Impact of Higher Capital Gains Inclusion Rate on Financial & Estate Planning

Impact of Higher Capital Gains Inclusion Rate on Financial & Estate Planning

by | May 1, 2024 | Accountants, Blog, buy sell, corporate, Family, financial advice, Financial Planning, incorporated professionals, individuals, Investment, tax

One change proposed in the April 16, 2024 Federal Budget is raising the inclusion rate on capital gains from 50% to 66.7%. For individual taxpayers, the initial $250,000 of capital gains remains taxed at the 50% inclusion rate. However, for corporations and trusts, the increased inclusion rate applies to all capital gains. These adjustments are slated to come into effect starting June 25, 2024.

What does this mean for individual taxpayers?

Income taxes on realized capital gains are increasing. For example, in B.C. with a top marginal income tax rate of 53.5%, taxes paid on capital gains under $250,000 are taxed at 26.75%. Now, for gains over $250,000 the tax rate increases to 35.85%. For most taxpayers, many of whom would not realize over $250,000 of capital gains in a taxation year, this change will not have any impact. However, for those who do realize such a gain the additional tax could be significant.

Consider someone who has just sold recreational property. If the amount of gain on that Whistler ski cabin, for example, was $500,000, the tax payable on the transaction will increase from $133,750 to $156,500. If that same property had been held in the family for generations the increase in taxes, with the new inclusion rate, could be substantial.

The same will be true for BC residents who own rental properties or investment portfolios that they wish to sell and generate profit. For each $100,000 of capital gain over the $250,000 limit they will pay an additional $9,100 in income tax.

The biggest potential impact of the increased inclusion rate on capital gains will be in estate planning. When a taxpayer in Canada dies, he or she is deemed to have disposed of all their capital property at fair market value. For estates with a large amount of non-registered investments, rental, and recreational property as well as other appreciable capital property, the inclusion rate of 66.7% will increase the final tax bill considerably.

What does this mean for owners of private corporations?

For private corporations (and trusts) there is no reduced inclusion rate for the first $250,000 of gain. Every dollar of realized capital gain is taxed based on an inclusion rate of 66.7%. Using the ski cabin in the first example, if that property had been held in a corporation, upon its sale, the full $500,000 would attract tax based on 66.7% inclusion, increasing the total tax payable to $179,150.

Many successful professionals earn their income in a private corporation retaining surplus income not required for immediate expenses to accumulate corporately for future use. The proposed tax increases on both corporate investment realization and shareholder access to proceeds have been substantial.

There is a vehicle for Canadian-Controlled Private Corporations (CCPCs) known as the Capital Dividend Account. This notional account allows a tax-free flow of the non-taxable portion of capital gains to the shareholder. The amount of tax-free capital dividends has now been reduced because of the increased inclusion rate. For instance, if a corporation realizes a $500,000 capital gain (using the example of a B.C. company with a 50.7% investment tax rate), the corporation’s tax liability would be $169,084, compared to the previous $126,750 with a 50% inclusion rate. Prior to June 25, 2024, the tax-free capital dividend flowing to the shareholder would be $250,000, decreasing to $166,500 thereafter. Consequently, more tax paid within the corporation translates to fewer tax-free proceeds for the shareholder.

For corporations, capital gains will increase their Adjusted Aggregate Investment Income (AAII) more quickly due to the higher inclusion rate. This will have the effect of accelerating the erosion of the Small Business Deduction (low rate of tax on the first $500,000 of active business income) which is reduced by $5 for every $1 of AAII.

Planning Opportunities and Strategies

What are some planning tips and strategies that can be used to mitigate the effect of these new provisions?

