This blog provides an overview of Estate Freezes, what an Estate Freeze is, the tax and non-tax benefits, and the negative consequences of freezing too early.
What is an Estate Freeze?
Estate Freezing is a popular mechanism used in estate and succession planning for an owner-manager of a privately-held corporation. An "Estate Freeze" is a reorganization aimed at fixing the value of the shares of a privately held corporation held by a particular taxpayer, generally referred to as "the freezor." This allows any future growth in the value of the privately held corporation to be attributed to other individuals, usually the children and other family members of the owner-manager or a family trust.
Generally, an "Estate Freeze" involves the owner-manager exchanging their common shares of the privately held corporation for fixed-value preference shares that are equal to the fair market value of the corporate entity at that time. Through this exchange, the value of the privately held corporation becomes frozen in the preference shares held by the owner-manager. As the company grows in value, the additional value will be attributed to the new owners of the growth shares. The overall effect of an Estate Freeze is to pass the growth in value of the privately held corporation to either the children or other family members of the owner-manager or a family trust.
Tax and Non-Tax Benefits of an Estate Freeze
Some of the tax and non-tax benefits of implementing an Estate Freeze are:
- minimizing or deferring capital gains upon death;
- income-splitting opportunities; and
- multiplying the use of the lifetime capital gain exemption ("LCGE").
(a) Minimizing or deferring capital gains upon death
When implementing an Estate Freeze, minimizing or deferring capital gains upon death is possible since an Estate Freeze enables the freezor to avoid paying capital gains tax on the entire amount of the future increase in the corporation's value which would otherwise occur on death.
(b) Income Splitting Opportunities
By having family members or a family trust subscribe for the common shares of a corporation, an Estate Freeze allows for the splitting of income among family members in appropriate circumstances. However, it is important to note that the ability to split income remains subject to various attribution rules and which need to be considered carefully when implementing an Estate Freeze.
(c) Multiplying the use of the lifetime capital gain exemption ("LCGE")
A significant tax break is provided on capital gains that are realized on the disposition of certain private shares known as Qualifying Small Business ("QSBC") shares. The LCGE is available to individuals who dispose of such shares.
In making a decision to freeze, the freezor should consider both the present capital gain and future capital gain of the business. If the value of the business increases beyond the amount of LCGE available to the freezor, the freezor may consider implementing an Estate Freeze to transfer some of the growth to the freezor's family members so that the family members may claim the LCGE during their lifetime when they dispose of the shares (assuming the shares are still considered QSBC shares). An Estate Freeze allows for the LCGE to multiply on the shares of a privately held corporation.
When an Estate Freeze Should (and Should Not) be Implemented
The implementation time of an Estate Freeze depends on the type of freeze and the motivation behind it.
A "traditional type" of Estate Freeze where a full freeze is made directly by the freezor in favour of their children with the intention to purely shift all of the future growth to the next generation should only be undertaken after careful consideration. Such an Estate Freeze should be implemented when the value of the preference shares issued to the owner-manager/parent represents enough value to fund the owner-manager/parent's eventual retirement. The relevant questions to consider when implementing this type of freeze are:
- is there enough value in the shares to consider a freeze;
- breakdown in the family;
- unexpected sale; and
- if a family trust is used, consideration to the 21 year rule.
(a) Is there enough value to consider a Freeze?
A major question or concern that arises when implementing an Estate Freeze is whether there is enough value in the corporation that will allow for the owner-manager to retire with ample financial independence. If an estate freeze is implemented too early, there may not be enough value in the corporation and the owner-manager may not be able to retire because there is a lack of value present to allow the owner-manager to live comfortably after retiring.
There may be a possibility of "thaw" or "re-freeze" of the corporation to re-introduce the parents into the ownership of growth shares; however, many detailed tax considerations need to be taken into account before thawing out a previously implemented Estate Freeze. Such a "thaw" may require the co-operation of the children and other family members.
(b) Breakdown in the Family
If an owner-manager decides to implement an Estate Freeze with the hopes that their business will be carried on by the next generation, this plan may backfire if their children decide not to be involved in the business or otherwise become estranged from the family. If not done correctly with appropriate agreements in place, the result of a freeze can allow control to pass to children and/or their partners. Some of this can be alleviated by designing share rights appropriately or using a family trust which may allow the freezor to continue to control the growth shares even though the growth has passed to the next generation.
(c) Unexpected Sale
When a freeze is completed either directly or through a trust, the new shareholders or the beneficiaries of the trust have ownership rights of future growth. If a sale happens in advance of when this is expected, this can result in significant wealth going to the growth shareholders prior to when the freezor would have intended. Some of this risk can be mitigated by creating the right classes of beneficiaries in a family trust.
(d) Consideration of the 21 year rule and Family Trusts
In some instances, an Estate Freeze is implemented where the growth shares of the business are held by a Family Trust. This is usually done by the freezor since their children are too young to be actively involved in the business. The growth shares are kept in a family trust until the children become of age, or they decide to become involved in the business. However for many reasons, children may decide that they are not interested in running the business and the growth shares may remain in the trust for an extended period of time.
After the 21st anniversary of the trust's creation, the trust will dispose of any assets held by the trust and trigger a capital gain on such distribution. Therefore, if a family trust is used in a Estate Freeze, it is important that the shares be distributed from the trust before the 21st anniversary as to prevent this capital gain. This may mean that shares held by the trust can end up in the hands of the beneficiaries prior to the freezor being ready for this to occur. Consideration should be given to ways to mitigate this risk when considering a freeze.
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.
