The Estate Freeze: More Than a Tax Minimization Strategy

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Many Canadian business owners follow several strategies to keep their businesses robust including an estate freeze, which can be critical to successful wealth preservation – today and in the future. An estate freeze is a legitimate tax planning strategy under which the owner often gives his or her children shares in a family business. It may result in the gradual transfer of ownership or future growth of a privately held corporation, often to the owner’s children. Business owners set up estate freezes: 1) To transfer future growth of the company from one owner to another, and 2) To limit the capital gains tax for the business owner who is transferring his or her shares to someone else. Both events happen simultaneously.

Owners usually consider a full estate freeze, based on the extent to which they want to maintain a financial interest in the business, and their cash flow needs in the immediate future.

In an estate freeze, capital assets, whose continued growth creates mounting tax and succession planning issues, are exchanged for similar assets that are fixed in value. Business owners may trigger an estate freeze when there is sufficient equity in the business to support their lifestyle. They “freeze” the value of their shares at current levels while deferring taxation on future business growth to the next generation. Since they can accurately price the value of the frozen shares, the owner will know exactly how much tax will be payable in the future.

Problems can arise when owners deploy an estate freeze solely to minimize taxes. An estate freeze can certainly make it easier for a business owner to pass on his or her company to the next generation or to an employee or group of employees. However, with the guidance of a lawyer, owners should consider broader wealth management issues and family dynamics before setting a freeze in motion. For example, a lawyer can help to ensure that prudent shareholder agreements are in place. He or she can also help to maintain a balanced approach to planning the estate, especially when only one of several children is identified as the beneficiary of the estate freeze.

Or, if there is acrimony among family members (or business employees) who may wish to take over the business, owners need to rethink their estate freeze strategy. This is because the value of the transferred company is fixed at the time of sale, and no tax relief is available if the value later declines. It’s important to transfer assets that are more likely to appreciate. For example, land and buildings are good choices; operating companies relying largely on human capital and the provision of services are not.

Regardless of the nature of the business and family dynamics, well written agreements among the preferred shareholder (the owner) and the common shareholder(s) (family members) are essential. This is where legal advice is again vital to an estate freeze process and outcome. In addition to helping to create a technically sound freeze, a lawyer can also assess the possible outcome of the freeze from an estate planning and family law perspective – potentially saving owners and their families stress, time and money.

In its simplest form, here is how an estate freeze works.

Richard owns 100% of his jet ski business, Ski Rich. He has just turned 63 and is considering an estate freeze to defer the tax he will otherwise be required to pay now.

Richard wants to stay involved in the business and needs the income to pay for his winter sunshine and boating trips. He does a full freeze and transfers 100% of the growth in Ski Rich to his son, Blair, and daughter, Terry.

He incorporates a holding company, “Richco,” and issues 50% (each) of the common shares (all with nominal value, as Richco has no assets or income) to Blair and Terry.

Richard then transfers his common shares in Ski Rich to the holding company, in return for preferred shares. This transfer will occur tax-free (under the rollover provision of section 85 of the Income Tax Act) as long as the value of Ski Rich’s preferred shares is equal to the value of the common shares of Richco.

Richard arranges for the preferred shares he receives from Richco to have a fair market value of $7 million. Any future increase in the value of Ski Rich, which is owned by Richco, will be reflected in the common shares of Richco. This structure will allow these common shares to be divided equally among family members.