Introduction to Estate Freezes
Tax planning and family business succession are concepts that often go hand in hand. When owners of a family business are at the stage where they are considering how and when to pass their business on to the next generation, minimizing the tax burden of the transaction is often a key objective. A well-planned tax strategy is crucial in ensuring that the hard-earned wealth from a family business is preserved for business owners and their successors.
One way family business owners can transfer their business to the next generation in a tax-efficient way is by implementing what is referred to as an “estate freeze.” An estate freeze is an estate planning strategy that involves “freezing” the value of the owners’ current shares in the company and allowing the next generation to participate in the future growth of the company.
This article provides a general overview of how an estate freeze works and goes through some of the key benefits of estate freezes in the business succession context.
Implementing an Estate Freeze
An estate freeze can be structured in various ways depending on the business involved and the specific objectives and circumstances of the owners, but the most common structure involves a business owner exchanging their common shares of their company for fixed-value, preferred shares (sometimes called “freeze” shares) that are redeemable and retractable at a price equal to the fair market value of the common shares for which they are exchanged. This type of share exchange can be implemented on a tax-deferred basis pursuant to section 51, 85 or 86 of the Income Tax Act (Canada). New shareholders can then purchase new common shares of the company at a nominal price, allowing them to participate in any increase in the value of the company after the estate freeze is implemented. In the family business context, these new shareholders are often members of the family, or in many cases, a family trust that includes members of the family as beneficiaries.
While the mechanics of an estate freeze can be fairly straightforward, there are many technical tax rules (as well as many non-tax considerations) that must be considered as part of the planning.
Potential Advantages of an Estate Freeze
Estate freezes, when planned and implemented properly, can provide various benefits for both the original business owner and the new shareholders. From the business owner’s perspective, the estate freeze fixes the value of the owner’s interest in the business. Since individuals are deemed to dispose of their assets at fair market value at the time of their death, this planning provides the business owner with an opportunity to manage their tax liability on death and defer the tax liability associated with the post-freeze value of the company until the new shareholder disposes of the shares.
From a business succession perspective, the business owner is able to pass on the family business to their children or other family members, and these new shareholders get to benefit from what could be a significant growth in value of the business over time.
There may also be other benefits to an estate freeze, including the possibility of multiplying access to the lifetime capital gains deduction in the event the shares of the company are sold in the future.
Estate Freezes involving Family Trusts
Many estate freezes are followed by a discretionary family trust subscribing for common shares of the company. There are many potential benefits to a family trust but in the estate freeze context, one of the key benefits of a trust is the flexibility it provides the business owner. When a family trust is incorporated into the structure, the business owner can defer the decision around when and to whom the future value of the company is ultimately distributed. This can be beneficial for business owners who may not yet have decided who their eventual successors will be or who are still planning to have a hand in the operation of the business for the foreseeable future. If the business owner is also a beneficiary of the family trust, it also provides the business owner with an opportunity to completely undo the freeze planning if circumstances change in the future and the business owner wishes to directly benefit from the future growth of the company. However, since a family trust is generally deemed to dispose of its assets at fair market value on its 21st anniversary, these decisions can’t be deferred indefinitely. Where family trusts are shareholders of the business, planning for the 21st anniversary of the trust is another critical part of the succession planning.
Estate freezes, when done properly, are an effective wealth-transfer strategy that can help minimize the tax burden on a business owner while ensuring the business stays in the family. However, it is important to remember that estate freezes are complex transactions. Careful tax planning is required to obtain the best result and avoid inadvertently triggering adverse tax consequences. If you are considering your family succession planning and whether an estate freeze makes sense for you, Areet Kaila and Clark Wilson’s Family Office and Tax groups can help structure the best course of action for your specific situation and goals.