Advantages of Estate Freezes and Issues to Consider
Tax Advantages during Lifetime
- During the freezor’s lifetime, it may be possible to split business income and capital gains among the different family shareholders (typically through a trust), providing access to the marginal tax rates. However, the income attribution and tax on split income (TOSI) rules need to be considered when attempting to income split with family members through a corporation.
- Wasting Freezes (otherwise known as Serial Redemptions) might be implemented to generate retirement income to the shareholder and reduce the overall tax liability at death. The effectiveness of this type of planning will depend on the prevailing tax rates and tax attributes of the company. An annual review of the strategy is required.
Tax Advantages at Death
- The value of the preferred shares will not increase after they are frozen. As such, the tax liability associated with those shares is also fixed and determined at that point in time. This makes it much easier for the person undertaking the freeze to plan for the future tax liability associated with their frozen shares. If for any reason, the person who undertook the freeze wishes to share in the further growth of company, this can be achieved by having that person (or his or her spouse) included as a beneficiary of the trust. After the estate freeze, while the value of the company may continue to grow, any future growth is shifted to the common shareholders, which are typically the children and grandchildren of the business owner(s).
- Since the person undertaking the freeze has a pre-determined future tax liability that will arise if the shares are held until death, advance planning can be undertaken as how this liability will be funded. There are two main ways of planning for this liability:
- Self-Funding: The tax liability on the preferred shares can be self-funded. This means using either available cash in the estate or the estate selling assets to fund the tax. Selling assets often means that the most liquid and thus most valuable assets will need to be sold. Depending on the current economic environment, these assets may have to be sold at a discount to raise the needed capital. The sale of assets can also result in additional tax liabilities. For example, there may be capital gains tax triggered on the sale of assets and/or there may be dividend tax payable where funds are withdrawn from the corporation. In some cases, the assets to be liquidated (such as private company shares) may be very valuable but not liquid and therefore not easily sold. Ultimately, when assets are used to fund the tax liability, the estate will be depleted.
- Life Insurance: Life insurance is often a more attractive option than self-funding. Using life insurance ensures that funds will be available at the time of death, and it will not give rise to the additional tax liabilities that can arise on a forced liquidation of other assets. As well, life insurance can create a unique opportunity to not only fund the tax liability at death but can also be used to reduce overall tax liability of the estate via the capital dividend account. Finally, given the special tax treatment that life insurance products receive, it provides a very attractive internal rate of return. For more information, see the Life Insurance and Estate Planning Section.
Timing Issues – some things to think about
It might be a good time to undertake a freeze if:
- circumstances arise, for instance a downturn in the economy, which temporarily reduces the value of the shareholder’s equity interest (common shares) in the corporation. This is a good time to freeze because the inherent tax liability will be frozen at the lower value.
- If the shareholder has sufficient assets and capital values (including the current value of their shares) and will not require the future growth in the corporation to maintain their standard of living.
- Where it is likely the value of the company will increase over time.
- there are family members (or possibly key employees) working in the business that deserve to have an equity interest.
- If the freezor thinks they might want to share in the future growth of the company, that person (or his or her spouse) could be included as a beneficiary of a discretionary trust.
- If someone has already completed a freeze and the value of the company has dropped since the original freeze, they might consider a “refreeze”. This would allow for the issue of new preference shares at a lower freeze value and consequently a lower tax liability arising from a deemed disposition on death.
- If the shareholder is planning to take advantage of an insurance strategy to reduce the tax liability on the freeze shares at death, the age and health of the shareholder might need to be considered when determining a good time to freeze.
When it might NOT be a good time to undertake a freeze:
- If the shareholder is still young and not in a position to reasonably anticipate costs and liabilities that might still arise in the future.
- If the intended common shareholders, namely the person’s children (who are beneficiaries of the family trust), will still be relatively young if the common shares need to be distributed because of the 21-year rule.
For example, if the children are currently 5 and 7 years old when the freeze is undertaken, this means they will receive common shares from the trust at ages 26 and 28, which may still be too young to receive a large amount of wealth.