Take Advantage of the Downturn: Revisit Your Estate Plan
The recession that we’re currently facing is creating challenges for all of us. For the business owner, business may have slowed, and the value of their corporation may have declined. For individuals with investment portfolios, they have also experienced adversity as investment prices have fallen.
Despite these conditions, the current environment is a positive one for two key tax planning ideas. First, in the last edition of the Tax Factor (and a subsequent BDO Tax Alert), we pointed out that now is the perfect time to consider splitting income with family members using prescribed rate loans due to unprecedented interest rate reductions. It is now possible to lend money to a family member with interest at 1%, and the loaned funds can be used by a family member to buy income producing property without income attribution.
The second key tax planning opportunity now available is to either establish an estate plan, or revisit the estate planning that you established in the past. In a nutshell, it may be possible to freeze the value of your estate at current levels so that the value recovery that will come will accrue to other members of your family. The key tool that makes this work is an “estate freeze”.
What is an estate freeze?
When an individual dies, they are deemed to dispose of most of their assets for tax purposes at their fair market value (subject to a rollover to a spouse or, in the case of farm property, to a child). For capital property, this means that all accrued capital gains will be taxed. If you own depreciable property such as a rental property, depreciation that you claimed in the past will be included in your income assuming that the current fair market value of the property exceeds its original cost.
For most individuals, the tax arising on these deemed dispositions will represent a significant tax cost on death. Consequently, one of the main goals of estate planning is to minimize these taxes where possible. Also, once you’ve minimized the tax bill, the next step is to try to defer the tax payment for as long as possible. An estate freeze can help on both fronts.
An estate freeze is a process where you take steps to ensure that the future growth of your estate accumulates in the hands of your intended beneficiaries. By freezing the value of your estate, you will effectively lock in the tax that will arise on your death (subject to changes in tax rates in the future). Consequently, an effective estate freeze will allow you to pre-determine the taxes that will arise on your death so that you can ensure that cash will be available to pay that tax (for example, by taking out sufficient life insurance).
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 have an incorporated business where you hold the common shares, there are two main estate freeze alternatives. First, you can use a holding company freeze by simply transferring the shares of your corporation to another corporation, as we just discussed, 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.
Although there would be a number of factors to discuss with your BDO advisor, a holding company freeze can provide additional benefits that are well suited for the current economic environment. If your business corporation has funds that are not currently needed in the business, these funds can be paid by the business corporation to a holding company on a tax-free basis. This will help ensure that the funds will be isolated from future business risks that may arise in the business corporation without a tax cost. It may even be possible to take this planning one step further by borrowing to pay a larger dividend to the holding company and loaning the funds back to the business corporation on a secured basis to pay off this loan.
Before undertaking an estate freeze, you should carefully consider whether you will have enough assets to live on without the future growth of the frozen assets. It is possible to structure the freeze so that you can reclaim future growth, but this will usually undo the value provided by the freeze.
What if I’m not sure whether a full estate freeze makes sense?
If you are unsure whether now is the right time to freeze the value of your assets, keep in mind that there are other options, such as:
- 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 participate in future growth while still deferring tax on some of the 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.
- Freeze the value of common shares later if necessary – If you do discover that you need additional wealth later, it may be possible to freeze the common shares held by your family and then all of you can subscribe for new common shares, so that you can participate in growth accruing after this freeze.
- Thaw the freeze – Provided that a family trust is used to hold the common shares for your family, it may be possible to undo a freeze in the future by naming you or your spouse as a beneficiary of the trust.
How does an estate freeze reduce or eliminate tax?
As we have just discussed, an estate freeze allows you to lock in the value of your investments, which in turn means that the capital gain on death that you will face will also be locked in at current levels. This means that future growth will accrue for the benefit of other, younger family members. A tax deferral will be achieved if they continue to hold the common shares after your death.
When deciding on whether an estate freeze makes sense, there is one key issue to consider: will your family continue to hold the property in question, or will they sell it when you pass away? If your family will sell the property, then this will reduce or eliminate the tax deferral benefit.
However, even if the property in question will be sold, it is important to remember that an estate freeze will allow you to multiply a key tax reduction tool — the capital gains exemption. If the shares of your corporation are shares of a qualified small business corporation or are qualified farm property, you can shelter up to $750,000 of gains ($375,000 of taxable capital gains) from tax by claiming the exemption. Each member of your family can be eligible provided that they realize appreciation as a shareholder.
