Advantages of Estate Freezes and Issues to Consider
Tax Advantages at Death
1. The value of the preferred shares are frozen at the time of freeze. As such, the tax liability associated with those shares is also frozen at a point in time and can be quantified. Over time, as the value of the company continues to grow, all future growth is shifted to the common shareholders which are typically owned by a trust with the children and grandchildren as beneficiaries. The parent who has frozen his/her tax liability will retain control through the preferred shares (or through a separate class of voting shares) but will not be subject to the tax liability associated with the future growth in value of the common shares. This makes it much easier for the person undertaking the freeze to plan for future tax liability associated with their frozen shares, because the value will not increase. If for any reason, the person who undertook the freeze wishes that the share growth common shares are returned them in the future, this can be achieved provided that they are included as aof the trust.
2. Since the person undertaking the freeze has a known future tax liability that will arise on death, they can plan in advance as how this liability will be funded. There are two main ways of planning for this liability:
Self-Funding: The tax liability on the preferred shares can be self-funded. This means using either cash or selling assets to fund the tax. Selling assets means that the most liquid and thus most valuable assets will be sold. The sale of assets may also create additional tax liabilities. For instance, there may be capital gains tax on the sale of the assets and there may be dividend tax to withdraw the funds if the assets are owned corporately. Also, in some cases, the assets (such as private company shares) may be very valuable but not very liquid and therefore not easily sold. Ultimately, where assets are used to fund the tax liability, the estate will be depleted by an amount equal to the amount of the tax.
- Life Insurance: Life insurance is a more attractive option than self-funding. Using life insurance ensures that funds will be available at the time of death regardless of when that is, and it will not give rise to the additional tax liabilities that can arise on a forced liquidation of other assets. As well, life insurance can create a unique opportunity to not only fund the tax liability at death, but also with the creation of capital dividend account, it can be used to reduce overall tax liability of the estate. Finally, given the special tax treatment that life insurance products receive, it provides for a very attractive internal rate of return. For more information, see the Life Insurance and Estate Planning Section.
Tax Advantages during Lifetime
1. During the freezor’s lifetime, income can be split amongst the different shareholders (typically through a trust), depending upon the dividend attributes of the various classes of shares. Where spouses and minor children/grandchildren are included as shareholders or beneficiaries of a trust, complex tax rules need to be considered.
2. Wasting Away Freezes (otherwise known as Serial Redemptions) might be implemented to tax-effectively generate income to the shareholder and reduce the overall tax liability at death. The effectiveness of this type of planning will depend on the prevailing tax rates and tax attributes of the company. An annual review of the strategy is required.
Timing Issues – some things to think about
When it might be a good time to undertake a freeze:
- If circumstances arise, for instance, a downturn in the economy, which temporarily reduces the value of the shareholder’s equity interest (common shares) in the corporation. This is a good time to freeze because the inherent tax liability will be frozen at the lower value.
- If the shareholder has sufficient value outside the shares so as to not need the future growth in the corporation.
- Where it is likely the value of the company will increase over time.
- If there are family members (or possibly key employees) working in the business that want an equity interest.
- If the freezor thinks they might want to retain the possibility of some equity interest going forward, the freezor should be included as a beneficiary of a discretionary trust.
- If someone has already done a freeze and the value of the company has dropped since the original freeze, they might consider a “refreeze”. This would allow for a lower freeze value and lower tax liability.
- If the shareholder is planning to take advantage of an insurance strategy to reduce the tax liability on the freeze shares at death, the age and health of the shareholder might need to be considered when determining a good time to freeze.
When it might NOT be a good time to undertake a freeze:
- If the shareholder is still young enough so as to not be able to reasonably anticipate costs and liability that might still arise in the future.
- If the intended common shareholders, namely the person's children who will be the beneficiaries of the trust, are so young that when the shares are distributed because of the 21-year rule, the children will still be too young to receive the shares.
- For Example: If the children are currently 5 and 7 years old when the freeze is undertaken, then that means they will receive common shares at ages 26 and 28, which may still be too young to receive a large amount of wealth.