Estate freezes are becoming increasingly popular, tax professionals say, as business owners take advantage of their businesses’ lower valuations.
“In the past three or four months, we’re doing more freezes and re-freezes,” says Edward Bartucci, a tax partner with the GTA Enterprise Group at KPMG LLP in Toronto. “People who had been sitting on the fence before, [now] understand it’s a good time to do them because they’ve now seen the value of their businesses diminish.”
An estate freeze is a corporate reorganization that allows a business owner to freeze the value of his or her ownership at today’s value and have the future growth accrue in the hands of the eventual beneficiaries.
A business owner can quantify or fix the amount of tax liability that will fall on the business owner’s estate upon his or her death while planning for the eventual transition of ownership of the business to children, grandchildren or other beneficiaries.
A freeze at a lower valuation will result in a lower tax liability at the time of death. Meanwhile, the beneficiaries won’t be taxed on the growth of the business until they sell the business or when they die themselves.
“You put the growth into the next generation’s hands, who will hopefully be living longer than you,” says Teresa Gombita, an executive director and industry leader of the private-client services group with Toronto-based Ernst & Young LLP.
And because the beneficiaries, often the children of the business’s owner, will participate financially in the growth of the company, the freeze may give them an extra incentive to help build the business.
Without an estate freeze — and in the absence of a spousal rollover or any other type of estate planning — a business’s shares will be subject to a deemed disposition at fair market value at the time of the owner’s death. Any capital gains on the deemed disposition will be taxable in the hands of the owner’s estate, which could represent a huge tax liability.
“You don’t want to leave your family no choice but to sell the business [in order to pay the taxes upon your death],” says Allison Marshall, a financial advisory consultant with Royal Bank of Canada’s wealth-management services division in Toronto.
In addition to tax deferral, estate freezes may also allow business owners the opportunity to split income with other family members, provide creditor protection to beneficiaries and manage the eventual transition of ownership of the company.
However, Marshall says, proper structuring and execution of an estate freeze strategy are vital.
In an estate freeze, the business owner exchanges his or her original common shares of the business for fixed-value shares, which generally come in the form of preferred shares. These shares are frozen in value.
The beneficiaries receive common shares, which would initially carry only a nominal value. The future growth in the value of the business would accrue to those common shares.
With an estate freeze, the tax liability at death is a fixed, known amount, so the business owner can purchase insurance to cover the tax cost to his or her estate.
Having a proper valuation of the company’s true worth, experts say, is critical in this strategy.
If the valuation of the business at the time of the freeze is set too high, then it may be some time before any growth in the business can be passed on to the beneficiaries, negating some of the benefit of having the freeze done in the first place.
If the valuation is set too low, the Canada Revenue Agency may challenge the valuation. If the CRA determines that the business owner did not make a reasonable attempt to arrive at the true valuation, the agency can tax the business owner on the difference between the freeze value and the true value of the business.
A business owner needs to consider the value of the business, his or her age and overall financial situation in deciding whether or not to execute an estate freeze. For example, should a business owner decide to freeze an estate when the valuation is too low, he or she may find himself or herself living off an insufficient income generated by the now frozen value of the company.
Often, a discretionary family trust will be created to be used in tandem with the estate freeze, with the common shares created out of the estate freeze issued to the family trust rather than directly to beneficiaries.
@page_break@The family trust gives the business owner the opportunity to be a trustee of that trust, and thus have the ability to decide which beneficiaries will receive the common shares. This is particularly useful when the business owner isn’t sure which of his or her children will be interested in or capable of running the business.
A family trust may also provide creditor protection to the beneficiaries if they are sued.
A beneficiary could argue that the value of his or her interest in the discretionary trust is nominal because there’s no guarantee that they will receive anything from the trust.
“It’s not 100% bulletproof,” Bartucci says. “But with a discretionary trust structure, beneficiaries have some further protection against creditor attacks.”
If properly structured, a family trust also gives the business owner the opportunity to be one of the beneficiaries of the trust, which may allow him or her to participate to a certain extent in the growth of the business.
If the value of the company declines significantly — as many have in the past 18 months — then a “refreeze” of an existing freeze may be justified. In a refreeze, the preferred shares are exchanged for new fixed-value shares now frozen at the current level.
Any growth from the new, lower level will now accrue to the common shares held by the beneficiaries.
Another thing to keep in mind is that a family trust within an estate freeze could be subject to the CRA’s “21-year rule”, which states that a family trust is considered to have gone through a deemed disposition on its 21st anniversary, which could result in a massive capital gains bill for the trust.
The most common strategy to deal with the 21-year rule is to distribute the common shares out of the trust and into the hands of the beneficiaries sometime before the 21st anniversary arrives.
The shares can be transferred to the Canadian-resident beneficiaries on a tax-free basis. However, the business owner/trustee no longer will have control over those shares.
Another possible benefit of an estate freeze is the potential to split income with family members. In a family trust-type estate-freeze structure, it may be possible to pay dividends to a spouse or children. If any of the family members are in lower tax brackets, the overall family tax burden may be reduced.
However, if the children are minors, any dividend paid to them may trigger the so-called “kiddie tax,” which is assessed at the highest marginal tax rate. The kiddie tax makes income-splitting with minors ineffective for reducing taxes.
It’s important to note is that if the company’s value drops below the freeze’s valuation level, or the value of the preferred shares, paying out dividends may longer be legally possible.
A solution to this problem would be a refreeze, which would give the business owner a new set of preferred shares, the value of which would match the lower valuation level of the business. The paying out of dividends may then be possible again.
Estate freezes may allow the business owner to maximize the use of the lifetime capital gains exemptions — both his or her own and those of his or her family members.
The CRA provides individuals with a lifetime capital gains exemption of $750,000, up from $500,000 in 2006, on the sale of a qualified small business.
If a business owner names his or her spouse and children as beneficiaries of the estate freeze, then the business owner and each of the beneficiaries may be able to claim their individual capital gains exemptions, should the business be sold in the years after the freeze is done. IE
A popular strategy for recession-weakened firms
Freezing an estate allows eventual beneficiaries to benefit from the future growth of the business
- By: Rudy Mezzetta
- October 20, 2009 October 20, 2009
- 14:37