Does an estate freeze provide other benefits?
In addition to the tax deferral benefit and the ability to multiply the capital gains exemption, an estate freeze can provide other benefits, such as:
- Income splitting – If you already have a corporation and you want to split income with other family members, a common first step is to freeze the value of the corporation so that family members can buy common shares at an affordable price using their own money.
- Probate tax planning – Where probate fees are an issue, freezing the value of a corporation will also lock in the probate tax on death. In Ontario, transferring assets to a corporation can also ensure that probate tax will not be payable at all with proper will planning.
I like the idea of an estate freeze, but I don’t want my family members to hold shares of my corporation right now. Is there an alternative?
Yes there is. One common concern for most business or portfolio owners is losing control over the property that they want to freeze. Another issue is that the current owner may like the concept of transferring future asset appreciation to the next generation in general, but they are not ready to decide now on who specifically should get this future growth. A discretionary family trust is a tool you can use to deal with both issues.
The main advantage of a trust is that it allows you to separate the control and management of an asset from its ownership. This fact makes trusts a powerful tool. How is this accomplished? It all stems from the legal arrangement involved in setting up a trust and the tax rules that apply to them. A trust is a legal relationship between three different parties. First, there’s the settlor of the trust. This is the person who sets up the trust and contributes assets to it. The settlor also sets out instructions on how the assets are to be used or managed and who will benefit from them. These instructions are set out in the trust agreement. Next, the person (or group of persons) the individual appoints to control and manage the assets in the trust is known as the trustee(s). Finally, there’s the person, or group of persons, who will benefit from the assets owned by the trust. They are known as the beneficiaries. Most family trusts are discretionary, which means that the trustee can decide at a later date who will benefit from the trust capital and income.
When you combine the legal and tax aspects, a family trust essentially allows you to set aside property for a group of beneficiaries under the care of a trustee and you can decide later who gets the property. In the context of an estate freeze, it will be this family trust that buys the common shares after you have received preferred shares in exchange for your property. Future appreciation will accrue to the beneficiaries as a group, and not to you. Once you are ready, you can transfer the common shares from the trust to the beneficiaries without triggering a tax liability.
There is a catch to this planning — a family trust will be deemed to dispose of its property after 21 years. Therefore, you will need to keep this in mind when you set up the trust, and the key question will be whether you’ll be ready within 21 years to split up the common shares and transfer them to your beneficiaries on a tax-deferred basis.
I have already frozen my estate and set up a family trust. However, the value of my company is now lower. Is there anything I can do?
If you have already done an estate freeze, there is usually no reason why you can’t freeze again. Many refer to this as a “refreeze”. Although we won’t go through the details of how you can accomplish a refreeze, what it effectively allows you to do is replace the estate freeze preferred shares you now hold with new preferred shares that are worth the current reduced value of the corporation. It may also be necessary to take back the common shares your beneficiaries hold, and issue new shares to them. The specific steps will vary, and you can discuss this with your BDO advisor. One key point when refreezing is to have documented reasons why the value of the corporation has declined in the form of a valuation.
An estate refreeze can produce a number of benefits that include:
- Increase/accelerate access to the capital gains exemption – Under the original freeze, any value recovery on a go forward basis will generally accrue to the preferred shares until the value of the company reaches the redemption value of those shares. If you refreeze, the value recovery after the refreeze should accrue to the common shares owned by family members. This will increase the gain that will qualify for the capital gains exemption, and will allow an earlier exemption claim if the shares are sold.
- Tax liability on death can be locked-in again at a lower amount – Once you have frozen your holdings at the current lower value, this will mean that the gain that will be taxable on death will be lower.
- Defer the 21-year rule for trusts – As part of your refreeze, you can wind up the family trust that you used for the original freeze, and set up a new family trust. The new trust won’t have a deemed disposition of its property until 21 years after the date of the refreeze. Even if the value of the corporation has increased, a second freeze with a new trust can provide a longer tax deferral on future growth.
Although tax planning may not be at the top of your mind under the current economic conditions, this is an excellent time to set up or update your estate plan. Please keep in mind that we have discussed the issues involved in general terms, and specific tax advice is needed. Your BDO advisor is ready to help you with every step along the way.
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