Tax Articles
Chill Out During the Downturn with an Estate Freeze
Dianne McMullen
Enterprise
July 2009
“With adversity, comes opportunity.” Admittedly, this may sound trite if the recession has slowed business for your company and reduced its value. But at the same time, an economic downturn can provide opportunities to save future taxes for your family.
If you intend to pass along some of the value you have created in your business to your children or other family members through your estate, by freezing the value of your estate now, your intended beneficiaries can benefit from the future growth in value of the business – and have cash available to pay the inevitable tax bill. An estate freeze effectively locks in the tax that will arise on your death and therefore allows you to pre-determine this tax so you can ensure that your family or other beneficiaries will have cash available to pay for it.
There are many ways to accomplish an estate freeze. One common method is to transfer the assets you want to freeze to a corporation. By taking back fixed value shares (usually preferred shares), this transfer can be accomplished on a tax-deferred basis using special rollover provisions in our income tax rules. Your beneficiaries can then subscribe for the growth shares (usually common shares) of the company. At the time of the estate freeze, the value of these common shares would be nominal, as the value of the property you are freezing has been incorporated into the value of your preferred shares. However, as the assets in the company grow in value, the value of the common shares will also grow. You can continue to control the assets in the company by ensuring that you can outvote the common shareholders. Control can also be achieved through the use of a family trust.
If you already hold the common shares of an incorporated business, there are two main estate freeze options. First, you can use a holding company freeze by simply transferring the shares of your corporation to another corporation, in exchange for preferred shares. Alternatively, you can reorganize the share capital of your existing corporation to accomplish the freeze. Under this scenario, you would transfer your common shares back to your corporation in exchange for preferred shares. Your beneficiaries could then subscribe for new common shares.
In the current economic environment, a holding company freeze can provide additional benefits. If your business corporation has funds that are not currently needed to operate the enterprise, the business corporation can pay these funds tax-free to a holding company. This ensures the funds are isolated from future business risks.
If your beneficiaries continue to hold the common shares after your death, taxes will also be deferred. Even if they sell the property, however, each beneficiary can shelter from tax up to $375,000 of taxable capital gains of the shares of a qualified small business corporation.
If you are not yet ready to decide who will inherit your estate, a discretionary family trust can enable you to set aside property – without having to immediately decide who should inherit it. The family trust would buy the common shares after you have received preferred shares in exchange for your property. Future appreciation would accrue to the beneficiaries as a group, and not to you. When the time is right, the common shares can be transferred from the trust to the beneficiaries without triggering a tax liability.
There may also be other benefits to an estate freeze, such as income splitting. If you already have a corporation and you want to split income with other family members, you can freeze the value of the corporation so that family members can buy common shares at an affordable price using their own money.
As well, where probate fees are an issue, freezing the value of a corporation will also lock in the probate tax on death. In Ontario, with proper will planning, transferring assets to a corporation can ensure that no probate tax will be payable.
If you want to participate in some of the future growth of your company, you can also do a partial estate freeze. Under this option, once the value of the assets has been frozen as an interest in preferred shares, you can subscribe for some of the new common shares along with other family members. This will ensure that you benefit from future growth while still deferring tax on some of that growth. In the future, once you are satisfied that you have accumulated enough value based on the preferred shares and your new common shares, you can freeze again to exchange your common shares for additional preferred shares.
As well, if you later discover that you need some of the accrued value, it may be possible to freeze the common shares held by your family and then all of you can subscribe for new common shares. This would enable you to participate in the growth that accrues after this freeze.
Keep in mind too, that it is possible to “defrost” a freeze. Provided that a family trust is used to hold the common shares for your family, you can usually undo a freeze by naming yourself or your spouse as a beneficiary of the trust.
So take the chill out of this frigid economic environment by checking out the merits of an estate freeze for yourself, your business and your family.
Dianne McMullen, FCA, TEP, CFP, is the tax business line leader for the large market region (Vancouver, Calgary, Toronto, Montreal) of BDO Dunwoody LLP (www.bdo.ca). She assists business leaders and professionals with a range of taxation issues including corporate and partnership reorganizations, mergers, sales and acquisitions, and retirement and estate planning. You can reach Dianne in the Toronto office at (416) 369-3095 or dmcmullen@bdo.ca.
