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Constructed-Response Questions - Part 2 - Post #03 - The CFP Examination - December 2017

Posted by John Gobeil on

The CFP Examination is the second of two exams that must be passed to obtain CFP certification. We have posted this entry to assist you in your preparation for The CFP Examination being held on Friday December 1, 2017.

In the previous Post, we reviewed the FPE2 Sample Examination Item #1 published by the FPSC.

In this Post, we will review the FPE2 Sample Examination Item #2. We have some suggestions for answering “In an email to Jackie, describe in detail the most tax efficient option for the transfer of Lynn’s shares to Jackie.”

Constructed-response questions

A constructed-response question is a question that requires you to produce an answer in your own words, using your laptop computer. These questions will range from short-answer questions to longer, extended-response questions. The questions involve client situations that require you to complete an analysis, prepare a written report, draft a financial plan or write a letter to a client.

Templates

Each of these questions includes a response template. A response template is a table with titles and other guidance that directs you in responding to a question. Apparently, every question will have a detailed response template.

A response template makes the answering of these questions much easier because it gives you considerable guidance as to what the examiners are expecting. In fact, it may indicate that you are required to provide information in the solution that was not specifically requested in the response instructions.

FPE2 Sample Examination Item #2

The client situation of this question is about half a page long and includes only three dollar amounts of financial information.

If you were to first read the situation carefully, underlining what you considered the important points, you would consider all of the information of importance and you would anticipate what you have to do with the information. Given the time pressure on the exam, you do not have the luxury of spending this time.

You need to determine what you have to do with the information before you spend any time analyzing it.

First, you should quickly read the situation, but only for context. Context involves essentially meeting Jackie, and the deceased Lynn, with the possibility of doing some planning for Jackie. You do not anticipate or solve any problems. You just note who they are and what kind of information the situation provides.

Client Situation

Lynn and Jackie are Canadian residents and equal shareholders of their computer networking company, TRC Inc., founded in 1985. TRC is a qualified small business corporation (QSBC). Lynn and Jackie are not related to one another and both were divorced prior to starting TRC.

In 1990, they followed the advice of Mike, their CFP professional, and carefully structured a shareholder agreement that gave the surviving shareholder discretion to use either a share purchase or share redemption strategy on the death of the other shareholder. TRC is the owner and beneficiary of a corporate life insurance policy on the lives of both shareholders with a death benefit of $1,000,000. The adjusted cost basis of the life insurance policy is $150,000.

Lynn died recently, and in accordance with the terms of the shareholder agreement, her shares were valued at $700,000 and must be purchased or redeemed within a year of her death. The adjusted cost base (ACB) of her shares is $50,000.

Lynn’s terminal return will be subject to a 46% marginal tax rate and any dividend to her estate will be taxed at 31%. She had never used any of her lifetime capital gains exemption.

Jackie has contacted Mike for guidance.

Next, you should carefully read the response instructions and the response template.

Response Instructions

In an email to Jackie, describe in detail the most tax efficient option for the transfer of Lynn’s shares to Jackie. Detail the resulting tax implications and benefits to all parties involved. (7 marks)

Response Template

Dear Jackie,

Sincerely,

Mike Treadwell, CFP

The fact that there are 7 marks suggests that you should include 7 pieces of information in your answer.

If there are 100 marks for each three-hour, paper, you have 12.6 minutes to answer the question, calculated as ((180 minutes ÷ 100 marks) × 7 marks for this question).

The response instructions say detail the most tax efficient option for the transfer of Lynn’s shares to Jackie. Detail the resulting tax implications and benefits to all parties.

The response provides nothing in the way of guidance.

The response instructions to detail the most tax efficient option for the transfer of Lynn’s shares to Jackie suggests that there is more than one option, so you want to identify the options and, even though the instructions do not specifically ask for it, you should include your rationale for one of the options being the most tax efficient option.

You also need to identify the tax implications of the most tax efficient option and benefits to all parties of the most tax efficient option. This sounds like your rationale for one of the options being the most tax efficient option.

So, before you go to the situation, note that you need to identify the options. Of course, you also need to determine your rationale for the most tax efficient option.

Now reread the situation for content.

In 1990, they … carefully structured a shareholder agreement that gave the surviving shareholder discretion to use either a share purchase or share redemption strategy on the death of the other shareholder. The corporation is the … beneficiary of a … life insurance policy on the lives of both shareholders with a death benefit of $1,000,000.

So, which strategy is most tax efficient: purchase of the shares by Jackie from Lynn’s estate or redemption of the shares from Lynn’s estate by TRC, the corporation?

In either situation,

  • upon receiving the life insurance proceeds, the corporation would increase its capital dividend account by $850,000, calculated as (life insurance proceeds – adjusted cost basis of policy) or ($1 million - $150,000);
  • the corporation would pay out $700,000 of cash;
  • Upon her death, Lynn would be deemed to have disposed of the shares for their fair market value of $700,000;
  • On Lynn’s final return, there would be no income tax on the capital appreciation because her trustee could use her lifetime capital gains exemption;
  • Lynn’s estate would acquire the shares from Lynn at their fair market value of $700,000, which would become their adjusted cost base to the estate;
  • For Lynn’s estate, there would be no income tax on the capital appreciation because their adjusted cost base would be $700,000; and
  • Jackie would be the sole shareholder of the corporation.

