Estate "re-freezes"
The recent oil price collapse has challenged many businesses, particularly in Western Canada where general economic conditions have slowed considerably or even declined as a result. In many cases, business values have decreased. One of the many things business owners may need to consider in this type of economic environment is whether any estate planning that they may have done before should be re-visited and possibly updated.
Estate freezes
When someone passes away, there is a deemed disposition at fair market value (FMV) of all capital property owned by that person on the date of death (except where property passes to a spouse or common-law partner). As such, any accrued gains in such properties are deemed realized and taxable in the year of death. The tax implications can be significant if no advance planning has been undertaken.
One common planning strategy is an estate freeze, which is possible when an individual owns shares of a private company and the value of the company is expected to increase over time. An estate freeze can be applied to "freeze" the shares at their current market value by exchanging common shares for preferred or "freeze" shares, so that the tax liability triggered upon the shareholder's death is based on the value of the shares when they were frozen.1 Any future growth in the value of the shares will, instead, accrue to other individuals, such as family members of the next generation, through the issue of common or "growth" shares to them or a family trust (i.e., with the family members as beneficiaries). Provided that certain conditions are met, an estate freeze can also allow for income splitting among family members, which can mean substantial tax savings for a family.
Assume, for example, that Derek is the sole shareholder of a small Alberta oil and gas exploration company and undertook an estate freeze five years ago, when the value of the company was $5 million. As a result of that estate freeze, he now owns $5 million of fixed value preferred shares, and the new common, or growth shares, are held by a family trust. Derek passes away 15 years later when his company is worth $15 million. The common shares held by the trust will be worth $10 million, representing the growth in the value of the company since the estate freeze was undertaken. Assuming that the next generation are the beneficiaries of the trust, this estate freeze will have effectively deferred and redistributed the tax liability on that $10 million of new growth.
Estate re-freezes
What if the value of a company decreases following an estate freeze? In this situation, the value of the outstanding preferred/freeze shares could be less than the value of the company as a whole. Using the same example, assume that the value of Derek's company has declined from $5 million to $3 million by 2016, due to the collapse in the oil and gas market. This may present a good tax planning opportunity as Derek could implement an estate re-freeze in order to freeze the value of his shares at the current, lower value. His preferred shares can be "re-frozen" and exchanged for new preferred shares equal to the current $3 million value, with new common shares issued to the family trust. As the new preferred shares have an even lower fixed value, Derek's tax liability upon his death will be lower than it otherwise would have been without the re-freeze. Any future recovery in the company's value (and the ultimate tax liability) will, instead, accrue to the common shareholders.
Another benefit of doing an estate re-freeze is the ability to continue income splitting with family members with no or limited interruptions (again, provided that certain conditions are met). Where income splitting has been achieved via the payment of dividends on common shares held in a family trust and the value of the company has declined below the freeze/preferred share value, the ability to income split may be at risk. To preserve the value of the preferred shares, the payment of dividends on common shares is generally prevented under corporate law where the value of the company would be reduced below the freeze value as a result of the proposed dividend. Instead, a re-freeze at the current lower value would allow the income splitting to continue or recommence sooner than if the original higher freeze value were left in place.
Footnotes
1 Capital assets other than shares (i.e., rental properties, investment portfolios) can be frozen as well, but they must first be transferred to a company. This transfer can often be achieved on a tax-deferred basis.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
