Many, if not most, Canadians are unaware that taxes are imposed upon their death. Current Canadian tax legislation provides that taxpayers are deemed to dispose of all their property at fair market value immediately before death. Consequently, significant income tax liability in the year of death can be produced and burden the deceased's estate beneficiaries. If the patrimony includes shares of a small business, additional undue stress and hardship can be caused if the beneficiaries don’t have the financial capacity to pay the liability. Their lack of funds would force them to sell the shares or liquidate the company in these circumstances. If the deceased planned to leave the family business to his heirs, this result would contradict his intentions. Although a deemed disposition can be deferred when assets are left to a spouse or a spousal trust, this is only a temporary fix to the problem. It does not solve the issue of transmission to children.
A solution to this ever-prevalent reality for small business owners can be to undertake an estate freeze. An estate freeze can reduce the estate's tax liability and garner the beneficiaries more time, allowing them to implement a financing strategy to ensure the business remains in the family's hands.
What is an Estate Freeze
An Estate Freeze is the process of "freezing" the current value of an asset to minimize the said asset's tax liability. This is done by substituting an asset that gains value over time, such as shares in a small company, with an asset that remains fixed in value regardless of time. In the case of a family business, undertaking an estate freeze can prove to be an invaluable transaction. The person who initiates the freeze (“initiator”) exchanges his shares of the corporation for shares that will not augment in value ("freeze shares"). The corporation then issues new shares representing any increase in value above the value at which the asset was frozen. These new shares are usually held by people the initiator intended's to benefit from the increase in the asset's value, such as children, grandchildren, or key employees.
Why undertake an Estate Freeze?
The primary reason for an estate freeze is to transfer the business to the next generation. This can be achieved while the initiator still maintains control of the corporation by ensuring the “freeze shares” are set up with voting rights. Another option available to the initiator is to freeze only a portion of his business's value, allowing him to retain common shares with voting rights. Furthermore, the initiator can still receive an income from the company through dividends on his new shares, redeeming his freeze shares or receiving a salary.
The main benefit of undertaking a freeze is to limit the tax liability the initiator’s estate will owe. The portion of his tax liability attributed to his shares in the business can be predetermined by subscribing to freeze shares. Any increase in the value of the shares in question will not alter the tax liability. Consequently, the initiator’s estate will not be left surprised and be forced to sell the shares to meet their tax obligations. The estate beneficiaries would gain valuable time to assess and implement financing strategies to ensure they will have the financial capacity to pay the tax liability upon the initiator’s death.
Consider the following example illustrating the benefits of an Estate Freeze:
John is the owner of Metacom Inc., a manufacturing company he started 30 years ago at age 25 with nominal capital. The company is now worth $500,000 represented by 50 common shares and is expected to keep growing in value and be worth $1,000,000 by the time he reaches 60 years old. John is a proud father to Jennifer and Brandon, two university students in their early 20s. He intends for the company to be run by them when he retires.
Should John die at age 60, there will be a deemed disposition of all his property, including his shares of Metacom Inc.. His death would generate a capital gain of nearly $1,000,000 on the shares alone. Thus, for Brandon and Jennifer to keep the business in the family, they would have to pay this tax liability. This can prove to be a challenging feat for young adults and can result in the beneficiaries being forced to sell the share to meet the tax liability.
In the event John decided to carry out an estate freeze, he would retain freeze shares of Metacom Inc. worth $500,000. His children would hold common shares of the company. As a result, they would benefit from future appreciation in the value of the corporation. If John were to die in ten years, the capital gain at that time would be cut in half as his shares would have remained valued at $500 000. Additionally, the freeze would make it possible to determine the amount of the tax liability with a degree of certainty and develop financing strategies for it, where applicable, by making use, for example, of insurance. Additionally, the tax could potentially be eliminated by applying the lifetime capital gains exemption.
The information above highlights the more common reasons and benefits someone would undergo an estate freeze. At Meditax, our experienced lawyers and tax specialists can help structure your estate freeze and ensure your business remains in your family's hand when you pass away.