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.

  • Year 1: Ownership structure before the estate freeze. A Father and Mother hold common shares in an Operating Company.
  • Year 1: Initial step is to “freeze” the value of shares owned by parents. Their common shares will be exchanged for preferred shares with a fixed value, thus freezing their tax liability which will be due on the 2nd to die. In order to fund this tax, it is advisable for them to obtain a life insurance policy. A Family Trust will be created and new common shares will be issued to it. The beneficiaries of the Family Trust are typically the children of the parents and in some cases the parents will also be beneficiaries. The Trustees which may include the parents, control the Trust.
  • The next step would be to create an Holding Company that will be a beneficiary of the Trust. Dividends can be paid on the common shares from the Operating Company to the Trust. Those funds may then be paid to either the individual beneficiaries and be subject to dividend tax, or alternatively to the Holding Company thereby deferring the dividend tax and allowing it to invest the funds , making it an "Investment Holding Company".
  • Year 21: Distribution from Trust. The "21 Year Rule", requires that 21 years after the Trust is established, the assets of the Trust will be subject to tax. To avoid this tax consequence, the assets are distributed tax free to one or all of the beneficiaries, at the discretion of the Trustees.
  • The beneficiaries now own the common shares of the Operating and Holding Company. They are now liable for the capital gains tax associated with the growth in the value of the shares either when they sell the shares or when they die, due to the deemed disposition rules. As such prior to the distribution of the shares, it is a good idea to obtain life insurance on each of the beneficiaries to fund their eventual estate tax liability.
  • On the second to die of the parents, an estate tax liability is triggered resulting from the deemed disposition of their preferred shares.
  • Children now own the company and their shares will be subject to tax on their death due to deemed disposition rules. At this stage, it may be appropriate to undertake a reorganization and possibly enter into a new estate freeze.

As you can see in this chart, the original company is made up of common shares. When the estate freeze occurs, the value of these original common shares become locked in at their current value and that value is reflected in the fixed value preferred shares. The new common shares are issued at a nominal value, and are issued to the family trust, as the company grows in value, this value will be captured by these common shares. In some cases, new common shares may be sold to the family trust (instead of issued from treasury) in order to maximize other tax planning objectives.

Primary Objectives of an Estate Freeze

  1. To limit and cap the capital gains tax liability associated with an asset (such as private company shares) that is growing in value.
  2. To defer future capital gains tax liability to the next generation, typically through a family trust. 
  3. To allow the current owner to maintain control over the asset during their lifetime.
  4. 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.

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