What is an estate freeze? How does it work? If these questions have been on your mind, then you are in the right place! Inside this guide, you will uncover one of the best ways to transfer assets from your estate to your heirs so that they are not saddled with an unexpectedly large tax liability. Your business and/or investments do not die when you do. It is important to plan for the most tax effective handling of your shares and assets so that more ends up in the hands of your beneficiaries than in the hands of the Canada Revenue Agency (CRA).
Before we continue, though, here are some terms and their definitions used in this guide:
|Capital asset||An item that you own for investment purposes because it is expected to generate value over a long period of time, e.g., building, machinery, stocks, and bonds|
|Capital gains tax||When Canadian investors sell a capital asset or investment for more than the original purchase price, the profit realized is subject to capital gains tax as part of your income tax.|
|Equity||Equity represents the shareholders’ stake in the company|
|Shares and stocks||Although used interchangeably, strictly speaking a share is a unit of ownership while a stock is a measurement of equity|
|Common shares||A type of stock that grants shareholders voting rights and ownership of the corporation’s assets after claims from creditors and preferred shareholders have been fulfilled. Their value is generally from growth in share price over time rather than dividends.|
|Preferred shares||Similar to a bond, this type of stock has a fixed redemption amount and pays shareholders a specified dividend ahead of common shares. (Sometimes called special shares or preference shares)|
|Aggregate par value||The nominal value of each share (as stated in the corporate charter) multiplied by the number of shares issued and typically unrelated to the actual value of the shares.|
|Deemed disposition||Working as if you have actually sold an asset at fair market value (FMV), even without a purchase or sale.|
|Annuity||A long-term investment that exchanges present contributions for future income payments of a fixed amount of money|
|Grantor trust||A type of living trust in which the creator of the trust maintains control over trust’s income and assets, making the trust’s income taxable to the grantor.|
|Attribution rules||Regulation that stops taxpayers from lowering their tax liability by diverting investment income to family members.|
|Lifetime capital gain exemption||An exemption of capital gains tax occurring when shares of a qualifying small business corporation are sold.|
As far back as 1726, Daniel Defoe noted in his Political History of the Devil that “Nothing is certain but death and taxes”. Fast-forward nearly 300 years, and not much has changed!
While there are no inheritance or estate taxes in Canada, the Canada Revenue Agency does impose a capital gains tax at death. According to Section 70(5) of the Income Tax Act (ITA), all your capital assets will be deemed as having been sold for proceeds equal to their fair market value on the date of your death. One exclusion of this deemed disposition capital gain is if your spouse (or common-law partner) or a qualifying spousal trust is the beneficiary. If this is the case, then the transferred assets will automatically defer capital gains tax.
Should your wealth comprise an incorporated family business or a portfolio of investments held in an investment holding company, then your estate is vulnerable to substantial taxation. At a time when they should be (hopefully) mourning you, your loved ones will be faced with confusing tax regulations and tough decisions about how to foot the tax bill. The more successful you have been at growing your investments or business, the greater the tax liability your estate will face. All the tax erodes the amount your beneficiaries will inherit. Whether your family members, key employees, or other successors, careful estate planning will save these beneficiaries from having to pay a hefty tax bill before receiving their inheritance.
What Is an Estate Freeze?
An estate freeze is an option for individuals like you to legally set the value of your corporation, qualified small business, real estate portfolio of passive assets, publicly traded securities, or investment accounts at what they are currently worth for tax purposes.
By “freezing” the value of your assets, an estate freeze allows you, the freezor, to:
- Postpone payment of tax that would otherwise be due on your death. (Using the time value of money principle, postponing tax equates to saving tax.)
- Calculate the expected tax that will be payable when the asset is disposed, including the deemed disposition, and plan for its funding (for example through life insurance).
- Multiply your lifetime capital gains exemption (LCGE) or the lifetime capital gains exemption that applies to the business.
- Transfer the future growth of the assets to the next generation (your children or key employees, for example) without triggering immediate tax consequences – assuming there are clear successors and that the value of the business is expected to appreciate significantly. This is particularly useful for ensuring a smoother transition, especially when there is a time delay in onboarding your successors. With attribution rules in mind, gift taxes prevent a simple handover of shares.
- Implement income splitting between family members – provided this is done in accordance with the tax on split income (TOSI) rules.
