ESTATE FREEZE - COMPLEXITY & MISTAKES
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While an estate freeze is an important tax planning strategy, its complexity gives rise to the prospect of serious mistakes, such that an experienced tax lawyer should be engaged to navigate this highly technical tax law procedure. Areas of complexity that can give rise to mistakes in the execution of an estate freeze include:
A. Failing to Get a Proper Valuation
One of the most critical steps in an estate freeze is determining the fair market value (FMV) of the assets or company shares being frozen.
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Under-valuing the assets: If the Canada Revenue Agency (CRA) determines that the value of the shares was understated at the time of the freeze, it could result in unexpected capital gains taxes, as the difference between the declared value and the actual FMV may be considered a taxable shareholder benefit.
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Over-valuing the assets: Conversely, an over-valuation could also lead to tax issues and may create an inappropriate capital structure.
Best Practice: Always obtain a professional, independent valuation of the business to ensure the freeze is based on a reasonable and defensible FMV. Consider including a price-adjustment clause in the legal agreements, although the CRA has specific conditions for when it will respect such a clause.
B. Ignoring the "Tax on Split Income" (TOSI) Rules
Estate freezes often involve issuing new shares to family members, such as children, with the intention of income splitting. However, the TOSI rules are designed to prevent this by taxing certain types of income at the highest marginal rate, regardless of the recipient's tax bracket.
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Distributing dividends to family members without considering TOSI: If dividends are paid to a family member who is not actively involved in the business, or does not own a sufficient number of shares, the income may be subject to TOSI.
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Issuing shares to minors or inactive family members: Transferring growth shares to minor children or other individuals who are not "significantly involved" in the business can trigger the TOSI rules.
Best Practice: Work with a tax professional who can analyze your family's situation and business structure to determine how the TOSI rules apply and how to distribute income in a tax-efficient manner.
C. Not Aligning the Freeze with Your Overall Estate Plan
An estate freeze is just one component of a comprehensive estate plan. A common mistake is to execute a freeze without updating other critical legal documents.
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Outdated will or shareholder agreement: If your will or shareholder agreement is not updated to reflect the new share structure and ownership, it can lead to confusion, disputes, and litigation after your death.
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Lack of control planning: The freeze should be structured in a way that allows the original owner to retain control of the business if desired. Improper share structures can lead to an unintended loss of control.
Best Practice: Ensure your corporate lawyer and financial advisor work together to update your will, powers of attorney, and shareholder agreements to align with the new ownership and control structure created by the freeze.
D. Freezing Too Early or Too Late
The timing of an estate freeze is crucial.
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Freezing too early: Implementing a freeze when you still require future growth from the business to fund your retirement or lifestyle needs can leave you with inadequate assets and may compromise your financial security.
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Freezing too late: Waiting too long to freeze your estate allows the value of your assets to continue to grow, which increases the amount of capital gains tax you will eventually owe. The more value that is "locked-in" to the frozen shares, the higher the tax liability on a future disposition or on death.
Best Practice: An estate freeze makes the most sense when you are confident the company will continue to grow in value and you have sufficient personal assets to maintain your lifestyle without relying on that future growth.
E. Overlooking the 21-Year Deemed Disposition Rule for Trusts
Many estate freezes utilize a family trust to hold the growth shares. While this offers flexibility, it comes with a critical tax rule.
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Ignoring the 21-year rule: Canadian tax law dictates that a trust is deemed to have disposed of all of its assets at fair market value on the 21st anniversary of its creation. This can trigger a significant capital gains tax bill if the assets have appreciated in value.
Best Practice: Be aware of the 21-year rule and have a plan to address it well in advance. This might involve winding up the trust, "rolling out" the assets to the beneficiaries on a tax-deferred basis, or paying the tax.
F. Failure to Seek Professional Advice
An estate freeze is not a 'do it yourself' project. The tax, corporate, and family law implications are complex and require specialized knowledge.
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Attempting to do it yourself: Mistakes in the legal documentation, share structure, or tax filings can negate the benefits of the freeze and lead to costly audits or penalties.
Best Practice: An estate freeze requires a coordinated effort from a team of professionals, including an accountant, a corporate lawyer, and a financial advisor. Their combined expertise is essential for a successful, legally sound, and tax-efficient plan..
Given the complexity and potential for severe 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 many 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.