  • If you are holding investments with more than $250,000 in deferred capital gains, consider declaring them prior to June 25, 2024. This will require careful consideration as it will require tax to be paid sooner than originally expected. It may also have some Alternative Minimum Tax implications so take this strategy under advisement;

  • Consider a further diversification of your investments to limit capital gain exposure. Cash value life insurance, in particular Participating Whole Life, has been growing in popularity for several years, primarily due to its stable growth and tax-exempt status. This product could prove beneficial in a re-allocation of current investments;

  • Permanent life insurance products have long been used in providing necessary estate liquidity to pay taxes at death. With estates now having a possibility of higher taxes due to the higher inclusion rates, the amount of life insurance held for this purpose should be increased;

  • For owners of private corporations holding capital investments, consider allocating some of those investments to personal ownership to take advantage of the lower inclusion rate for up to $250,000;

  • Corporations should also consider diversifying and re-allocating corporate surplus to a tax-exempt life insurance policy owned by the corporation. This will shelter those investments from high passive corporate investment income tax as well as help protect the Small Business Income Tax rate on the first $500,000 of active business income;

  • You may also want to reassess corporately owned life insurance to help provide for the estate liquidity needs of the business owner, since the death benefit of the policy in excess of its ACB can be paid to the surviving shareholder or family tax free from the Capital Dividend Account.

As in previous budgets, there is currently no draft legislation enacting the provisions of the April 16th budget. Once enacted, however, the terms of the budget impacting the inclusion rate of capital gains will be effective June 25, 2024. It would be prudent to discuss your planning and develop strategies sooner rather than later.

Donating to Charity Using Life Insurance

Donating to Charity Using Life Insurance

by | Mar 1, 2024 | Blog, Charitable Gifting, life insurance

If you are interested in creating a legacy at your death by making a charitable donation, you may wish to investigate using life insurance for that purpose. There are different ways you can structure life insurance for use in philanthropy. The most common are:

Gifting an Existing Life Insurance Policy

If you currently own a life insurance policy, you can donate that policy to a charity. The charity will become owner and beneficiary of the policy and will issue a charitable receipt for the value of the policy at the time the transfer is made, which is usually the cash surrender value of the existing policy.

There are circumstances, however, where the fair market value may be in excess of cash surrender value. If for example, the donor is uninsurable at the time of the transfer, or if the replacement cost of the policy would be in excess of the current premium, the value of the donation may be higher. Under these conditions, it is advisable for the donor to have a professional valuation of the policy, done by an actuary, prior to the donation.

Any subsequent premium payments made to the policy by the donor after the transfer to the charity will receive a charitable receipt.

Gifting a New Life Insurance Policy

In this situation, a donor would apply for a life insurance policy on his or her life with the charity as owner and beneficiary of the policy at the time of issue. All premiums made by the donor on behalf of the charity would be considered as charitable donations.

Gift of the Life Insurance Death Benefit

With this strategy, an individual would retain ownership of the policy but would name the charity as the beneficiary. Upon the death of the insured, the proceeds would be paid to the charity and the estate of the owner of the policy would receive a charitable receipt for the death benefit proceeds. The naming of the charity can be made at any time prior to death. There is no required minimum period that must be satisfied prior to naming the charity as beneficiary.

As long as the life claim is settled within 3 years of death, the executor of the estate has the option to claim the life insurance donation on:

  • The final or terminal return of the insured;

  • The prior income tax year’s return preceding death of the insured;

  • Both the current and prior year tax returns with any excess amount able to carry forward for the next five subsequent years;

  • Any combination of the above.

With this strategy, there are no charitable receipts issued while the insured is alive, only after death when the insurance proceeds are paid to the named charity.

Replacing Donated Assets to the Estate

There may be circumstances where a sizeable donation is made to a charity that would greatly reduce the value of the estate that would be left to family or other heirs. For donors who are concerned that their heirs would receive less than originally intended as a result of this donation, purchasing life insurance to replace the donated asset is a possible solution.

The previous headings represent the ways in which life insurance can enhance or complement philanthropy. As well, life insurance can be a valuable addition to a charitable giving program in that it enables the donor to bequeath a larger donation than otherwise would be possible with just hard assets alone.

If you have been or are contemplating making a significant charitable donation, be sure not to overlook how life insurance can enhance your gifting plans.

