In working with business owner clients and families of real estate wealth, we assist in identifying gaps and planning opportunities to enable our clients in achieving their legacy goals and objectives. As part of this planning process, we will highlight where there may be potential challenges that should be proactively addressed - so as to avoid issues “down the road”.
One key issue we regularly focus on is the need for liquidity as part of a complete and comprehensive Estate / Succession Plan. In particular, liquidity needs may arise for multiple reasons, including but not limited to the following: funding tax liabilities on death, estate equalization (e.g., for a family business with active and non-active children in the business), funding buy-sell agreements, funding charitable bequests, etc. Failing to have sufficient liquidity (when it is required), could result in significant challenges and potentially lead to unintended consequences. e.g., sale of assets at “fire sale” prices to fund these obligations, etc.
For many of the families we work with, most of their wealth is concentrated in illiquid assets - such as an operating business or real estate - which the family generally wants to preserve / “keep in the family” for the benefit of future generations. For such families, we discuss the importance of having sufficient liquidity to fund these estate obligations - so as to avoid potential “hiccups” that could otherwise sidetrack the family’s legacy vision from being achieved.
In this regard, we will evaluate a client’s net worth and determine what their estate liquidity needs are today and what they may look like in the future. It is critical to assess the costs of converting non-liquid assets into cash for the purpose of funding these estate obligations.
In general, clients may underestimate some of these costs. For example, a business owner who has a corporation with a $100M Fair Market Value (“FMV”), may not appreciate that the $100M FMV of his/her business does not equate to his/her beneficiaries actually receiving $100M upon his/her passing. Specifically, upon the shareholder’s passing, there will generally be capital gains tax owing by the estate and potentially double or triple layers of tax to ultimately distribute the corporate surplus to the shareholder’s beneficiaries. Without proper and thoughtful Tax/Estate Planning, there could be more taxes paid than otherwise required and less wealth left to one’s family/beneficiaries.
Based on the foregoing understanding, we help clients in understanding the various options for creating estate liquidity. These options and their associated advantages / disadvantages can be summarized as follows - using an example of a founder whose wealth is held in corporately-owned real estate:
1. Creating a Liquidity Pool / “Sinking Fund”
This option effectively involves “self-funding” for the known, future estate obligation.
However, this option entails multiple risks and disadvantages. For example, if the founder experiences a premature death, there is the risk of a financial shortfall; there is inherent market risk (in achieving the target savings goal) and the disadvantages that an investment portfolio will attract fees and income tax; another disadvantage is that this forced savings method requires discipline, and by having to maintain a liquidity pool, this may restrict the business owner from pursuing higher growth opportunities.
One of the key disadvantages of this option is that the ultimate distribution will generally be fully taxable. Thus, for example, if the estate tax need is $10M, the corporation may need to save as much as ~$19M+ in order to net $10M of cash to the estate - assuming a 47.74% top combined Federal/Ontario personal tax rate for non-eligible dividends for the 2024 tax year.
2. Sell Assets
Disposing of the asset is generally inconsistent with the founder’s estate intentions as typically families want to keep significant real estate assets “in the family” for the benefit of future generations. Moreover, as the timing of the founder’s death is unknown, the need to liquidate assets could occur at an inopportune time if markets are temporarily depressed – which exposes one to the risk of a “fire sale”.
Similar to Option #1, this scenario will generally also attract multiple layers of tax – including corporate income tax (as the property has likely appreciated in value) and personal tax to the estate when the net corporate proceeds are distributed in the form of a taxable dividend.
3. Borrow Funds
In general, borrowing funds may be the least desirable solution and have the highest financial cost.
Specifically, the key considerations are the cost of borrowing and determining how/when the debt will ultimately be repaid (including both the payment of interest and principal repayment). Moreover, for families of real estate wealth (who may already be leveraged), obtaining further bank financing may not be possible and/or securing the lending (to pay a tax debt) may impact the borrowing capacity of the family and thus hinder future investment opportunities.
4. Life Insurance
Lastly, Corporate-Owned Life Insurance (“COLI”) generally works most cost-effectively (relative to the previous options) as it may provide the lowest Net Present Value (“NPV”) funding option; COLI provides the instant liquidity (when it is needed; i.e., matching the insurance payout with the timing of when the taxes are owing); aligns with succession planning goals of the founder (as the liquidity need can be proactively funded to provide peace of mind); etc.
Moreover, through the Capital Dividend Account (“CDA”) credit generated from the COLI proceeds, this option effectively represents “pre-funding” the known estate liquidity need in the most tax-efficient manner.
Lastly, it should be noted that the use of financed premiums, where desired, can help improve a family’s net after-tax cash flow position - so the family may continue to invest in real estate, business operations, etc. while ensuring that their liquidity needs and estate planning goals have been satisfied.
Takeaways
It is our belief that when evaluating how to fund a particular client’s estate needs, all funding options should be reviewed and considered. This planning process starts with a deep discovery to clarify, organize and prioritize the client’s specific estate intentions and legacy goals. Based on this understanding, we develop a customized Roadmap to guide us towards achieving the client’s vision. Part of this analysis will identify where gaps may exist today (e.g., inadequate liquidity to fund estate taxes), so we may put in place solutions to proactively address these issues and thus provide for a tax-efficient wealth transfer strategy.
Contact Korenblum Wealth if you would like to learn more.
P.S. At the time of this writing, the 2024 Federal Budget is proposing to increase the Capital Gain Inclusion Rate from 50% to 66.67%. Thus, it is now more important than ever to review / revisit one’s Estate Planning to ensure that this tax rate increase does not result in roadblocks which could prevent a family from achieving their legacy goals.
The information contained herein has been provided for information purposes only. The information does not provide financial, legal, tax or investment advice. This does not constitute a recommendation or solicitation to buy or sell securities of any kind. Korenblum Wealth Inc. (“KWI”) does not guarantee the accuracy or completeness of the information contained herein, nor does KWI assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Clients should obtain independent tax and legal advice before implementing any of the suggestions contained herein.
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