Estate Freeze Overview
An estate freeze is a way to lock (or freeze) the current value of an individual's shares in a private company that has accumulated in value during their lifetime. The objective of the estate freeze is to prevent further capital gains tax liability from accruing to the individual, the result being that the individual has frozen (or crystallized) their tax liability at a point in time. Generally, the estate freeze allows any future increase in the capital gains tax to accrue to the next generation, usually through an inter vivos family trust.
The estate freeze transaction allows a shareholder to exchange the common shares they own in their company for fixed value preferred shares with value equal to the common shares. The new preferred shares will be fixed amount, in other words frozen, and as such they will not increase in value into the future. At the same time, new common shares are issued by the company, typically to a family trust for the benefit of the next generation. The "freezor" will typically remain in control of the company, either through the preferred shares or through a separate class of voting shares. The family trust will typically own non-voting common shares.
The estate freeze transaction essentially splits the value of the company into two parts. The first part of the transaction is related to the current value of the company, which becomes locked in or "frozen" with the newly created preferred shares which are owned by the initial shareholder(s). The second part is the future growth of the company, which will now accrue to the newly issued common shares. These new common shares will be owned by someone or some entity other than the person who owns the "frozen" preferred shares and they will benefit from the future growth in the company. In most cases, the new common shares will be owned by a family trust.
A key element of the freeze transaction is to transfer future growth to the next generation, while also maintaining control of the company with the patriarch or matriarch undertaking the freeze.
Primary Objectives of an Estate Freeze
- To limit and cap the capital gains tax liability associated with an asset (such as private company shares) that is growing in value.
- To defer future capital gains tax liability to the next generation, typically through a family trust.
- To allow the current owner to maintain control over the asset during their lifetime.
- Allow the next generation (children, grandchildren) to participate in the growth of the business.
Why do an Estate freeze?
An estate freeze is typically undertaken by one or both parents that own shares in a company that they either founded during their lifetime or they themselves inherited. Assuming that the value of their shares has grown in value since they founded or received the shares, there may be a desire to limit the future tax liability that will arise on their death, as a result of the deemed disposition that occurs on death, which will create capital gains tax.
Valuation of Shares
The shares that are to be frozen in value and converted into fixed value preferred shares will have to be valued at the time of the freeze. Although a formal valuation is not technically required, a valuation expert (such as a Certified Business Valuator) is typically retained at the time of freeze to support the value and to reduce the chance of dispute in the future with CRA surrounding the valuation of the fixed value preferred shares. Another reason to engage a valuation expert is to support the fact that a reasonable attempt at valuing the shares has occurred. Where a reasonable attempt at valuing the shares has taken place, the CRA will respect a price adjustment clause included as part of the freeze. This can help to avoid any adverse tax implications should CRA dispute the value of the preferred shares in the future.
Estate Freeze and Spousal Trusts
If the original shares were owned by the father, he may undertake the estate freeze and thereby receive the newly issued fixed value preferred shares (the frozen shares), which an inherent capital gain equal to the excess of the fair market value of the shares at the time of the freeze and the adjusted cost base of the shares. If on death, the father transfers the shares directly to his spouse or through a spousal trust in his Will, the preferred shares will be transferred to his wife tax free on his death (assuming that he pre-deceases her). The result being, that the tax liability associated with the frozen preferred shares will be deferred until the second to die of mother and father.
Funding the Tax Liability
The freeze transaction provides certainty as to the capital gains tax liability associated with the preferred shares owned on the last to die of the parents. This eventual tax liability can be funded in one of three ways; by using cash or selling assets in the estate or company, by borrowing from a bank, or through life insurance existing at the time of death. In anticipation of the capital gains tax liability, the preferred shares can be redeemed during the lifetime of the father or mother, however this approach may or may not be tax effective depending on the prevailing dividend tax rates at the time of the redemptions.
New Common Shares
The common shares issued as part of the estate freeze are typically issued to a Family Trust with the beneficiaries of this Trust being the parents, children, grandchildren. We also typically include a corporate beneficiary of the Trust, which can serve to achieve other tax planning objectives, such as "purifying" an operating company of its excess cash such that eligibility for the capital gains exemption is maintained. During the first 21 years of the Trust, there will be no capital gains (see above) tax liability on the value of the common shares should one or more of the beneficiaries of the Trust die. The creation of the Trust also allows for other tax planning opportunities, such as allowing for other family members to participate in the growth of the new common shares of the company, thereby creating the ability to income split and multiply opportunities to use the capital gains exemption.
In this section you will learn about:
- Types of Freezes: Freezes are generally done by way of (1) internal freeze; (2) holding company freeze. Each option has issues which need to be considered.
- General Advantages of Estate Freezes: This includes many tax advantages during life and after death.
- Serial redemptions (Wasting-away freezes): This can be a useful way to structure an estate freeze, depending on the circumstances.