An estate freeze is a recognized tax-planning technique used by owner-managers to achieve a wide range of objectives for their businesses. These can include:
- passing future growth of the business to the next generation
- maximizing use of small business and capital gains exemptions for qualifying small business shares
- minimizing capital gains tax payable upon the death of the owner
- taking advantage of income-splitting
- maintaining flexibility in retaining or transferring control to the next generation
- maintaining future cash flow sufficient to meet the needs of the owner
Techniques available to implement an estate freeze
There are several techniques for implementing an estate freeze. The basic ones in use today include:
- reorganization of share capital, in which common shares of an operating company are converted or exchanged into preferred shares
- use of a holding company, in which common shares of an operating company are transferred to a holding company in exchange for preferred shares
- use of a family trust, in which common shares of an operating company are transferred to a holding company in exchange for preferred shares
- gift of assets or shares by a parent
- sale of assets or shares by a parent
Option 4 and 5 listed above are the simplest but are limited in their effectiveness from both an income tax and control perspective. This article will focus on option 1, 2 and 3. This article will assume the estate freeze is occurring between a parent and child.
1. Reorganization of share capital
This technique results in the existing common shares held by a party being exchanged for preferred shares of equal fair market value (redemption value). The exchange is not considered a disposition for tax purposes and the new preferred shares will have the adjusted cost base of the old common shares. The new preferred shares must have a right of redemption so that a preferred shareholder may realize value on their shares for an amount equal to the fair market value of the common shares immediately prior to exchange. The children will receive a new class of common shares of nominal value (which represents that the company’s value at that point in time is recognized in the preferred shares). Any future growth of the company will accrue to the new common shares. An offshoot of this method is the partial freeze whereby the parent does not give up all their common shares thereby retaining some benefit of future growth.
This is simplest method to enact an estate freeze as it only involves the existing company and does not require additional tax filings. In addition, it avoids potential double taxation that can happen under scenario 2 discussed below. However, a significant drawback of this method is that there is no ability to receive non-share consideration as part of the transaction.
2. Use of a holding company
Under this method, the parent transfers his or her shares of the operating company (OpCo) on a tax-deferred basis to a newly established holding company (HoldCo) in exchange for a special class of preferred shares of HoldCo, pursuant to section 85 of the Income Tax Act. The shares of OpCo become assets of HoldCo. To avoid negative tax consequences, these preferred shares are redeemable and retractable at the fair market value of all the shares that were transferred. Additional caveats are also added to the new preferred shares and careful consideration has to be given to this to ensure no negative tax consequences.
The children then subscribe for the common shares of HoldCo, which have a nominal value at the time of receipt but receive all future growth in the value of HoldCo, including the value of the OpCo shares that are owned by HoldCo. Dividends passed from OpCo to HoldCo typically pass tax-free as inter-corporate dividends.
This method is more complex than a reorganization of share capital as it involves incorporating an additional company which will result in more cost and yearly filings. In addition, special elections have to be filed with CRA at the time of the transaction. However, this method has the significant benefit of providing additional flexibility, such as the ability to remove passive income from the OpCo to preserve Canadian Controlled Private Corporation status (a status that has numerous tax benefits), as well as the opportunity to receive non-share consideration as part of the freeze.
3. Use of a family trust
Techniques 1 and 2 described above both involve transferring direct ownership of OpCo to the next generation. This could have unforeseen complications down the road.
- Property given directly to children at the time of the freeze becomes the legal property of the children. A parent cannot subsequently change his or her mind about how to allocate the property among the children.
- Since the children legally own the property, the property (including company shares owned by the children) could be subject to claims from creditors, and from the children’s spouses on matrimonial breakdown.
A family trust can eliminate the above risks. With a family trust the property of OpCo is transferred to a trustee as opposed to the children directly. The parent would retain preferred shares of the company and the trust would subscribe for common shares to be held for the benefit of the children. While this type of structure is typically more expensive, it can provide some attractive features for the business owner:
- The trustees of a family trust may have the discretion to make decisions regarding capital and income distributions to beneficiaries. This discretion is useful as it provides flexibility for trustees as to the timing and amount of allocations of funds to beneficiaries. Trustees may consider factors, such as the children’s involvement in the business, ages, tax situations, and the children’s individual needs when determining appropriate and desirable amounts for distributions. When the business owner’s spouse has been named as a beneficiary of the trust, the trustees would be able to allocate distributions to the spouse, which would allow for future growth to be retained among the parents in certain events. Since the trustees could direct distributions to beneficiaries in low tax brackets, the trust can also provide a convenient way to split income, as well as to multiply the use of the small business capital gains exemption, assuming all other requirements are satisfied.
- Another advantage to moving the business into a trust for the children is that the trust assets can be protected from claims of the children’s creditors or from inclusion in their net family property if their marriages fail.
- On the death of the child, the distribution of the property will be determined by the trust document, not by the will of the deceased child. As the shares will not form part of the deceased child’s estate, probate fees payable on the child’s death will be reduced since no probate fees will be payable on the value of the shares. Furthermore, the shares will not be subject to a deemed disposition at death under income tax legislation (with the resultant tax consequences).
Using a family trust results in additional costs to establish and maintain the trust and related annual tax returns. In addition, trust income that is not distributed is taxed at the highest marginal rate without personal tax credits. Lastly, it is worth noting that the trust is deemed to have disposed of its capital property for its fair market value every 21 years, causing any accrued capital gains to be realized. Further tax planning should occur before this event.
An estate freeze can offer significant benefits; however, the circumstances and objectives of the individuals involved will determine the best option. This is not a comprehensive guide on estate freezes, but rather a high level summary. There are numerous intricacies and pitfalls that have to be maneuvered. An estate freeze is a highly complex option in estate planning. Contact us for further discussion and analysis.