If you hold shares of a privately held company that has appreciated in value and you expect the value to continue to increase over time, there are ways in which you can limit your tax liability and transfer future wealth to other family members. An estate freeze allows you to reorganize your company on a tax deferred basis by effectively capping the current value of the business and transferring the future growth of the business to the next generation. This allows future growth that would have otherwise been taxed in your hands, to be taxed by the next generation.
Some of the other benefits of an estate freeze include:
- fixes the amount of the gain and keeps the parent’s tax on death from growing;
- can allow the parent to still maintain control of the Company;
- can allow new shareholders to acquire shares at a nominal cost;
- can utilize the capital gains exemption and possibly multiply the capital gains exemption;
- help reduce probate fees, although there are other strategies available;
- may help protect assets from creditors.
How does it work?
To implement an estate freeze for an existing corporation, the individual that holds the common shares would exchange their existing common shares on a tax deferred basis for fixed value preferred shares of the company. For example, if the company is currently worth $500,000 and it is expected over time that the company may increase significantly in value to say $2,000,000 you would exchange your common shares for fixed value preferred shares worth $500,000. These fixed value shares will not increase in value over time. Since the company is currently worth $500,000 and the company has issued fixed value shares worth $500,000, new shareholders can be introduced and subscribe for new common shares for a nominal amount such as $1. These shares can be the growth shares whereby the future value of the company would attribute to these shares.
It is important that a proper valuation is done as this would impact the fixed value preferred shares and the value that would be attributable to the new growth shares. These transactions can be very complex and it is important that your advisor has experience with these types of transactions. When doing a reorganization such as this, many will want to do this transaction on a tax-deferred basis meaning they do not want to trigger the tax liability now. Typically, a gain would only be recognized when you dispose of your shares to a third party or if there is a deemed disposition such as upon death. Generally, individuals do not want to trigger the tax early. If such a reorganization is done improperly, you could prematurely trigger the tax event which could cause a significant tax liability. If you are a U.S. person (U.S. citizen, green card holder, or resident), an estate freeze will likely not work.
When should you consider such a strategy?
There are a number of different reasons why you may wish to do an estate freeze but the timing must be right. These transactions can be complex and once implemented, they cannot be unwound easily and without possible tax implications.
Minimize tax and introduce new shareholders to the business
A great time to consider an estate freeze is if your children are already active in the business and you would like to start transitioning the business over to them. You may still be in good health and wish to take a step back from the business. By implementing an estate freeze, it allows you to crystallize the current value and have the children subscribe for the new growth shares. The transaction could be structured such that future profits of the business are used to redeem out the fixed value preferred shares over time which would act as your pension plan.
Utilization of your lifetime capital gains exemption (LCGE)
In Canada, when you sell the shares of a qualified small business corporation (“QSBC”), an individual has the opportunity to exclude the capital gain from the sale of up to $913,630 in 2022. This amount is indexed for inflation. Therefore, if a husband and wife own shares of the family business that have appreciated significantly, they could shelter just under $2 million in a capital gain without paying any tax.
There are a number of conditions that must be met in order to qualify:
- The corporation must be a Canadian Controlled Private Corporation;
- At the time of sale, 90% or more of the assets must be used principally in an active business carried on primarily in Canada;
- The shareholder(s) needs to have owned the shares for a 24 month period preceding the sale (some exception apply);
- In the last 24 months prior to the disposition, 50% of the fair market value of the assets of the corporation must have been used principally in an active business carried on primarily in Canada.
As a business owner, it is important to consider the risks of the business and plan accordingly. Generally, when someone goes into business, they don’t plan on getting sued or plan for the worse case scenario. Unfortunately, these worse case scenarios do happen, and it can be difficult to time properly.
One strategy that can help protect your business and family assets is to set up a holding company structure. If you currently hold the shares of your operating company personally, paying out excess profits or retained earnings will trigger tax and therefore you will generally want to keep the excess retained earnings inside of the corporation. However, generally intercorporate dividends can be paid on a tax-free basis. As such, if you were to implement an estate freeze, you could reorganize the company whereby you exchange your shares of the operating company and take back shares of a newly formed holding company on a tax deferred basis.
Implications of an Estate Freeze
There are a number of other reasons why an estate freeze could work well. However, it is also important to consider if an estate freeze may not be right for you. Before implementing an estate freeze, you should consider whether you will require the future growth to fund your retirement or lifestyle needs. If an estate freeze is done too early, it could leave yourself without sufficient funds in your retirement years. Also, if you or the new shareholders intend to sell the shares of your business shortly after you complete your estate freeze, it may not make sense since there may be minimal growth attributable to the new common shares.
Please keep in mind that these types of transactions can be quite complex. This article is of a general nature only and should not be acted upon. The information in this article is not intended to provide legal or tax advice. To ensure that your specific facts and circumstances are considered you should obtain professional advice from a qualified tax or legal advisor before acting on any of this information.