When an individual passes away, there is a deemed disposition at fair market value (FMV) of all capital property owned by the individual on the date of death, including any shares of private corporations that the individual may own. There is an exception to this deemed FMV disposition for any property that passes to an individual’s spouse or common-law partner. The tax implications can be quite severe if no prior planning has been executed. Typically, the implementation of corporate reorganizations including, estate freezes are used for owners who can expect substantial growth in their business or other assets in the future.
What is an Estate Freeze?
An estate freeze refers to the transfer of the future growth in value of a business, investments or other assets into the hands of the subsequent generations. After a properly structured freeze, any future growth in the company’s value will accrue not to the principal shareholder, but to his or her successors, or to a discretionary trust set up as part of the freeze. Family trusts are also useful to facilitate income splitting in some cases.
The estate freeze limits the value and therefore the capital gain (calculated as FMV- Adjusted Cost Base), of the principal shareholder’s (typically, the parents) estate to the value at the date that the freeze was implemented. Any capital gains on the future growth in value after the date of the freeze is deferred. An estate freeze is an effective strategy to implement if an individual believes that the value of their business or other assets are expected to increase over time.
Implementing an Estate Freeze
Alex is a Canadian resident who has been running an active construction business for 15 years. Alex is the sole shareholder, with 100 common shares at an estimated value of $10 million dollars. Due to the booming housing market in Canada, Alex believes that the value of his business will at least double by the time he retires and passes on the reins of his business to his two adult children. As such, Alex has decided to conduct an estate freeze to limit the amount of tax payable on his death.
Alex can implement an estate freeze on a tax-deferred basis using either section 86, 85, and 51 of the Income Tax Act (the Act). This would enable Alex to exchange his common shares for fixed value preferred shares equal to the appraised value of the business. Immediately after the exchange, Alex’s children can subscribe for new common shares of the construction company, or more commonly, a discretionary family trust can subscribe for shares for the benefit of Alex’s children. Once the estate freeze has been implemented, any future growth in the value of Alex’s construction company would accrue to the common shares normally held by the family trust. As a result of the freeze, Alex can quantify the tax exposure on his death.
An estate freeze can also be implemented for individuals who do not own a business, but who may own assets with large accrued gains, or assets which they anticipate will significantly increase in value over time. These individuals can incorporate a company to own these assets. A family trust can then subscribe for growth shares of the newly formed company, which would ultimately hold any accrued gain in the value of the assets. Where a family trust is used, the 21-year disposition rule must be considered and planned for.
Issues to Watch Out For
In order to further reduce the value of assets that are taxable in Alex’s estate upon his death, he can periodically redeem his preferred shares throughout his lifetime. This is known as a wasting estate freeze and is an effective strategy for individuals that want to maintain a certain level of income during retirement. When implementing this strategy, it is recommended that a separate class of nominal value voting control shares be issued in order for Alex to continue to retain control of his company while alive. If this strategy is not implemented, Alex’s control of his company may be eroded over time as he redeems his preference shares.
Another potential issue when undertaking an estate freeze is ensuring that the value of the preferred shares is an accurate reflection of the fair market value of the company at the time of the freeze. This is very important because the Canada Revenue Agency has been known to scrutinize the value of these shares in the past. For this reason, it is typically recommended that an independent valuation of the company be conducted by a qualified business valuator prior to the implementation of an estate freeze. A price adjustment clause in the terms of preference shares should also be included, which, if drafted properly, should avoid a taxable shareholder benefit.
An estate freeze involves a number of issues relating to tax law, corporate law, family law, and possibly trust law. Accordingly, it is always recommended that appropriate specialists be consulted when considering this type of corporate restructuring.