When you own a business with substantial earnings, an estate freeze can keep tax costs down.

Canada imposes a capital gains tax at death, which says a person who dies is deemed to have sold all capital assets at fair market value immediately. The proceeds are taxed as capital gains in the deceased person’s terminal tax return.

Without proper planning, this means that shares of closely held corporations are exposed to significant tax liability. An estate freeze can help mitigate that.

Estate freeze basics

This strategy freezes the corporate capital gains taxable in your estate. After a properly structured freeze, any further growth in the company’s value will accrue not to you, but rather to your successors or to a discretionary trust set up as part of the freeze.

Consider this example. Hugh is a Canadian citizen and resident, who’s been running an active business for 10 years. He’s the only shareholder, with 100 common shares at an estimated current value of $5 million. Hugh expects the value to double by the time he retires. To limit the tax payable on his death, Hugh is considering an estate freeze.

If the estate freeze proceeds, the law lets Hugh exchange his common shares for preferred shares bearing an aggregate par value equal to the appraised value of the business. This reorganization would be permitted on a tax-deferred basis. Immediately after, new common shares could be issued to Hugh’s adult children, or to a discretionary trust for their benefit.

Since Hugh would then hold fixed-value preferred shares, any future growth in the value of the company would accrue to the common shares held by the trust. Once the freeze has been implemented, Hugh will know his maximum capital gains tax on death.

In another variation of the estate freeze, Hugh would contribute his common shares in the operating company for preferred shares in a new holding company. Again, common shares would be issued to Hugh’s children, or a trust, allowing future growth of the company to accrue outside of Hugh’s death tax exposure.

For the rest of Hugh’s life, he can redeem preferred shares to provide funds for retirement. The share redemption will further reduce the value of assets taxable in his estate. But it would also erode his voting control of the company, so structure the shares in the frozen company carefully.

Tips when freezing

If you use this strategy, ensure you get an independent valuation of the corporation because Canadian Revenue Agency (CRA) will scrutinize the stated value of shares.

Also, consider the impact of Canadian attribution rules. They result in income or capital gains being attributed back from an arm’s length corporation to the person who transferred them.

The rules are intended to prevent income splitting between related parties (e.g. spouses and minor children). But if, like Hugh, your goal is to defer taxes on the value of a business, rather than taxes on income, you should be able to avoid the attribution rules.

And once the exposure to death tax is determined through a freeze, life insurance can be purchased to ensure no cash flow issues complicate the settlement of your estate.