AMANDA VISSER: There is no escape from death or taxes, and when planning your estate, it is vitally important to understand the impact of tax and how the failure to plan accordingly can hurt and even haunt your loved ones. With me, Amanda Visser, is Louis van Vuren, CEO of Fisa, the Fiduciary Institute of Southern Africa, who will give us an example of how things can go wrong and how it could be done better.
LOUIS VAN VUREN: Thank you, Amanda. Thank you for the opportunity. What I thought we could do today is to look at a case study. Let’s take John, 46 years old, and let’s say he’s been married to Anne for the last 18 years. They’ve been married out of community of property but with the inclusion of the accrual. When they married, they recorded their commencement values as R100 000 for John and R50 000 for Anne. As you may know, you can record commencement values in an accrual marriage.
It’s John’s second marriage, having previously been married to Claudia for a few years, and he has two sons from this first marriage. The two sons live with him and Anne, and he has a daughter with Anne. Now, during this marriage with Anne, John’s business really took off and he accumulated some wealth.
Now let’s say he started the business with two other people after he got married to Anne. He owns half the shares in this business and his half of those shares are valued at R15 million now. He also owns a beach cottage valued at R2 million with an outstanding bond of R500 000, which he also bought after his marriage to Anne. The purchase price of the beach house is R1 million.
And he has a unit trust investment of R5 million. He invested R1 million in this some years ago, so there has been an increase in value of R4 million.
He has life cover of R1 million, but with no beneficiary or nomination, which means it will pay into his deceased estate should he die.
And he has no liabilities apart from the R500 000 bond on the beach cottage.
Let’s say the family home is valued at R4 million. It was bought some years ago, but after 2001, for R2 million, and it’s owned jointly – 50:50 by John and Anne.
Anne’s total net estate is about R5 million, including almost R3 million in the unit trust investment, with no life cover on her life.
Importantly, in John’s current will he bequeaths half of his shares in the business and the beach cottage to his three children, and the residue is bequeathed to Anne.
So, let’s take that as a case study. It’s, I think, a fairly common case study among people who have generated some wealth during their lives.
AMANDA VISSER: Louis, if John were to die today what would the tax consequences be?
LOUIS VAN VUREN: Firstly, there will be estate duty. The estate duty will be on the assets that are bequeathed to the children. Now, just to refresh our memories, the assets bequeathed to the children are half the shares, John’s 50% shareholding in the business, and the beach cottage. Those values would be R7.5 million for the shares and R2 million for the beach cottage for estate-duty purposes. Those assets going to the children will then cause estate duty in John’s estate. Now there’s a standard deduction of R3.5 million for estate duty, which means that after R9.5 million, R6 million [of that] will be dutiable and, at 20% estate duty rate, well, that’s exactly R1.2 million in estate duty that will be payable.
On top of that, there will be capital gains tax [CGT] payable, and that will be approximately R2.8 million if one assumes that John is on a 45% marginal personal income tax rate. This capital gains tax liability is because it is deemed that a person disposes of all your assets to your deceased estate on the date of your death, and at the market value as at the date of your death.
Now, because John’s half of the shares and the beach cottage will go to the children, those assets will then attract capital gains tax. For the beach cottage, it will be R1 million, the increase in the value. The base cost is R1 million. That’s the price he paid for the beach cottage. It’s worth R2 million now. And his shares – he started the business from scratch – had negligible value at the start and they are now valued at R15 million of which R7.5 million is going to the children, so that’s a R7.5 million capital gain, and that will then result in approximately R2.8 million in capital gains tax.
There is an exclusion in the year of death of R300 000. So the first R300 000 of capital gain is excluded from the capital gain, of which 40% is then included in the taxable income for the year in which he died, and at 45% tax on that, the CGT payable will be in excess of R2.8 million right now.
Everything that goes to Anne fortunately will qualify for rollover relief, and will not cause CGT.
But there’s a word of warning here, and that is that all that rollover relief does with capital gains tax on death, is that it postpones the capital gains tax event.
So when Anne eventually disposes of these assets, or when she dies still holding these assets, the capital gain will then be calculated from the base cost at which John acquired the assets, to the market value on the date that Anne disposes of the assets, or the date that Anne dies.
So it’s just a postponement of capital gains tax, the so-called ‘rollover relief’ on assets that accrued to the surviving spouse at the death of the spouse who was the original owner of the assets.
There’s another problem in this estate, and that is that there’s clearly insufficient cash. The unit trusts will have to be sold. The R1 million in life cover that will go to the estate will only cover liabilities and administration costs, and not even everything. So, if the unit trusts are sold, that will cause a further CGT liability if the unit trusts are sold to generate cash to have enough cash in the estate to pay all the liabilities, pay all the administration costs, and pay all the taxes. And the taxes, as we’ve seen, are going to be about R4 million.
