Protect your heirs from steep tax burdens through executing an estate freeze

Almost half of Canadian business owners do not have a transition plan for their business, according to a 2015 CIBC poll.

If you’re a business owner you’ll eventually have to pass on your business by either selling it or having its ownership transferred to your successor of choice. If you choose the latter, the law requires that your assets be disposed based on the fair market value (FMV) immediately before time of death. As FMV changes over time, so does the value on which capital gains taxes will be based.

Increased FMV means higher taxes. This means that you may not be able to predict how much taxes your beneficiaries will have to pay by the time they inherit your business. Your successors might find it difficult to pay these taxes, and they may not be able to fully reap the fruits of your life’s work.

That is, unless you protect your business by undertaking an estate freeze.

What is an estate freeze?

An estate freeze is an estate planning strategy. It allows a business owner to lock in or “freeze” the value of an asset, hence, it frees the successors from the tax liabilities that arise when an asset’s value increases. At the same time, the business owner can still maintain control and receive some income for the duration of the freeze.

With an estate freeze in place, your successor can still benefit from the business’ future growth, without being accountable for tax increases you may accrue before they inherit the business. Hence, you can plan your tax spending properly. This gives you peace of mind that your successors won’t have to spend a huge part of their inheritance on excessive taxes.

What happens when you freeze your estate?

1. Your successors subscribe to common shares. When you execute an estate freeze, you exchange your common shares to preferred shares. The preferred shares (also called “freeze shares”) would take on whatever is the FMV of the common shares when the freeze started. Your successors, meanwhile, would subscribe to common shares for a nominal price. Subscription doesn’t make them own the stocks yet; it only means that they will take ownership of the stocks at a future date.

When you bring in new shareholders in the execution of an estate freeze, make sure to have a shareholders’ agreement ready. This agreement provides terms and conditions related to the purchase, redemption or transfer of the company’s shares. It also specifies other necessary matters such as financing these transactions.

2. You may still opt to derive some retirement income. You may also opt to receive some retirement income from preferred shares by cashing in on a fixed amount gradually. This reduces the total value of your preferred shares, which also reduces income tax liability upon death. For instance, if your shares are worth $10,000,000 and you need $100,000 annually, you may opt to redeem the latter amount. If you live for another 30 years after you freeze your estate, you will have withdrawn $3,000,000 of your shares, reducing the value of your shares to $7,000,000. This would mean the tax liability would be lower than it would have been, had your shares remained at the original value of $10,000,000.

3. You may opt to maintain voting control. This may be tricky, but you may arrange your estate freeze in such a way that you still have voting control in the business with your preferred stock.

How you can benefit from an estate freeze

1. You get peace of mind. You can rest assured that your successors, whether they’re a family member or anyone you trust to take over your business, will receive what is entitled to them without unpredictable tax burdens. An estate freeze fixes the maximum amount of taxes to be paid, hence, you can properly plan how much to set aside for this. You may also use a life insurance policy to make sure your estate will have enough to pay for these taxes.

2. You incentivize participation in growing the business. Your chosen successors will be more motivated to help the business grow, knowing that this will also benefit them in the future.

3. Further tax reductions. If your shares qualify for lifetime capital gains exemption, an estate freeze will further reduce your successor’s tax liability.

Is an estate freeze the right strategy for you?

Whether or not an estate freeze would be the best move to manage your estate depends on a few factors.

1. Retirement funding. If you heavily rely on the sale value of your company to derive retirement income, then an estate freeze may not be the best option for you. On the other hand, if you derive retirement income from other sources such as RRSPs, then read on.

2. Succession plans. Have you already identified an eligible successor? Before implementing an estate freeze, make sure that you choose a successor who has the right skills and enthusiasm to grow your business.

3. Family relationships. While it may seem fair to name all your children as successors to your business, this may not always be an equitable plan. Some may be more active in the business than others, which may create resentment within the family. To make sure all your children are taken care of, whether or not they actively participate in the business, you may want to consider life insurance as well.

An estate freeze may function as an effective safety net, not only for your own business, but also for your heirs. On the other hand, planning an estate freeze may be complicated. Be sure to consult a trustworthy specialist before starting any plans to freeze your estate.