An estate freeze is a popular strategy used by business owners and wealthier individuals planning their estates.
It allows you to defer taxes on the future growth of your business or investment portfolio to younger generations of your family, cap the tax liability on your passing and potentially split income to your children along the way.
So, what is an estate freeze?
Well, you first have to know that in Canada there is no estate tax on your assets when you die.
For tax purposes, you are deemed to have sold all of your assets just before your death. The government collects capital gains tax on the growth in the value of those assets. For most couples, this typically happens when the last surviving spouse passes away.
The goal of an estate freeze is to postpone paying a portion of the capital gains tax on the growth of a family business or an investment portfolio that is held in a private corporation.
Once you know you have more money than you’ll need to retire comfortably, you can freeze the current value of your business or portfolio and transfer the future growth to your children or grandchildren.
In this way, it will be your heirs who eventually pay capital gains tax on the growth between the time of the estate freeze and your death. This allows the family to defer tax on this portion for many years into the future.
That’s the theory. But how does it work in practice?
If you’re putting the estate freeze in place for a large investment portfolio that is held personally, you first need to roll that portfolio of investments into a holding corporation. The corporation gives you preferred shares in return that are fixed in value and won’t grow over time.
Under Canada Revenue Agency rules, this exchange doesn’t trigger any capital gains tax. Any unrealized gain in the value of the investments get baked into the tax characteristics of those preferred shares.
If you’re putting the freeze in place on a family business, then you exchange your current common shares in the business for fixed value preferred shares. Again, there is no tax on this transaction because the new preferred shares lock in the tax characteristics of the old common shares.
Another crucial attribute of the preferred shares is that they retain all the voting rights in the corporation. This ensures that you keep control of the corporation.
In both cases, at the same time as the new preferred shares are issued, new common shares in the corporation with a nominal value are issued to your family members. All future growth of the corporation will be reflected in the rising value of these new common shares.
In this way, the value of the corporation in your hands is frozen at today’s value in the preferred shares, while the future growth accumulates in the hands of your children and/or grandchildren in the common shares.
Now, instead of giving the common shares directly to your children or grandchildren, you can put them into a family trust and name family members as beneficiaries of the trust.
At the same time, you would name yourself and your spouse as trustees. This lets you retain decision-making power over how the common shares and any dividends paid to them are used. In Quebec, you also have to name an independent trustee, who is neither the creator of the trust, nor a beneficiary. This is typically a close friend or family member.
Using a family trust in an estate freeze gives you more flexibility than giving the new common shares in your corporation directly to family members. This can be important for a number of reasons.
Once you give shares to a person, you can’t easily take them back. Maybe you’re worried about one of your children’s spending habits or maybe you’re concerned about the spouse of one your kids getting control of the shares if their marriage breaks down.
By naming yourself and your spouse as beneficiaries, you can unwind the structure if ever things don’t play out as expected.
Placing the common shares in a trust also gives you more control over how dividends can be flowed from the corporation to the beneficiaries, and it can also protect the shares from creditors.
In Canada, a trust is treated as if it has sold all of its property every 21 years, triggering capital gains tax. However, after your death, the family trust can be dissolved, and the shares distributed to children or grandchildren. This has the effect of extending the deferral of capital gains tax. This is a good reason not to put an estate freeze in place too soon. You want to be reasonably sure that you’ll have passed away before the trust reaches its 21st anniversary.
Now let’s look at a simple imaginary example of how an estate freeze and a family trust work together to defer taxes.
James and Louise are both 75 years old and co-owners of a holding company. They have done well, and the holding company has a current value of about $6 million in an investment portfolio.
Assuming the first spouse to pass away leaves the holding company shares to the other spouse, either James or Louise will have a capital gains liability of about $2 million, based on the current value of the shares. However, growth over the next 20 years could easily double that tax bill when the last surviving spouse passes away.
The couple decides to set up a family trust, naming their two children as beneficiaries. They implement an estate freeze, locking in the value of the holding company in their hands at its current level, along with the $2 million gain. They retain control of the company through the votes attached to their new preferred shares.
New non-voting common shares are issued to the family trust where the future growth in value, along with the capital gains liability, accrue to the trust.
Upon the death of the last surviving spouse, the $2 million gain on the preferred shares is taxed. Some time later, the family trust is dissolved and the common shares in the corporation are distributed to the two children. Distributing the common shares from the trust does not trigger the tax on their gain. As I mentioned, this has the effect of further extending the deferral of capital gains tax on the assets held in the corporation. The gain on the common shares won’t be taxed until the children decide to unwind the corporation.
From this quick example, you can see these are complicated matters. That’s why it’s important to get legal, tax and investment advice from experienced professionals if you are considering going this route in your estate planning.