When a Canadian owns shares in a private company, they might think about using an “estate freeze” to “freeze” or “lock-in” the value of their shares.
Why do this? As I explain below, estate freezes can be an effective tax planning and business succession planning tool. Done properly, freezing the value of their shares can help the Canadian business owner-manager limit the income tax that they would otherwise pay on the future capital gain on their shares; it can reduce provincial probate fees that the business owner-manager would otherwise pay on their shares at death; and estate freezes can provide a tax-efficient way for the business owner to pass on control of the company to the next generation.
What happens in an estate freeze?
There are many different ways to carry out an estate freeze. Most commonly, the person who owns common shares in a private company (I will call them the “Freezor”) exchanges those shares for preferred shares that have a fixed value that is equal to the fair market value of the common shares at that time. At the same time the Freezor exchanges his or her shares, the company issues common shares to one or more new shareholders chosen by the Freezor, such as the Freezor’s children, family members, key employees, or even a family trust.
Through these steps, the value of the company at the time of the freeze becomes fixed or “frozen”, and that fixed value is reflected in the preferred shares that the Freezor holds at the end of the process. As the company grows in value, that growth accrues to the new common shares now owned by the Freezor’s children, family members, key employees, or family trust. The Freezor’s preferred shares, however, stay “frozen” and do not grow in value as the value of the company grows.
What are the benefits of an estate freeze?
Freezors and their intended beneficiaries enjoy many benefits from carrying out an estate freeze. Below, I will cover five tax and non-tax benefits.
Deferring capital gains
Estate freezes are commonly used when there is an expectation that the corporation will continue to grow in value, resulting in capital gains to the owner of the shares, and where there is a clear successor or next generation of owners ready to take over the corporation. To avoid triggering large capital gains tax on the death of the Freezor, which happens due to the deemed disposition of all capital assets on death under the Income Tax Act, the Freezor can limit the accrued capital gain on the shares and transfer future capital gains to the Freezor’s intended beneficiaries without triggering immediate tax consequences by using an estate freeze. Aside from deferring capital gains tax, this freeze allows the Freezor to calculate the expected tax liability that will arise at the deemed disposition on death, cap that liability, and then can look at strategies for paying off that liability during their lifetimes or at death.
Further, if the estate freeze is structured in such a way that any increase in the value of the common shares accrues to the new common shares held by the Freezor’s children, family members, key employees, or family trust, there is a deferral of the tax liability associated with this increase in value until the new shareholder either disposes of the shares or dies, whichever occurs first. Generally speaking, depending on the amounts involved, this tax deferral can result in a substantial benefit to the next generation.
Using the lifetime capital gain exemption
Along with avoiding certain capital gains by the Freezor, there is a significant tax break that is provided on capital gains that are realized on the disposition of certain private shares that qualify as “Qualifying Small Business” shares. The lifetime capital gain exemption (“LCGE”) is available to individuals who dispose of such shares. When the estate freeze is completed, the LCGE may be available for both the Freezor and the new shareholders to use during their lifetime when they dispose of the shares.
Splitting income
By structuring the estate freeze such that the Freezor’s children or family members hold the newly issued common shares, the whole family can use income splitting strategies to their overall advantage. For example, certain dividend payments can be made to the class of new common shares held by members of the next generation as they are often in a lower tax bracket and therefore taxed at a lower rate than the Freezor is taxed. However, the ability to split income remains subject to various attribution rules in the Income Tax Act (Canada) which need to be considered carefully when carrying out an estate freeze.
Reducing probate fees
Each province has different probate fees that apply when an executor or would-be administrator applies for probate. Probate is the process that named executors in a Will or would-be administrators of an estate must go through in order to be approved by a court to act for an estate. As part of the probate process, the provincial probate court will generally levy a probate fee which is based on the fair market value of the deceased’s assets at the date of the death. Some provinces, such as British Columbia, Ontario, and Saskatchewan, have the highest probate fees in the country, and often individuals try to find ways during their lifetime either to avoid or reduce these fees (by contrast, other provinces, such as Alberta, have a maximum probate fee payable, which is small). Therefore, depending on where the Freezor lives, it may be advisable for the Freezor to have the company redeem the Freezor’s preferred shares while the Freezor is alive or to use multiple wills or to transferring their preferred shares to an alter ego or joint partner trust. All of these strategies can help a Freezor reduce or even avoid the probate fees that their estates might otherwise have to pay.
Protecting family assets
An estate freeze allows business owner-managers to pass ownership and control of a key family asset–the family business–to the next generation. If the children, however, are too young or if the direct ownership of family shares will cause family strife, business owners could set up a family trust to be the owner of the new shares. The Freezor can set up and structure the trust such that the children or grandchildren are the beneficiaries of the trust but the Freezor remains in control of the trust as the trustee or protector. When the next generation is ready to take control of the company or when the Freezor is ready to take a step back from the corporation, the trust could then distribute the common shares to the eventual successors of the business.
Estate freeze considerations
Implementing an estate freeze has its advantages, but it can be very complex as well. While an estate freeze may be quite helpful in some situations, it is not appropriate in all circumstances. Freezors should be mindful of certain concerns and considerations when determining whether an estate freeze is right for them and their situation.
