Estate Freeze

By Theresa Arsenault, Q.C.

WHAT IS AN ESTATE FREEZE?

An estate freeze is a process by which a client takes steps to stop or limit the future growth of his or her estate and provides for the future growth to accrue to the benefit of his or her children or other family members.  Most commonly, an estate freeze is accomplished by the transfer of capital assets into a company in exchange for preferred shares in the Company and a promissory note or by the exchange of common shares in a company for preferred shares having a redemption value equal to the fair market value of the common shares.  Estate freezes can also be undertaken through existing companies (reorganizations of capital, stock dividends, etc.) or by fair market value transfers to trusts.

OBJECTIVES OF AN ESTATE FREEZE:

1.          The overall objective is to arrange for an orderly transition of a client’s business assets to the next generation with the least amount of tax and future complications.

2.          A freeze allows a client to quantify and lock in the capital gains tax liability which will be triggered on death in order to arrange financing for those liabilities.

3.          A freeze can reduce liability for probate fees and potential estate taxes by limiting the value of the estate.

4.          If a client has shares in a company which qualifies as a Qualified Small Business Corporation, one can multiply the number of capital gains exemptions by increasing the number of taxpayers who are shareholders.

5.          If the client’s assets include Qualified Small Business Corporation shares or qualified farm property and there is a concern that the enhanced capital gains exemption may be limited or removed by Revenue Canada, the client may wish to crystalize the enhanced capital gains deduction by freezing now.

6.          If the frozen asset is a closely-held business, a freeze provides a means of putting growth shares into the hands of family members or valued employees for little cost which can create the opportunity both for continuity in the business and may give a stronger sense of commitment to the objectives of the business.

7.          An estate freeze can transfer to select beneficiaries an asset, the growth in value of which will not be subject to challenge of the freezor’s Will under the Wills Variation Act.

WHEN IS AN ESTATE FREEZE APPROPRIATE?

Typical assets that are candidates for an estate freeze are businesses, whether incorporated, partnerships or proprietorships, or investment assets that are expected to appreciate.  Anticipated appreciation in value of the asset is the key to whether an estate freeze will be desirable.

Considerations include:

(a) Enough Money Left?

After the freeze will the client have sufficient wealth to live out his or her remaining years in his or her accustomed style?  Once given away, recovering assets from even your own children can be very difficult.

(b) Am I Rich Enough?

Is the client psychologically ready to accept that future growth in his or her assets will be limited and will accrue to another party?

(c) Who Should Get the Future Growth?

Should the children share future growth equally?  Are some children involved in the business and not others?  What happens if a child dies or divorces?  Should grandchildren be involved too?

(d) Control

To what degree does the client wish to retain control of the business operations?  Once other parties are brought in as shareholders of the corporation, the freezor will have to deal with the beneficiaries of the freeze as shareholders who have rights and who must not be oppressed by the actions of the freezor.

Control can be maintained by keeping voting control while divesting oneself of the equity growth shares in the company, by contractual arrangements, by giving the freezor a veto for certain types of transactions, or by registering security over assets for monies owing to the freezor.  Caution that the client cannot exercise his or her control in a manner that would allow divestiture from the beneficiaries of assets which had already been transferred to them as such powers will make the freeze ineffective or render the growth shares valueless.

(e) Use of a Family Trust

If one of the main objectives behind the freeze is to pass capital appreciation into the hands of the ultimate beneficiaries, the earlier one embarks on the freeze, the better.  However, if the beneficiaries are minors or are otherwise not in a position to make business decisions or there are concerns about allocation of value among certain beneficiaries, a discretionary family trust may be the vehicle to hold the shares (for up to 21 years, when a decision must be made).  The freezor can also retain control in a trust situation, subject to the attribution rules.

(f) Rollover to Spouse

A freeze is normally not necessary in favour of a spouse because of the rollover provisions that are available and because the greater benefits of a freeze arise when moving assets down to a younger generation in order to get the longest period of deferral.  Normally a freeze would be in favour of children with the freezor receiving the frozen shares to which the tax-free rollover to a spouse on death would apply.

(g) Enhanced Capital Gain Exemption Assets

A freeze may not be appropriate in the transfer of property where special rollover rules apply.  For example, if an active farm is intended to be left to a child, there is no income tax reason for the farm asset to be frozen since there will be no adverse tax consequence to keeping it and bequeathing it under the Will as long as the gain on the farm is not greater than the enhanced farm capital gains exemption available.  However, it is a good idea to do a rollover before death if the gain is higher than the exemption.  Also, with probate fees now being an issue, the parties may wish to move the asset to the next generation prior to death in order to avoid probate fees.

Some people are freezing qualifying family farm assets now, rather than assuming that the capital gains exemptions for qualified farm properties will be available at the time of the testator’s death because of a fear that the enhanced capital gain exemption for qualified farm properties may be removed or restricted prior to death.  To protect against this concern for both qualified farm properties and qualified small business corporation shares, a freeze is often undertaken to crystalize the gain up to the amount of the available capital gains exemption.  If the capital gain exceeds the amount of the exemption, the incentive to freeze will be even greater since each beneficiary of the freeze may also be eligible for the capital gains exemption with respect to gains accrued after the freeze.

(h) Principal Residence

Where an asset can be transferred to any person tax-free, such as a principal residence, there is no income tax benefit to freezing such an asset (although there may be probate benefits or non-tax benefits).

CAPITAL STRUCTURE REQUIRED FOR AN ESTATE FREEZE

1.          Voting non-participating shares for the freezor to allow the freezor to control the company by electing directors but without equity participation.

2.          One or more classes of non-voting common shares for the family trust or the adult children to participate in the equity growth without control of business decisions.

3.          Non-voting redeemable and retractable preferred shares having a redemption value equal to the value of the assets rolled into the company as set by the directors at the time of issue, with a price adjustment clause.  This class may have a limited right to dividends, must have priority on winding up and must provide that no dividend can be paid on the other classes of shares if the corporation would then have insufficient assets to redeem the preferred shares.

4.          Non-voting low par value high redemption value class of preferred shares to use for tax deferred stock dividends.

5.          Non-voting preferred shares having a par value equal to the redemption value for taxable stock dividends and for equity investment purposes or compliance with PST regulations.

6.          The company may also have a class of voting common shares, although these might not be issued initially.

REVERSING THE FREEZE

Often one of the biggest problems with an estate freeze is that once something has been given away, even if only for the purpose of achieving favorable tax results, you cannot necessarily take it back whenever you wish.  Some common methods for providing for unfreezing include:

1.          Making the freezor and/or spouse beneficiaries under a completely discretionary trust which holds the equity participation shares in the company.

2.         The preference shares given to the freezor can contain a conversion right into common shares.  The conversion rights should be very restrictive and expire on the client’s death so that no part of the growth in the company from the date of the freeze is included in the value of the preference shares on the client’s death.

3.                   The freezor could do a second freeze at a later date and subscribe for the second level of growth shares in order that the benefit to the original beneficiary of the freeze is limited to the growth in value between the time of the first freeze and the time of the second freeze.  The last class of common voting shares can be used for the purpose of a second freeze.

This article was prepared by Theresa Arsenault of Pushor Mitchell LLP in Kelowna, British Columbia.  This article is not to be taken as legal advice and readers with any particular requirements should seek legal advice from a lawyer with experience in the area of practice.