Creating a succession plan
Lawyer Peter Lillico's six-point plan
Families should try to seek a tentative consensus before sitting down with a lawyer or tax accountant, who will charge, typically, $250 an hour to fine-tune the details.
The key to creating a solid plan is sitting down as a family with all the information and following a decision tree like the one outlined by Peterborough, Ont., estate-planning lawyer Peter Lillico on his law firm’s website. Lillico, senior partner at Lillico Bazuk Kent Galloway, boils down the process into six steps:
1. estimating the capital gains tax due upon transfer;
2. reducing the tax bite by possibly designating the cottage as your principal residence;
3. funding the tax liability;
4. deciding when to give the cottage to the children and whether it should be by gift or sale;
5. preparing a co-ownership agreement for the children to sign in the event that you give it to more than one child;
6. establishing a testamentary trust with a fund to pay for a portion of the operating costs if there are significant inequalities between the kids’ financial circumstances that could lead to disharmony, or if some siblings use it significantly more than others.
“The fight we’ve frequently seen between siblings is when one lives farther away and can’t use it as often, and pays a smaller portion of a big cottage roof repair, then the next year moves back to the area and uses it much more,” says Virginia McKenna, a tax partner at PricewaterhouseCoopers in Hamilton, Ont. Let it be known that I paid $350 as my quarter share of the chimney repair last year, even though I only used the cottage for two days in the summer.
Generally, you will need the advice of more than just an estate-planning lawyer.
In fact, your lawyer will probably recommend consulting a tax accountant and perhaps a financial planner as well because each has a different focus. Accountants may be most concerned with helping you avoid capital gains tax. Financial planners may be more focused on selling you insurance to help fund the capital gains tax liability. Lawyers may want you to concentrate on drafting a co-ownership agreement between the children and on avoiding probate fees. Pursuing a trust or a corporation structure may involve trust officials at financial institutions and corporate lawyers. Luckily, you can do much of the groundwork yourself on the internet.
Before consulting the various experts, though, Lillico and other estate-planning lawyers recommend that the parents talk to the children about their future interest in the cottage. “It’s best to say to the children, ‘You have to hammer it out while I’m alive or we will sell the cottage,’” says Lillico. “While the parents are alive, they have moral authority. If the children can’t get it together to sign a co-ownership agreement, then the parents know it’s going to sink like the Titanic after they die.”
Moreover, some children may say that they have no interest in the cottage or that they would prefer a life interest in the cottage, rather than an ownership stake, and would be happy instead with an equivalent share of the estate’s liquid assets. Most important, in my mind, is that children should ask their parents to speak frankly about their own desires and needs in old age. Perhaps the parents want to use the capital from the cottage to fund potential nursing home stays or other long-term care or travel, but for selfless reasons are once again putting their children first. Or perhaps they would like to continue using the cottage themselves but can’t afford to and would really like some financial assistance from the children to cover the fixed costs. As a close friend of mine said to her father, “Our wish is for you to make the most of your remaining years and not think about providing for us.”
Families should try to seek a tentative consensus before sitting down with a lawyer or tax accountant, who will charge, typically, $250 an hour to fine-tune the details. But consulting a lawyer briefly up front with a few key questions will also help family members structure their initial deliberations. For example, estate experts will advise that if the children are interested in occupying severed lots on the cottage property, do the severing now because executors should not be expected to carry out something that elaborate.
Those whose children are still undecided might follow the example of one Toronto-based couple, who own a four-acre island in Lake Muskoka. They undertook a severance for their three children in advance of a municipal zoning change that increased the minimum requirement for severed waterfront parcels from one acre to two acres. The parents, who are in their 60s, first asked the children to indicate their long-term interest in the island and its 1891 six-bedroom cottage. They learned that one son might prefer a wilder, more remote canoe lake and that their daughter in Ottawa might not be able to use it as frequently because of the five-hour cross-Ontario trek to get there. Since the children were of the age that their lives and views might evolve down the road, and since the onerous carrying costs of the property ($12,000 annually for taxes and insurance alone) would make it a major financial responsibility for the eventual owner, the couple have set up a simple method in their wills for their children to choose the part of the estate (which also includes insurance and investments) they might wish. “If they cannot sort out the island ownership on their own, then we’ve said that they must put three pieces of paper into a hat,” explains the father. “The person who draws the paper marked ‘First’ has the right to choose first and say which lot on the island he or she would like or whether they are not interested. The person who draws the paper marked ‘Second’ then states whether he or she would like one of the remaining lots or not. The process continues in rotation until all the island lots are spoken for. For example, if one child passes during the first rotation, the person with the paper marked ‘First’ has first dibs on the unclaimed third lot. The executor would sell any lots that all the children have rejected and the proceeds would form part of the estate. It could end up that one child owns the entire island or two-thirds of it or that they all opt out. But looking at the totality of the estate, each child takes his or her equal share in any combination of real estate and other assets.” In other words, any child who passes on a share of the cottage property would receive a larger portion of the rest of the estate.