- Postpone paying tax accrued on future growth until the asset is sold by those who will have benefited from the proceeds of said future growth.
- Protect assets from creditors.
- Move surplus cash to a holding company on a tax deferred basis.
- Sell preferred shares back to the company (in lieu of dividends) so that over time you reduce historical capital gains that have accumulated in your estate. (As per the income tax act, this will be taxed as a dividend and not at capital gain rate.)
Estate Freeze Implementation Methods and Structures
At its core, the gains resulting from an estate freeze are the same. Exactly how you swop your common shares for preferred shares depends on the nature of the asset and the structure of your corporation. Because the implementation methods and structures of estate freezes are so varied, exploring each one in-depth is beyond the scope of this article.
That said, let’s take a look at some common scenarios. The basic process of implementing an estate freeze can be broken down into three steps:
Step 1: A proper valuation must be done to determine the value of the capital property subject to the freeze. Going forward, we will assume that the capital property refers to shares in a private corporation.
Step 2: You convert your common stock to fixed value preferred shares with a value equal to that of the common shares at the time of the freeze.
At this stage, there are various options available:
- If you own your own business, you can transfer your common shares to your corporation on a rollover basis and avoid triggering any immediate tax liability. In exchange, you receive frozen preferred shares of the same current value. Now that the entire value of your existing company is now in the preferred shares, the next generation can subscribe for new common shares at a nominal amount.
- An alternative option is to transfer your common shares to a new holding company in exchange for preferred stock equal in value to the existing value of your common shares. Incorporating a holding company into your structure lets you move passive assets to it from the operating company on a tax deferred basis, thus qualifying the operating company’s shares for LCGE purposes. Not only does this help to purify the business, but it can also offer your operating company a degree of creditor protection. There are inherent risks involved in this structure, making it imperative that you consult with an experienced wealth advisor.
- Utilizing a family trust when implementing your estate freeze lets you retain some control of the common shares in your role as (one of the) trustees of the trust. As such, you are also able to decide how the rights associated with the common shares are exercised. A family trust structure affords flexibility in identifying if, when, and who receives dividends from the common shares as well as who receives the family trust’s common shares in the end. Despite its increased reporting and accounting burden, a family trust is highly recommended when implementing an estate freeze.
Step 3: New common shares with a nominal value are then immediately issued to others, typically your children or a discretionary family trust with the children designated as beneficiaries. Future growth of the company then accrues to the common shares – and outside of your estate and associated death tax exposure.
Note that this article is not meant to replace qualified financial or legal advice.
To use the lifetime capital gain exemption, various criteria need to be met:
- You must be a resident in Canada throughout the tax year in which you claim the capital gain deduction.
- Your private corporation must devote at least 90% of its assets in an active business in Canada.
- Your shares must be considered a qualified small business corporation (QSBC) share. At the time of sale and throughout the 24 months immediately before that, the share was owned by you, your spouse / common-law partner, or a partnership of which you were a member. (In other words, estate freezes must be implemented at least two years before a sale.)
- During the two years preceding the QSBC share’s disposition, it was a share in a Canadian-controlled private corporation using at least 50% of its assets in an active business in Canada.
Can an Estate Freeze Be Undone?
The short answer is, “Yes!”
It is possible to re-freeze an estate because:
- Your heirs have fallen out of favor.
- The 21-year clock for the trust deemed disposition rule needs to be reset. Accommodate a bump in the cost of the shares and start the freeze process again going forward.
- The shares have dropped in value. An estate freeze is a type of bet on the growth of your business. However, should an economic downturn prove your bet wrong (like during the COVID-19 pandemic, for example), then you can undo the freeze and set a new, lower value for the re-freeze. Effectively, you are placing your family and company in a better position for the appreciation that will occur as the economy picks up. When the value of your shares recovers, you will also have eliminated capital gains on the difference.
Estate Freeze and Asset Management Strategies
Nour Private Wealth (NPW) is a Canadian company with a team of wealth advisors servicing clients across seven provinces. For more information on all forms of wealth creation and preservation, contact us today and speak to one of our wealth advisors. We will gladly further fill you in on the question, “What is an estate freeze?”
This commentary is provided for general informational purposes only and does not constitute financial, investment, tax, legal, or accounting advice. Please speak with your accountant about tax or accounting advice. Individual circumstances and current events are critical to sound investment planning and not all investments are suitable. Please speak with your investment advisor prior to investing.