Debt Is a Four-Letter Word

Debt Is a Four-Letter Word

by | Feb 1, 2024 | Blog, Debt

Debt today is so common, you might say it can’t be avoided. Most people are not in a position to purchase a house or car for cash, while those who can buy such things outright may prefer to finance and keep control of their capital.

The truth is, while most of us see debt as a bad thing, any money borrowed to generate income or increase net worth can be considered “good debt.”

If the amount borrowed is invested for an overall gain, the debt is a tool. Borrowing to further your education, for example, is good debt since an education generally increases the likelihood you will earn more in the future. Most often, too, the interest paid on this type of debt is tax deductible.

Examples of Good Debt:

  • Education. Student loans for university, college or trade school education can be good debt. As mentioned, interest rates are usually quite low, and repayment is commonly deferred until after graduation. In general, educated workers earn considerably more than uneducated ones, making the cost of borrowing easier to repay. A student loan is the first experience many Canadians have in borrowing and in managing (i.e., paying back) a large fiscal obligation.

  • Business ownership. Many entrepreneurs start their businesses with borrowed funds. For a person with a strong business plan, good entrepreneurial instincts and a desire to succeed, assuming such a loan can be the best investment an individual can make.

  • Real estate. Whether a primary residence or revenue property, real estate has proven to be a prudent long-term investment.

  • Investing. Borrowing to invest allows you to put more money into your investment in an effort to earn extra returns.

This is not to say good debt is without risk. If you take out a leverage loan and your investment fails, you will find yourself owing the borrowed amount plus interest, regardless. Real estate markets can fall, businesses often fail, and there are no guarantees that an education will result in higher income or stable employment.

With that in mind, it is important to think about insuring your loans to protect your family and estate from unwanted liabilities if you die, become critically ill, or disabled.

Bad Debt

Unlike good debt – borrowing to acquire assets that are likely to increase in value – bad debt is incurred when we purchase assets that will decrease in value. Some examples:

  • Automobiles. As soon as you drive that shiny new car off the lot, it loses value and continues to do so for as long as you own it. Unless you use your vehicle for business purposes, paying interest on a car loan makes little sense.

  • Credit cards. If you use credit cards to buy clothing, consumables and other goods or services, you are building a balance of bad debt. Credit card interest rates are extremely high, and rewards cards often charge additional annual fees, making any balance you carry a prohibitively expensive liability.

  • Vacations. Travel now and pay later is simply a bad idea. Once the joy of the vacation wears off, the borrower is left with a high-cost travel loan.

In between good debt and bad debt lies the consolidation loan. Although it is used to merge all “bad” debts, it makes the burden easier to bear by lowering interest costs and monthly payments.

Get Rid of Debt!

Two plans often recommended for getting out of bad and consolidated debt are the debt snowball method and the debt stacking method.

Debt Snowball Method

  1. List all of your debts in ascending order from the smallest (by amount owed) to the largest.

  2. Pay the minimum payment on every debt every month.

  3. Determine how much extra you can pay each month; begin paying off your smallest debt with this amount plus your minimum payment.

  4. Continue to pay this amount until your smallest debt is repaid.

  5. Once the smallest debt is paid, add your minimum payment from debt #1 (now retired) plus the extra you were paying on it to the minimum payment due on debt #2, your second smallest amount owing. Each time one debt is paid off, your payment amount “snowballs,” grows larger, as it is added to the next.

  6. Continue doing this until each debt is retired.

Debt Stacking Method

  1. List all of your debts according to their interest rates.

  2. Continue to make all minimum payments on each balance.

  3. Work out how much additional money, over the minimum payment, you can afford to pay each month, and add this to your minimum payment being made on the loan with the highest interest costs.

  4. Once the highest-interest balance is repaid, start paying the debt with the next highest interest rate.

  5. Continue until all bad debt is retired.

Whichever strategy you use, make sure non-deductible-interest debt is paid off before you tackle the “good” debt.

Anyone concerned about debt load is well advised to seek the advice of a qualified financial planner who will help develop an action plan and recommend risk-management steps. As a qualified planner, I would be most happy to assist you in your debt-management efforts. Please feel free to call me at any time.