What if only one of your darling offspring wants the cottage and yet it represents the lion’s share of the estate?
The question arises, of course, what if only one of your darling offspring wants the cottage and yet it represents the lion’s share of the estate? Financial planners may suggest that cottage owners buy life insurance that will pay out a tax-free lump sum to the remaining siblings and help equalize the estate assets. But this can be prohibitive for an elderly couple on a fixed income. Kevin Wark, president and CEO of Equinox Financial Group in Toronto, says that a joint second-to-die term-to-100 life insurance policy for $1 million for a 65-year-old woman and her 67-year-old husband, if both were non-smokers, would cost them $15,000 in premiums each year. And at that price, it begs the question: Why should the parents go to such lengths to inflate their estate in order to be fair? Wark suggests that another option is for the child who gets the cottage to be required to take out a mortgage on the property and use the mortgage funds that the bank advances to pay the other siblings their share.
Step 1: Estimating the tax
When estimating the capital gains due on the cottage, there are several on-line resources you can use, including Lillico’s website. You only need to calculate the gain since Dec. 31, 1971 (or since 1981 if the family designated the cottage as the spouse’s principal residence, which was allowed until 1982). If you had already used up your $100,000 lifetime capital gains exemption on other investments before it was snatched away by the government in 1994, and you own an $800,000 historic cottage in Muskoka, the capital gains tax hit could be more than $100,000. (Your own labour on cottage improvements doesn’t count, which seems a bit unfair.) Here’s what the calculation looks like, assuming the property was worth $200,000 in 1971:
Cottage value in 1971: $200,000
Plus capital improvements (for which, of course, you have receipts): +$50,000
Adjusted cost base: $250,000
Today's value: $800,000
Minus adjusted cost base: - $250,000
Capital gain: $550,000
Amount on which you pay tax (50%): $275,000
Total capital gains tax at top individual rate in Ontario (46%): $126,000
If you already crystallized most of the gains in the mid-1990s in order to use the now-obsolete $100,000 lifetime capital gains exemption and your property hasn’t climbed greatly in value since then, consider transferring the property to your children now, so that the next event triggering significant capital gains will not be until they pass it to their children.
Step 2: Reducing the tax bite
If the value of your cottage has increased much more than the value of your house, it may make sense to designate the cottage as your principal residence and take advantage of the principal residence exemption. To do so, you do not need to occupy the cottage most of the time. Surprisingly, even a few weekends a year at the cottage may qualify it as a principal residence, as long as at least either you, your spouse, or one of your children spent time there. Moreover, don’t overlook a clever loophole that is explained in The Canadian Guide to Will and Estate Planning by John Budd and Douglas Gray. Due to a quirk in the formula for calculating the principal residence exemption, you can also designate your house as your principal residence for one year, and still get a 100 per cent exemption on the gain in the cottage. The book also points out a small wrinkle – that the principal residence exemption only covers about two acres of land around the cottage, and that to include more acreage, you have to prove that it is necessary to your use and enjoyment of the property.
Another useful strategy, according to Lillico, is transferring only perhaps 20 per cent of the cottage to the children each year for five years so that you only include one-fifth of the deemed gain in your income each year and only pay the capital gains tax on the portion transferred each year. This might avoid bumping your income into a higher marginal tax bracket and might also avoid generating an income so high that it would trigger a clawback of Old Age Security. The downside of this approach is that if cottage prices are climbing, you may be required to pay for a new real estate appraisal each of the five years and you will have to have a new deed prepared and registered each time at a cost of about $200.
Step 3: funding the capital gains tax liability
Suggestions from Lillico include severing and selling off a lot that will help pay the tax, or even asking the children to help fund the premium on a life insurance policy that would pay out a sum at death roughly equal to the estimated tax bill. One other possibility is asking the children to start saving now to pay the tax man or prepare them for the possibility of taking out a loan later.
Step 4: deciding when and how to give the cottage to the children
This is the hard part, but basically it boils down to giving it or selling it to a child or children, or transferring it into a trust, a non-profit organization, or a corporation—all of which are considered to be dispositions at fair market value. So even if you gift the cottage to your children, for tax purposes, it is considered to have been sold at full value and you’ll be taxed on that basis.
