Estate Planning

Estate Freeze Overview

An estate freeze is a way to cap (or freeze) the current value of an individual’s shares in a private company, while preventing further growth in the capital gains tax liability that will result on the disposition of those shares (either while the shareholder is alive or upon death). The result is that that the individual has frozen (or crystallized) their tax liability at that point in time. Generally, any future growth in share value (as well as any resulting capital gains liability) will accrue to newly issued shares held by the next generation.

The estate freeze transaction typically involves shareholder exchanging common shares in their company for fixed value preferred shares, which takes place on a non-taxable basis. The value of the preferred shares is equal to the value of common shares at the time of the freeze and will not grow in value. At the same time, new common shares are issued by the company, often to a family trust for the benefit of the next generation. The “freezor” will typically remain in control of the company, either through voting rights attached to the preferred shares or through a separate class of voting shares. The family trust will normally own non-voting common shares.

The estate freeze transaction essentially splits the current and future value of the company into separate component. The current value of the company becomes locked in or “frozen” with the newly created preferred shares which are owned by the initial shareholder(s). The future growth of the company will now accrue to the newly issued common shares.

 

As shown in the chart, the company originally issued common shares to the business owner. When the estate freeze takes place, the value of these original common shares become locked-in at their current value and that value is reflected in the newly issued fixed value preferred shares. The new common shares are issued at a nominal value to the family trust. As the company grows in value, this value will be captured in the value of the new common shares. In some cases, new common shares may be sold to the family trust (instead of issued from treasury) in order to maximize other tax planning objectives.

Valuation of Shares

The common shares that are to be frozen in value will need to be appraised prior to their conversion into the fixed value preferred shares. Although a formal valuation is not technically required, a valuation expert (such as a Certified Business Valuator) is typically retained to determine the value of the corporation and various classes of shares. This will reduce the possibility that the Canada Revenue Agency (CRA) dispute the value of the fixed value preference shares in the future. Where a reasonable attempt has been made to value the shares, the CRA will respect a price adjustment clause included as part of the freeze. This can help to avoid any adverse tax implications should the CRA successfully dispute the value of the preferred shares in the future.

Estate Freeze and Spousal Trusts

The newly issued preference shares will have an inherent capital gain equal to the excess of the fair market value of the shares at the time of the freeze and the adjusted cost base of the shares (which may have been increased by utilizing the shareholder’s lifetime capital gains exemption). If on death, the business owner transfers the shares directly to his or her surviving spouse or through a spousal trust in a Will, the preferred shares will be transferred to the survivor on a rollover basis and no tax will be triggered. The inherent capital gains tax liability associated with the frozen preferred shares can therefore be deferred until the second to die of owner and spouse.

Funding the Tax Liability

The freeze transaction also creates certainty as to the capital gains tax liability associated with the preferred shares. If the disposition of these shares takes place on death, this tax liability can be funded in one of three ways; by using cash or selling assets in the estate or company, by borrowing from a bank, or through life insurance on the life of the business owner or jointly on the owner and spouse. The preferred shares may also be gradually redeemed during the lifetime of the owner and spouse. However, this approach triggers dividend tax treatment, which currently results in an overall tax liability that is significantly higher than capital gains tax rates. There is also the potential for the expanded tax on split income rules to apply in certain situations, which ensure the dividends are taxed at the highest marginal tax rate. The TOSI rules are explained in more detail here.

New Common Shares

A trust is treated as a separate taxpayer and will be taxable on any income or capital gains that it retains at the top marginal tax rate. However, income distributed to beneficiaries will typically be taxable to the beneficiaries at their marginal tax rate, and certain income such as taxable dividends and capital gains will retain their tax character. Subject to the possible application of the tax on split income (TOSI) rules, this will permit income splitting and possible multiplication of the lifetime capital gains exemption.

However, if the trust is not a life interest trust, the trust will be deemed to have disposed of its capital property every 21 years and any gains will be taxed to the trust at the top marginal tax rate. This can be avoided by distributing trust assets (i.e. the common shares) to the beneficiaries of the trust prior to the end of the 21-year period. Provided such beneficiaries are residents of Canada, the transfer of trust property can take place on a rollover basis.

If the trust is a life interest trust, the 21-year deemed disposition rule will be deferred and there is no deemed disposition of property until the death of the life interest beneficiary. Subsequently, if the trust is maintained, the 21-year rule will start to apply as of the date of death of the life interest beneficiary.

In the next sections you will learn about:

  • Types of Freezes:  Freezes are generally done by way of (1) internal freeze; (2) holding company freeze. Each option has issues which need to be considered.
  • General Advantages of Estate Freezes:  This includes many tax advantages during life and after death.
  • Serial redemptions (Wasting-away freezes):  This can be a useful way to structure an estate freeze, depending on the circumstances.
Recap – Objectives of an Estate Freeze
  1. To limit the capital gains tax liability associated with private company shares that are expected to continue to grow in value.
  2. To utilize the lifetime capital gains exemption of the shareholder to offset current gains.
  3. To defer future capital gains tax liability to the next generation of shareholders, typically through a family trust.
  4. To allow the current owners to maintain control over corporation during their lifetime.
  5. Allow the next generation (children, grandchildren) to participate in the growth of the business and eventually assume control of the corporation.