Timing an estate freeze
The timing of an estate freeze depends on many factors, including but not limited to, the personal and financial circumstances of the Freezor and their family members and the nature of the corporation. Freezors must also ask whether there is enough value in the corporation that will allow for the Freezor to retire with ample financial independence. If the estate freeze is carried out too early in the Freezor’s life, there may not be enough value in the corporation to allow the Freezor to live comfortably after retiring. While there is an ability to “thaw” their shares and then “re-freeze” the corporation at a future time to help the Freezor if needed, Freezors need to review carefully all of the tax consequences of doing so and will also need the co-operation of the other shareholders.
Valuating shares
Along with considering the timing of the estate freeze, Freezors should obtain a proper valuation of their shares. A proper valuation is critical to carrying out a successful estate freeze, calculating the Freezor’s expected future tax liability, and avoiding unnecessary tax problems. For example, if the shares to-be-frozen are valued below the shares’ fair market value, the Freezor may have to realize a capital gain equal to the difference between the shares’ fair market value and their undervalued amount. Alternatively, if the shares are valued at too high a price, the Freezor may recognize a taxable benefit. It is critical that an accurate valuation of the Freezor’s shares be performed around as close to the time of the freeze in order to set up the estate freeze properly.
Dealing with inflation
While an estate freeze freezes the value of the Freezor’s shares, the market is not frozen. Inflation may reduce the value of the Freezor’s preferred shares and could potentially compromise the Freezor’s retirement plans. As such, it is important to consider how both recent and potential future inflation in the market could affect the estate freeze. There are tools available to the Freezor to mitigate the impact of inflation, such as carrying out a partial estate freeze in which the company issues some of the new growth shares to the Freezor in order to give the Freezor more flexibility and allow them to continue to participate in some of the future growth of the corporation. However, this strategy may not be appropriate in all circumstances.
Dealing with the 21 year deemed disposition rule for trusts
If the Freezor wishes to pass on their business ultimately to their children but the children are currently too young to be actively involved in the business, the Freezor may consider setting up a family trust and having the company issue the new growth shares to the family trust. When the children become of age, or when the Freezor decides that the children should become more actively involved in the business, the trust can then distribute the shares to one or more children at that time.
When setting up a trust, the Freezor must be mindful of the 21-year rule in Canada. To prevent the indefinite deferral of capital gains accumulated in a trust, the trust is deemed to have disposed of its assets every 21 years for tax purposes. As such, the trust is required to report all accumulated gains and losses on its tax return as if it had actually sold the assets for fair market value. Any gains realized as a result of this deemed disposition are taxed in the trust at the highest marginal tax rate in the trust’s province of residence. Unfortunately, these gains cannot be allocated to a beneficiary to be taxed in their hands. Even though the trust is deemed to dispose of all assets and to pay the tax on the resulting capital gain every 21 years, the trust does not dissolve or wind up. Instead, once it pays the tax, the trust continues to operate as it did before.
When using a trust in an estate freeze, the Freezor will want to consider the timing of the freeze. If the trust plans to hold the new growth shares for longer than 21 years, the Freezor should actively plan for ways to reduce the impact of, or even avoid, the 21 year deemed disposition.
Exercising control
While the Freezor’s goal may be to freeze their tax liability on death and transfer the future growth of the company’s assets to their family members, the Freezor may wish to maintain control over the corporation. To do that, the Freezor could have the company issue to them preferred shares that have special voting rights. Alternatively, the Freezor’s family members could receive growth shares that have limiting voting rights. Then there is the option of having a family trust, rather than having family members, hold the growth shares. By putting the new common shares in a family trust, the Freezor may be able to maintain some control if the Freezor is the sole trustee or one of the trustees of the trust. As trustee, the Freezor also has the added flexibility of determining which beneficiaries should receive the trust’s income each year and ultimately which beneficiaries should receive the growth shares at a later date.
Considering cross-border issues
If the Freezor has beneficiaries who are US citizens, green card holders, or US residents, the Freezor might not want to carry out an estate freeze. Here, an estate freeze may not be an effective tax planning strategy due to the various potentially adverse tax consequences associated with gifting shares to such persons, as well as trust rules that affect cross-border planning.
Dealing with a breakdown in the family
An estate freeze is optimal when there are strong relationships between and among the Freezor and their family members. Unfortunately, not all families get along. A plan to pass on the family business to the next generation might backfire if the new shareholders, being the Freezor’s children or family members, decide they do not wish to be involved in the corporation or if they become estranged from the family. Growth shares issued to children may also be at risk if those children later get divorced or have creditor problems. Unless the Freezor designs the estate freeze carefully and makes back-up plans, the estate freeze could result in control unintentionally passing to uncooperative children and/or their partners. The Freezor can alleviate some of these concerns by allocating voting rights appropriately or by using a family trust which may allow the Freezor and their chosen successors to continue who should benefit from and receive the growth shares of the company.
Dealing with an unexpected sale
If the new shareholders own the growth shares of the corporation and have voting rights, there is the possibility that such shareholders could sell the corporation earlier than the Freezor might have wished or intended. The Freezor can mitigate some of this risk by using a family trust, with different classes of beneficiaries, to own the growth shares of the company.
Conclusion
An estate freeze is a tool that should always be a part of the Canadian business owner’s estate and business planning toolkit – though it should not always be used. Estate freezes should be deployed in only certain situations. If carried out, an estate freeze should be tailored both to achieve the Freezor’s specific objectives and to reflect the Freezor’s personal and family circumstances.
This article provided an overview of estate freezes, its advantages, its potential issues, and its variations. It is merely a tip of the iceberg. If you require advice on implementing an estate freeze or are considering whether an estate freeze is right for you, please contact one of the members of our National Private Client Services Group to help.
