Intergenerational wealth transfers: Part 2

Part 1 of this series of articles focused on how attribution rules play a role in decisions regarding gifts while living versus at death. This article focuses on common gifting strategies for clients as they consider their family dynamics and suitable wealth transfer options.

Common strategies for gifting while living

There are a number of strategies families can consider for inter vivos transfers.

Gifts to minors. While the attribution rules apply to income from gifts to related minors, they do not apply to capital gains. This creates an income-splitting opportunity for gifts to minors when the gift will be used to earn capital gains from capital appreciating assets. Non-dividend-paying stocks or corporate class mutual funds that generate primarily capital gains or capital gains dividends can be a solution. Contributions to RESPs can also be a way to share wealth tax-efficiently with minors.

Gifts to adults. Gift to adults (including children and grandchildren) are not subject to the attribution rules and, depending on the tax brackets of all involved, are a tax-efficient way to share wealth. This form of gifting can provide children with access to certain markets (e.g., housing) and can allow for their contribution to registered plans including RRSPs, TFSAs and first home savings accounts.

Giftors should be cautious with gifts of appreciated assets; when appreciated capital assets are gifted, capital gains tax can arise at that time, accelerating a tax bill for the parent or grandparent.

When parents or grandparents wish for pre-death gifts to be considered in the distribution of estate assets at death — perhaps to equalize gifts for all children — they can speak with their lawyers about including a “hotchpot” clause in their wills. A hotchpot clause adds the value of pre-death gifts to the value of the parent’s or grandparent’s estate for the purpose of determining amounts to which estate beneficiaries are entitled.

Gifts via inter vivos trusts. There may be cases when a parent or grandparent does not want to gift assets directly to a child. The child may have disabilities that make it challenging to manage assets, have spendthrift behaviours or creditors, or be part of an unstable marital relationship. In these cases, the parent or grandparent might wish to gift the assets indirectly via an inter vivos (or living) trust.

When a beneficiary has no control over when or how trust assets are paid, it allows for greater control of the assets managed and distributed by the trustee as defined by the trust’s settlor. For example, if specified by the trust terms, a trustee can pay assets from the trust over time as opposed to granting full access via a lump sum to a beneficiary child or grandchild.

When the trust is settled during the settlor’s lifetime, it allows the assets to bypass the settlor’s estate, avoiding complex estate settlements and, where applicable, estate administration fees upon death.

However, with the exception of certain spousal, self-benefit, alter ego and joint partner trusts, appreciated assets transferred to the trust would normally trigger capital gains tax on transfer. Parents and grandparents can speak with their lawyers about the pros, cons and options related to the setup of an inter vivos trust and should be mindful of new trust reporting rules that can add to the cost of running a trust. Also, depending on the parties involved, settlors should keep in mind that the attribution rules normally apply even if assets are to be transferred via a trust.

Fair market value exchanges. Parents and grandparents may choose to sell assets to their children or grandchildren instead of making an outright gift. Benefits of this strategy include the receipt of assets that can be used to fund retirement or any tax liability resulting from the sale of the assets. Fair market value (FMV) sales avoid the attribution rules and allow for future income splitting. When children do not have sufficient assets to pay full FMV up front, parents can claim a capital gains reserve allowing for the realization of capital gains — and capital gains taxes — over a period of up to five years.^[1]

Parents and grandparents should be careful about arranging for sales at less than FMV. Doing so can result in double taxation as the parent would be deemed to sell the asset at FMV, while the child would establish an adjusted cost base based on the price paid.

Alternatively, families may consider a FMV sale with the proceeds payable over time, with the option to forgive an outstanding balance on death of the parent or grandparent. If the sold assets will be used mainly to earn income, attribution may apply to the income, but interest charged on the unpaid amount at the prescribed interest rate could avoid the attribution rules.

Loans. Loans can be an effective way to transfer assets to children or grandchildren to allow them to manage cost-of-living challenges. Attribution can apply if it can reasonably be considered that one of the main reasons for making the loan was to reduce or avoid tax.

To avoid attribution of future income, interest should be charged on the loan at the prescribed interest rate. If the loan will not be used to earn income, interest on the loan is not required. A loan with a parent or grandparent as a secured creditor can be an effective way to provide help while also achieving a level of creditor protection when the parent or grandparent ranks ahead of other creditors. Loans can be forgiven at death, and the outstanding balance of the loan at that time can be included in a hotchpot clause to allow for equalization among estate beneficiaries.

