fully resolve. The capital dividend account is a good example there is no U.S. counterpart, and the funds will be taxable in the United States if paid to Ginnie, and Canadian tax law requires that withholding tax must be withheld on this dividend (so much for it being untaxed!).

In addition, the United States is concerned about U.S. taxpayers who have an interest in a foreign trust, including a testamentary trust such as Ginnie's father's estate, so it's possible that paying the insurance proceeds out as a capital dividend to her father's estate could create U.S. income tax problems for Ginnie if the estate is not wound up within the tax year that the capital dividend is paid out to the estate.

It is clear, therefore, that great care needs to be taken in structuring life insurance arrangements if there is any possibility that one of the heirs may be or become non-resident, and particularly if they become resident in the United States. It may be preferable, in this case, for the estate itself, or Frank and his Canadian sister Dot, to use some other source of funds to buy Ginnie's shares, perhaps in part by drawing out funds from the company via the Capital Dividend Account to effect the eventual purchase.

Transborder situations can give rise to ugly tax outcomes, and relatively new U.S. tax policy makes this situation a challenging one, to put it mildly. And timing will be a vital factor. U.S. tax law is intricate, and something we cannot provide advice on. What Frank and his sisters urgently need is help from an expert in both Canadian and U.S. income tax, and they need it quickly, so that Ginnie's share of their father's estate can be distributed to her after the capital dividend is paid out to the trust, and before the end of her tax year, if at all possible, to avoid trust income (and her share of the capital dividend) being imputed to her for U.S. tax purposes.

Converting Ginnie's common shares to preferred shares and then redeeming them over time might have been a solution while Ginnie was resident here, but her move to the United States made that part of her parents' estate planning potentially tax-inefficient. While Canadian tax law permits certain share-for-share conversions on a tax-deferred basis, United States tax law does not, nor does the Internal Revenue Code tax redemption proceeds in the same way Canada does. There is serious potential for a tax mismatch, thereby increasing Ginnie's overall tax liability.

In a nutshell, Frank and Hope need expert cross-border tax and legal advice to help them work out their best course of action. Merely proceed-ing on the basis of Canadian tax law can be a formula for disaster in this case. And it's a lesson for the future when couples are making plans for "tomorrow," they need to consider that one or more of their children may later move outside Canada, and they may need to keep their plans flexible enough to adjust as needed.

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Scenario 3: Estate Equity

The Plan and Issues
Finally, there are the Goodfellows down the street, Bob and Cathy. Bob's business has been hit hard by the recession. He's had to lay off eight employees, three of whom had been with the firm for over 10 years. Their middle son has cut all ties with the family over arguments about his substance abuse, and their two other children each think they should be the one to take over the company when Bob decides to retire. Bob hasn't yet entered into any formal agreements with either of them he does have company-owned life insurance to cover the potential capital gains tax liability when he dies, and he has put a clause in his will giving his eldest child, Art, the option to buy the company from Bob's estate if he so wishes.

Review and Analysis
Bob and Cathy have serious reservations about leaving any funds at all to the son who cut ties with the family. In at least one province, British Columbia, that child might still have a claim to at least some share in his parents' estate. It's clear that they need to review and revise their wills to reflect their changing wishes and family situation, and they also need to devote time and effort to determining what role each of their other two children will play in the company's future.

But here's the problem: upon the death of the survivor their estate is to be left equally to all of their children. Even if they revise their wills to leave the bulk of their estate just to the two children who are still "part of the family," the option given to their son Art to buy the company sets the stage for misunderstanding and dissension. If Bob and Cathy died tomorrow, and Art exercised his right to buy the company shares, does he have the right to the proceeds of the corporate-owned life insurance policy and capital dividend account created by such insurance?

The short answer is "yes," in the absence of anything in writing to the contrary, and just such a case was litigated a few years ago. Fortunately, in that case, the parties settled amongst themselves before their court date, after they found buried in their father's business files a copy of the letter his insurance advisor had sent at the time of the policy's purchase, mentioning that the purpose of the insurance was "to cover capital gains," and agreed to honour the spirit, if not the letter, of his wishes. They were lucky if it goes to court, no matter who wins such a dispute, family ties can be strained or broken at a time when they're most needed. And anyone who has gone to court on such issues can attest to the fact that such litigation can be enormously costly, both in terms of legal fees and in family relationships.

If it's not in writing, there is no legal obligation. How many times have our clients bought company-owned insurance to finance buyout arrange-ments, or to fund personal tax liabilities on death? How many times have such agreements, when drafted, left out the crucial issue of whether or not the insurance proceeds are to be included in the valuation? Or how the credit created by the insurance proceeds to the company's Capital Dividend Account is to be applied? Even this was litigated recently, in the case of Ribeiro (Estate) v. Braun Nursery Limited[4] where the deceased employee-shareholder was very close friends with the majority shareholders. The court ruled that in the absence of anything in the agreement, the estate of the deceased shareholder did not have any right to require that the capital dividend be applied to his proceeds of redemption.

It's simple to avoid this problem: If the intention is that the funds owned by the company are to be paid out to the trustees to enable them to pay estate costs and taxes, then the will should explicitly state that the executors are to withdraw the proceeds of policy number such-and-such, via the capital dividend account if practical, before any shares are sold or transferred to heirs or anyone else, and any buy-sell agreement should also expressly direct that such proceeds are to be applied in this fashion.

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Lessons Learned

There is nothing as constant as change in the economy, in families, in tax and estate legislation. The key is "flexibility" we cannot count on "all things remaining equal." Clients and their advisors cannot predict the future accurately, and good planning means constant review and adjustment, recognizing when special expert assistance is needed from other professionals, and leaving more doors opened than are closed.

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[1] R.S.C.1985 c.3 (2nd Supp.).
[2]  2008 CANLII 11640 (ON S. C.), Court File No. 05-FD-310184FIS, March 19, 2008.
[3]  SOR/97-175
[4]  2009 CanLII 1149 (ON S.C.) Court File No.: 06-25122, Jan. 19, 2009.

About the Author

In this article, Susan (Sue) Hudson shares her long experience in financial planning and emphasizes that in uncertain times the importance of ensuring a financial plan is appropriate for not only the clients´ present circumstances, but also provides the flexibility to accommodate future changes, be they legislative, economic or in family circumstances.

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