Now, if there was a buy-and-sell agreement in place between John and his co-shareholders in the business, and that buy-and-sell agreement was properly funded by life insurance, then there would be sufficient cash in the estate because John’s shares in the business would then be sold to the co-shareholders for cash, and that cash would’ve been generated by the life insurance on his life.
Now, if life insurance in a buy-and-sell agreement is correctly done, it will not cause further estate duty in his estate. However, if the shares that will go to Anne are then also sold during the administration of John’s estate, those shares will then not qualify for rollover relief anymore, and they will also generate further capital gains tax, depending on how the buy-and-sell agreement was structured.
But that’s not where the tax story stops, Amanda, unfortunately. Because there is a cash shortfall in this estate, it may be necessary to sell the family home to generate cash. And if that is done during the administration of the estate, that will cause transfer duty. In a deceased estate transfer duty is not charged on assets of fixed property that accrues to an heir. So the transfer to an heir in a deceased estate is not subject to transfer duty. But if the fixed property is sold during the administration process of the estate, there could be in this case transfer duty payable of well over a quarter of a million rand.
There is a further issue, and that is that fortunately under John’s current will Anne receives more from John’s estate than the amount of her accrual claim, because she will have an accrual claim against John’s estate if John dies now, because he is seeing a substantially bigger accrual in the value of his estate than she did.
So if John dies first, she will have an accrual claim against his estate, but because she inherits more from the estate than the amount of her accrual claim against the estate, that will not cause any problems.
But should Anne die before John, her estate will have an accrual claim against John. And if he inherits the lion’s share of her estate, then there won’t be any problem. But if he does not inherit the lion’s share of her estate, or the whole estate, it could place him in severe financial distress as he will have to generate cash or transfer assets to her estate. This could trigger further CGT and possibly transfer duty.
AMANDA VISSER: Well, that [makes it] quite clear how not planning correctly can hurt and even haunt you, but what could John have done differently?
LOUIS VAN VUREN: The first thing that springs to mind, Amanda, is that the beach house could have been bought in a trust. Now that is not a magical answer to every problem. A trust pays CGT at a higher rate than individuals, but fortunately, trusts are also for tax purposes treated as conduits, and any capital gains that would arise in a trust can, upon the disposal of the property from the trust – whether it’s distributed to the beneficiaries or sold from the trust – be attributed to the beneficiaries and be taxed in their hands and not at the higher tax rate in the trust. The trust pays capital gains tax at a flat rate of 36% of the gain.
Now, if the idea was to hold the beach cottage for a long time, then a trust could be a solution. If not, if the idea was to hold it for some years and then sell it again, then a trust may not be an ideal option.
Secondly, before John’s shares in this business increased substantially in value because the business was a success and took off, the shares in the business – let’s say it’s a private company – could have been placed in a trust, and then the huge increase in value of the business would be in the trust and not in John’s own hands and in his own estate for estate-duty purposes upon death.
Now, with tax legislation changing over the last number of years, there are some pitfalls here because, if you extend an interest-free loan to a trust under those circumstances or to the company, under those circumstances, there could be a donation-tax implication for the donor or for the lender of the money to the trust or to the company. But careful planning around that is also possible and some of those negative points can be alleviated and avoided.
He could donate some of the shares to his spouse and children while the shares are still at lower values, and that could have softened the blow at death as well – the estate-duty blow because of the shares. He could bequeath all the shares to Anne and not to his children, but that may cause other problems and will postpone the estate-duty liability until Anne’s death.
The most important thing to my mind, and what I think John needs to bear in mind, is that there is not sufficient liquidity in the estates, and there’s nothing that delays the finalisation of a deceased estate more than insufficient liquidity in the estate, insufficient cash.
There’s clearly not enough life cover on John’s life and there’s no life cover on Anne’s life, and there are no other sources of ready cash. One shouldn’t really treat unit trusts as a ready source of cash in a deceased estate unless it is a money-market fund or an income fund or something like that, because it may not be a good time to sell, firstly, and secondly, selling those units may add to the capital gains tax liability in the estate.
Amanda, by far I think the best thing that John could have done would’ve been to consult a structuring and estate-planning specialist – such as a good fiduciary practitioner – in good time, long before he started to accumulate substantial wealth.
It’s never too early to start with estate planning, and proper structuring can avoid a lot of these pitfalls and a lot of the negative tax consequences that I spoke about.
AMANDA VISSER: Thank you, Louis. Louis van Vuren, CEO of Fisa, leaves us with a very important lesson – and that is to plan properly but never to allow the tax tail to wag the planning dog.
Brought to you by the Fiduciary Institute of Southern Africa (Fisa).
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