Common strategies for gifting at death

Via will. A will allows a testator to define how their assets should be distributed at death. When an individual dies without a will (i.e., intestate), the jurisdiction where the testator lived at the time of death normally defines how the deceased’s estate will be distributed (through intestacy legislation). While in many cases, those closest to the deceased would benefit through intestacy, dying without a will can present challenges, including:

• future legislation changes may not align with the person’s wishes;
• property may be transferred to beneficiaries who are unable to effectively manage assets (e.g., beneficiaries with certain disabilities, beneficiaries who demonstrate spendthrift behaviour, minors); and
• conflict between a spouse and children may arise, as children may be directly entitled to estate assets under intestacy rules.

Outlining wishes in a will helps avoid these challenges.

Via testamentary trusts. Similar to inter vivos trusts, testamentary trusts allow a settlor to transfer assets to a trustee for the benefit of a beneficiary. This may be an appropriate solution when management or control of assets is important post-death. Unlike an inter vivos trust, which is established before death, a testamentary trust is established upon the settlor’s death, which makes the assets subject to potentially complex estate settlements, creditors of the estate, and estate administration fees. However, gifting in this manner allows the assets to be available to the giftor throughout retirement, which can be important in periods of increasing health-care costs.

Generally, assets can be transferred to the trust through the deceased’s estate per instructions in a will, or by way of a contract-level designation on registered plans (outside Quebec) or insurance contracts. As with inter vivos trusts, parents and grandparents should be mindful of new trust reporting rules, which can add to the cost of running the trust.

Named beneficiaries on registered plans and insurance contracts. When permitted in the jurisdiction where the contract holder resides, naming a child or grandchild beneficiary on a registered plan or insurance contract can expedite the transfer of assets at death and bypass the deceased’s estate for purposes of estate administration fees. When a parent or grandparent would like to achieve these benefits but not gift the assets directly to a beneficiary, it is possible to direct the assets to a testamentary trust to allow for control and managed distributions over time. An estate planning lawyer can help with the drafting of trust terms for such a trust.

Tax-deferred rollovers. With limited exceptions,^[2] the transfer of assets to children and grandchildren normally occurs at FMV without the opportunity to defer taxes at that time. This is generally true for both registered (e.g., RRSPs and RRIFs) and non-registered assets and includes transfers at the time of death.^[3]

With RRSPs and RRIFs, tax-deferred rollovers to financially dependent children and grandchildren are possible when the child/grandchild has a mental or physical disability and transfers the assets to their own RRSP, RRIF, registered disability savings plan or registered annuity.

Also, should the child/grandchild be financially dependent but not have a disability, the date of death value of the parent’s RRSP or RRIF can be taxed to the child in the current year (as opposed to the deceased parent or grandparent). While not tax-deferred in this situation (unless the child is a minor and a qualified annuity is purchased), when the child or grandchild has a lower income than the deceased, tax savings can be achieved.

Joint ownership. Adding children or grandchildren as joint owners for non-registered assets is commonly used (outside Quebec) as an estate planning strategy to ease administration on death and/or avoid estate administration fees. Depending on the circumstances, while the strategy may produce intended results, risks include signing authority requirements before death, creditor concerns and the potential for conflict after death if distribution instructions are not made clear. Where joint ownership is being considered as an estate planning strategy, guidance from an estate planning lawyer is strongly suggested.

Importance of knowledge transfers

“Give a fish and feed for a day. Teach to fish and feed for a lifetime.”

This often quoted saying demonstrates the power of knowledge transfers. While wealth transfer conversations often focus on asset transfers, consideration should also be given to knowledge transfers, which can extend across generations.

Knowledge transfers promote dialogue, allow for shared learning and create opportunities to connect resources (including trusted advisors), which can go a long way toward maximizing and transitioning wealth across generations.

[1] A 10-year period is available for certain farming and fishing properties and qualified small business corporation shares.

[2] Certain farming and fishing properties can be transferred on a tax-deferred basis to children and grandchildren.

[3] The value of TFSAs on the date of death normally transfers tax-free.