ESTATE FREEZE - tax planning strategy
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An estate freeze is a complex but powerful estate-planning strategy used primarily by business owners and high-net-worth individuals to manage their tax liability and facilitate the transfer of assets to the next generation. At its core, an estate freeze is a transaction that "freezes" the value of appreciating assets at their current fair market value. The individual performing the freeze, known as the "freezor," exchanges their "growth" assets (typically common shares in a private company) for "frozen" assets (fixed-value preferred shares).
The key result of implementing an estate freeze is that any future growth in the value of the assets is no longer attributed to the freezor. Instead, this future growth is transferred to other individuals, usually their children or grandchildren, who receive new common shares. To realize this tax-driven objective, the estate freeze effectuates the following steps:
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Valuation: The first step is to get a professional valuation of the assets to be frozen. This is crucial as the value of the preferred shares the freezor receives will be based on this valuation.
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Exchange of Shares: The freezor exchanges their common shares for a new class of fixed-value preferred shares. This is often done on a tax-deferred basis, so the freezor does not immediately incur a capital gains tax liability on the existing appreciation of their shares.
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Issuing New Shares: The corporation then issues new common shares to the next generation (or a family trust established for their benefit). These new shares will now capture all future growth of the company.
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Retention of Control: To maintain control over the business, the freezor can have their preferred shares structured with special voting rights. This allows them to manage the company while the future value accrues to the new shareholders.
The primary objectives of an estate freeze are to minimize or defer taxes and to create an orderly succession plan. To realize those objectives, the estate freeze looks to effectuate:
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Tax Deferral on Capital Gains: In Canada, when a person dies, they are "deemed" to have sold all their capital property at its fair market value, which can trigger a significant tax bill. By freezing the value of their shares, the freezor caps the capital gains tax liability they will face on their death. The tax on the future growth is deferred until the next generation sells their shares or is deemed to have disposed of them.
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Business Succession Planning: An estate freeze is an excellent tool for passing a family business to the next generation. It allows the senior generation to transition ownership and responsibility to their children while maintaining control and a source of income (through dividends on their preferred shares) for their retirement.
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Income Splitting: Once the freeze is in place, the company can pay dividends on the new common shares to the next generation. If the new shareholders are in a lower tax bracket, this can help reduce the family's overall tax burden. However, it's important to be aware of the "tax on split income" (TOSI) rules, which can limit this benefit.
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Multiplication of the Capital Gains Exemption (CGE): If the company qualifies as a "qualified small business corporation" (QSBC), a trust-based estate freeze can be used to multiply the lifetime CGE among multiple beneficiaries, leading to substantial tax savings.
An estate freeze is a complex tax-driven transaction that requires careful planning and professional advice. Some key considerations include:
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Professional Expertise: The process involves complex corporate and tax law. It is essential to work with a qualified team of tax lawyers, accountants, and financial advisors to ensure the freeze is structured correctly.
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Canada Revenue Agency (CRA) Scrutiny: The CRA can challenge the valuation of the frozen assets, which could have significant negative tax consequences.
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Family Dynamics: An estate freeze can have a major impact on family members. It is crucial to have open discussions about the plan and its implications for each person involved.
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Family Trusts: Often, the new common shares are issued to a family trust instead of directly to the children. This can provide added flexibility for distributing assets and can offer asset protection benefits. However, family trusts have their own complexities, including the "21-year deemed disposition" rule, which must be managed.
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Attribution Rules: The Income Tax Act has "attribution rules" that can negate the benefits of an estate freeze if not planned for properly. For example, if the freezor loans money to the trust, the interest rate must be at a prescribed rate to avoid income being attributed back to them.
Although an estate freeze is a major tax deferral tool, it does not eliminate the tax liability entirely; it simply defers it. The tax is postponed until a later date, such as when the corporation sells the assets or when the individual sells their shares in the corporation. Due to the complexity and strict rules involved, it is highly recommended to seek professional tax law advice is retained when undertaking an estate freeze [more on complexity and mistakes].
Given the complexity and potential for serious tax penalties, it is critical that your estate freeze is correctly structured, with the appropriate legal and supporting paperwork, such that it might effectively respond to any scrutiny. With over two decades of legal experience, which includes designing and implementing a multitude of estate freezes and other corporate tax planning strategies, we can put that knowledge and experience to use for the advancement of your business.
Our law firm strives to provide strategic tax-driven legal advice and direction to Calgary businesses looking to optimize their business structures and corporate transactions. Contact our law firm at Chris@NeufeldLegal.com or 403-400-4092 to schedule a confidential initial consultation for your business' tax structuring and tax planning initiatives.
