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How a Profitable Hobby Led to a Financial Opportunity

case study of Dr. F

Dr. F., a retired physician, wants to know how he can share his income with his grandchildren in a tax-efficient manner.

For most physicians, just running a medical practice would be challenging enough. Not so for Dr. F., a retired physician living in Southwestern Ontario. Though medicine was his chosen profession, he and his wife also owned and operated a busy farm during their working years.

Dr. F’s Profile

Age: 77

Career stage: Retired

Issue: Tax-efficient access to the income earned on investments to be made available to his grandchildren

Assets: Registered accounts, $947,000; non-registered accounts, $1.1 million; home, $912,000; farms, $3.33 million; other assets, $2.8 million; total, $9.09 million

Required annual income: $100,000

Born into a farming family, Dr. F. has always had a love for agriculture. After he’d been practising medicine for some time, he and his wife purchased land for farming and began experimenting with different types of farming, with both crops and livestock. Eventually, they found a farming solution that worked well and proved to be very profitable.

In 2011, Dr. and Mrs. F. received $1 million in proceeds from the sale of some of their farm properties—earnings they didn’t need for supplementing their retirement income. “We suddenly had a lot of money, and what do you do with a lot of money?” says Mrs. F. “We didn’t need it—we’re simple people and live frugally.”

Dr. and Mrs. F. are well set in their retirement. They have assets of over $8 million (excluding their principal residence), regular rent from several properties they own, approximately $57,000 per year from a registered retirement income fund, and non-registered investments that provide dividends and capital gains.

While their four adult children had already been financially provided for as part of Dr. and Mrs. F.’s estate plan, the couple also wanted to benefit their 12 grandchildren now. “We wanted to give our grandchildren the money now instead of waiting until they’re older—there was no point in leaving it in the bank,” Mrs. F. explains. “Our kids and their spouses all have good jobs, but can the grandkids afford university in the future?”

For Dr. and Mrs. F., ensuring that their assets could help support their grandchildren during the couple’s lifetime made the most financial sense.

Saving taxes with prescribed rate loan planning

Their MD Private Trust Estate and Trust Advisor suggested that Dr. and Mrs. F. consider income splitting using a family trust—a tax-planning technique designed to make income available to beneficiaries who pay tax at a lower rate, while taking that income out of the hands of someone paying a high rate of personal tax.

To do this, MD recommended funding the family trust with a prescribed rate loan, a simple and effective strategy that would allow them to divide the income earned on the funds loaned to the trust among their 12 grandchildren. This approach allows them to make funds available to their grandchildren now while minimizing the entire family’s income tax exposure.

The prescribed rate loan strategy involves an individual in a high personal tax bracket loaning money directly to one or more family members who typically pay income tax at lower tax rates, or to fund a trust (required for minor children) established for such family members.

With MD’s guidance, Dr. and Mrs. F. set up four trusts (one for each family unit), funded with loans at 1%, which was the Canada Revenue Agency’s prescribed interest rate at the time the loan was made. Each trust was loaned $250,000.

This structure allows the income earned in the trust (less trustee fees and an annual payment to the lenders of 1% on the amount of the outstanding loan) to be taxed in the hands of the grandchildren, at lower tax rates than would apply to Dr. and Mrs. F. The grandchildren don’t currently earn enough income to attract any personal income tax. Dr. and Mrs. F. report only the 1% interest paid to them on the loan as income, while the net trust income is paid out to their grandchildren annually.

Creation of a secondary will may avoid probate

To create this estate planning structure, Dr. and Mrs. F. loaned funds to the four trusts, and the loans were evidenced by a demand note signed by the trustees of the trust. The notes were structured in such a way that Dr. and Mrs. F. can demand full or partial payment of the loan from the trusts at any time during their lifetimes.

If the notes are still outstanding when both Dr. and Mrs. F. have died, the notes will form part of the estate and be subject to estate administration tax, commonly referred to as “probate.” In Ontario, this tax is approximately 1.5% of the value of the assets. In this instance, the estate plan was set up so that the demand notes would be distributed under the secondary will, which may avoid estate administration tax in certain circumstances.

A look at the numbers

Non-Registered Investments ($) MD’s Solution ($)
Starting value 1,000,000 1,000,000
Estimated annual income 40,000 40,000
Fixed loan interest at 1% n/a 10,000
Trustee fees to administer the four trusts n/a 15,000
Estimated income tax payable by Dr. F. 21,400 5,350
Estimated probate tax payable on original $1 million, plus accumulated income over 15 years of $600,000 24,000
Income available to the 12 grandchildren 0 15,000
Amount paid to each grandchild 0 1,250

The following assumptions were made in the above table:

  • investment income remains at 4% and is “other investment income”
  • Dr. and Mrs. F. are in the top personal tax bracket in Ontario (the 2016 tax rate for that bracket is 53.5%)
  • probate is based on an Ontario estate administration tax rate of 1.5%

In addition to Dr. and Mrs. F., MD Private Trust was appointed as a trustee of the trusts, ensuring continuity and professional ongoing investment management and administrative support.

While they consider themselves financially savvy, Dr. and Mrs. F. were happy to leave the financial planning to MD. “We weren’t interested in doing the research and planning—we just wanted it taken care of,” says Mrs. F. “MD did that for us.”

1 The prescribed interest rate is released by the Canada Revenue Agency every quarter and is subject to change. However, when the loan is properly structured, the prevailing rate at the time the loan is made is locked in for the lifetime of the loan—it does not fluctuate.

2 Subject to probate owned by the deceased.

Estate and trust services are offered through MD Private Trust Company, a CMA company.

In the province of Quebec, notarial wills do not require probate, whereas all other wills do require probate and are subject to a fixed application fee. All references to probate and probate tax in this document should be read accordingly.

MD Financial Management includes MD Financial Management Inc., MD Management Limited, MD Private Trust Company, MD Life Insurance Company and MD Insurance Agency Limited.

The information contained in this document is not intended to offer foreign or domestic taxation, legal, accounting or similar professional advice, nor is it intended to replace the advice of independent tax, accounting or legal professionals. Incorporation guidance is limited to asset allocation and integrating corporate entities into financial plans and wealth strategies. Any tax-related information is applicable to Canadian residents only and is in accordance with current Canadian tax law including judicial and administrative interpretation. The information and strategies presented here may not be suitable for U.S. persons (citizens, residents or green card holders) or non-residents of Canada, or for situations involving such individuals. Employees of the MD Group of Companies are not authorized to make any determination of a client’s U.S. status or tax filing obligations, whether foreign or domestic. The MD ExO® service provides financial products and guidance to clients, delivered through the MD Group of Companies (MD Financial Management Inc., MD Management Limited, MD Private Trust Company, MD Life Insurance Company and MD Insurance Agency Limited). For a detailed list of these companies, visit MD Financial Management provides financial products and services, the MD Family of Funds and investment counselling services through the MD Group of Companies. MD Financial Management Inc. is owned by the Canadian Medical Association.