The purchase of the shares by Jackie from Lynn’s estate would proceed as follows:

  1. Jackie would purchase Lynn’s shares from her estate using a promissory note;
  2. As the sole shareholder, Jackie would have the corporation pay her a non-taxable capital dividend in an amount equal to the price in accordance with the terms of the shareholder agreement of $700,000; and
  3. Jackie would then use the $700,000 to purchase the shares from Lynn’s estate.

The tax implications and benefits to all parties of this option are:

  1. After the corporation pays her a non-taxable capital dividend in an amount equal to the price in accordance with the terms of the shareholder agreement of $700,000, the corporation would have an amount of $150,000 from the death benefit in its capital dividend account, calculated as (increase its capital dividend account from death benefit - capital dividend to Jackie) or ($850,000 - $700,000);
  2. The corporation has cash of $300,000 from the life insurance proceeds that it can invest or distribute to the shareholder;
  3. Jackie’s adjusted cost base of the shares purchased from Lynn’s estate would be their value of $700,000;
  4. Jackie would be able to instruct the corporation to pay her a non-taxable capital dividend in the amount of $150,000 if the corporation has liquid funds available; and
  5. Jackie could instruct the corporation to redeem the shares that she purchased for Lynn’s estate for their value of $700,000 and would have to report a taxable capital gain of $0 because they have an adjusted cost base of $700,000.

The redemption of the shares from Lynn’s estate by the corporation would proceed as follows:

  1. The corporation would purchase Lynn’s shares from her estate using part of the life insurance proceeds in the amount of $700,000.

The tax implications of this option and benefits to all parties of this option are:

  1. The corporation would have an amount of $850,000 from the death benefit in its capital dividend account, calculated as (increase its capital dividend account from death benefit) or ($850,000);
  2. The adjusted cost base of Jackie’s shares would not change;
  3. The corporation has cash of $1 million from the life insurance proceeds that it can invest or distribute to the shareholder; and
  4. Jackie would be able to instruct the corporation to pay her a non-taxable capital dividend of $850,000 if the corporation has liquid funds available.

So, which strategy is most tax efficient: purchase of the shares by Jackie from Lynn’s estate or redemption of the shares from Lynn’s estate by the corporation?

There is no apparent advantage to either option in terms of “tax efficiency”.

In the solution, the FPSC says Jackie should purchase Lynn’s shares from her estate and there was no consideration of redemption of the shares from Lynn’s estate by the corporation.

So, the first lesson is “keep it simple”. Which option is the simpler?

Now suppose you kept it simple and Jackie should purchase Lynn’s shares from her estate, you need to draft your email. The model solution is somewhat formal and repetitive in that both the first and third paragraphs address the taxation of Lynn’s estate.

What does the FPSC’s Scoring Table look like?

  1. Determines there will be no tax on these transactions on Lynn’s terminal return
  2. Determines there will be no tax on these transactions in Lynn’s estate
  3. Recommends Jackie purchase Lynn’s shares from her estate using a promissory note
  4. Recommends that Jackie use $700,000 tax-free capital dividend to retire the promissory note to Lynn’s estate
  5. Identifies that Jackie receives a step up in the adjusted cost base (ACB) of her shares of $700,000
  6. Identifies that life insurance proceeds minus adjusted cost basis is a capital dividend account (CDA) credit to TRC Inc.
  7. Identifies that Jackie should seek independent tax and legal advice

So, your answer should look like this.

Dear Jackie,

There will be no tax on these transactions on Lynn’s terminal return because …

There will be no tax on these transactions in Lynn’s estate because …

You should purchase Lynn’s shares from her estate using a promissory note because …

You should use $700,000 tax-free capital dividend to retire the promissory note to Lynn’s estate because …

You would receive a step up in the adjusted cost base (ACB) of your shares of $700,000 because …

From the death benefit, the corporation will have an increase in its capital dividend account of $850,000, calculated as (life insurance proceeds – adjusted cost basis of policy) or ($1 million - $150,000).

You should seek independent tax and legal advice.

Sincerely,

Mike Treadwell, CFP

Lessons Learned

So, from this question, we learn to keep it simple. You had to describe in detail the most tax efficient option, but you did not have to justify your decision as to which was the most tax efficient.

Do not write a formal communication; just identify and list the points that you think will be in the scoring table.

When giving tax and legal advice, always throw in the last line, “You should seek independent tax and legal advice.”

Seven marks seem to mean seven things in your response.

If you have the time available, you could expand on your answer beyond the minimum seven points because you never know what the FPSC might give a mark for.

The detailed templates, such as the one for the first sample examination item, make it very easy to determine what you are required to include in your answer.

The FPE2 Sample Examination Item #2 did not have a detailed template and, if you had followed the Response Instructions, you might have gotten lost in detail.

Next Post

In our next Post, we will consider the Refinements to FPSC® Financial Planning Practice Standards.                 

Effectiveness of our study aids

We always appreciate feedback on the effectiveness of our study aids. Together, we can continue to have the best study aids available.

Regards,

John Gobeil, BSc, CFP®

David Gobeil, CPA, CA, CFP®


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