Step 5: preparing a co-ownership agreement
Several of the lawyers I talked to advised against choosing a corporation. Although a corporation can work like a classic estate freeze and allow taxation to skip a generation, accountants advise that any family member spending time at the cottage would need to calculate the fair market value rent for those days, and include that in their income as a taxable benefit from the corporation that owns the cottage (deducting against that any payments they made toward operating costs). Setting it up and completing the corporate filings and tax returns can be complicated and disadvantageous. “We tell our clients it’s not a good idea,” say accountant Beth Webel and succession-planning specialist Luanna McGowan at PricewaterhouseCoopers in Hamilton, unless the clients are buying a vacation property in the U.S. where it enables them to avoid paying U.S. estate tax. A trust can be beneficial if you are concerned about a child’s financial insecurity or immaturity. And some families find it works for a larger property or cottage compound. One thing that is important, no matter which option you choose: At the time of transfer to the children, your lawyer should provide you with documentation recording the transaction as a gift, so that a divorcing spouse can’t force a sale under the Family Law Act.
At the very least, advises Karon Bales, an estate-planning lawyer with Gowling Lafleur Henderson in Toronto, set up a co-ownership agreement for the children and include a shotgun clause. That gives siblings who do want to extricate themselves an out. Under this kind of buy-sell clause, a sibling can name a price for the others to buy him out. If the other siblings turn him down, he has the option of buying each of their shares for the same price. It may not be a good solution, however, in situations where the siblings do not have similar financial resources. As Peter Lillico says, this seemingly fair mechanism could result in one sibling losing the cottage to a more affluent one at less than fair market value.
Other hostility-reducing clauses in a co-ownership agreement might include: a system whereby the owners exchange preferred dates by, say, April 1 and take turns getting first choice of the best weeks or cottages; a provision to allow the owners to renegotiate terms as their life circumstances change; and language requiring majority consent for major expenditures. Karon Bales has a rule in her family that would be a helpful clause in any co-ownership agreement: Whoever closes the cottage in the fall, also opens it the following spring. “Then if you screw up in the fall, it’s not someone else’s problem when they open in the spring,” explains Bales.
Step 6: creating a testamentary trust to help fund cottage operational costs
A testamentary trust is one that is created with funds set aside in the parents’ wills for a specific purpose. For cottaging families, a testamentary trust designed solely for cottage use is a great vehicle for helping to cover fixed costs such as cottage property taxes, insurance and utilities, and/or major repair projects and improvements such as a new dock or roof. Lillico suggests that the investment income can be used to help reduce the annual carrying costs that each child would otherwise pay. Or, he notes, trust capital can be used to fund major projects such as a new septic system if one or more of the siblings is unable to share the cost, although that approach would gradually whittle down the capital in the trust.
Tax lawyer Arthur Drache, with the Ottawa law firm of Drache, Burke-Robertson & Buchmayer, says the cottage is usually the most sticky point in any estate planning. “In most families nobody thinks twice about the family home. The parents die—you sell the house, even if you grew up in it. The cottage, on the other hand, generates emotion and possessiveness that is far out of keeping with anything else.”
Cottage owners sometimes choose to establish inter vivos, or living, trusts to give the property to the children during their lifetime and thus avoid the probate process associated with a will. The province charges probate fees at a rate of $5 per thousand on the first $50,000, then $15 per thousand for the remaining value (for example $2,500 on a $200,000 cottage).
In the past, inter vivos trusts had the downside of triggering capital gains tax when the owner transferred the property in. But according to Mike Bushell, a trust advisor with Scotia Private Client Group in Barrie, Ont., there is now a new vehicle called an alter ego trust, which allows an individual who is 65 years old or older to set aside the property for the children without triggering any tax liability. The property that is rolled into the trust continues to be held in his own name and for his own benefit during his lifetime. He can even designate himself the sole trustee. Upon his death, the trust document acts like a will and identifies the children who will receive the cottage, which will finally trigger capital gains tax, but not probate fees nor any of the typical delays or lack of privacy associated with probate.
The downside is that the tax treatment of assets coming out of these trusts is at the highest marginal rate for individuals, not graduated rates. An upside, however, is that the tax becomes payable at a time when other assets in the estate, such as life insurance, may be available to fund it. Also, parents can inform the ultimate beneficiaries in advance, so that family members can plan accordingly, although the owner is not compelled to do so.
This article was originally published on May 17, 2004