Estate freezes can come in as many varieties as there are business owners with unique company and family circumstances. A plan’s success depends on getting it right from the start: choosing the right style of freeze for your clients and giving them the support they need to follow through. Find the right freeze for any client with this guide.
Classic estate freeze
Who it’s best for
A client with an established business who wants to transfer company ownership to children or management while managing her estate tax bill. For tax purposes, an estate freeze locks in current value for the owner while passing on future growth to a transferee. “We typically use estate freezes to fix the existing shareholder’s interest, and allow the new shareholder to effectively come into an ownership position paying a nominal amount,” explains accountant Paul Coleman, partner at Grant Thornton in Southern Ontario.
Typically, business owners consider estate freezes when their companies are worth at least $1 million, he says. Freezes aren’t necessary if the owner’s tax on disposition can be covered by the $824,176 lifetime capital gains exemption (LCGE; indexed for inflation).
A simple estate freeze costs a minimum of $15,000 in legal, business valuation and accounting fees, he says. Costs increase if the owner’s succession plan is complicated, such as if she’s giving the company to children with varying business involvement.
How it works
A freeze locks a business’s current value into preferred shares for the original owners, and transfers growth to new owners through new common shares.
The original owner exchanges her existing shares for preferred shares. The preferred shares can be in either the operating company (under s. 86 of the Income Tax Act); or in a holding company that owns the OpCo (under s. 85(1) of the act). In both cases, the preferred shares should have a fixed (a.k.a. “frozen”) value equal to the company’s present fair market value. The company then issues common shares. The successors buy those common shares for a nominal amount (e.g., $1 per share), and any further increase in the company’s value accumulates in their hands.
If the freeze uses s. 85(1) rules, ensure your client and her business each complete Form T2057—Election on disposition of property by a taxpayer to a taxable Canadian corporation and submit it to CRA, says Jason Rideout, partner at ANR Accountants in St. Stephen, N.B. The form isn’t necessary if the freeze is organized under s. 86.
Your client may want to recognize (a.k.a. crystallize) her capital gains at the time of the freeze, says Rideout. He says this strategy was popular more than a decade ago, when business owners were worried the government might repeal the LCGE. “But tax legislation can change at any point in time, so it’s always a consideration,” he adds. To crystallize the gain, the shares must be either qualified small business corporation shares or in a farm or fishery. The owner would report her capital gain and offset them on her personal return using the LCGE.
Once the freeze is done, ensure your client completes Form T2SCH50—Shareholder information of as part of her corporate tax return, Rideout adds. It must be updated to include the new shareholders and ownership arrangement.
Notify lenders of a planned estate freeze, says Rideout. If the original owner has given the bank a personal guarantee, the debt covenant may be voided or jeopardized when another shareholder is introduced.
The company’s articles of incorporation may not include the types of shares needed for an estate freeze, says accountant Sonja Chong, partner at Sonja Chong Professional Corporation in Toronto. In that case, file articles of amendment with the federal or provincial government that allow the business to create the types of shares needed in a freeze.
If the owner’s spouse and children are issued shares, they may have their own LCGEs, in effect multiplying the family’s net tax savings, notes Chong. To qualify for the LCGE, the company must be a qualified small business corporation, the spouse and children must be Canadian residents, and they or a related party or partnership must have owned the shares for 24 months (see “What are qualified shares?”).
Who it’s best for
A mid-career business owner who wants to broaden ownership to successors or employees, but who still wants to participate in the company’s future growth.
How it works
A partial freeze works like a traditional estate freeze, but when it comes time to issue the common shares, both the original and new owners buy them for a nominal amount. This way, the original owner will lock in the present value of the company in the preferred shares, while profiting from future growth through the common shares.
If your client’s main goal is to limit her future estate tax, a partial freeze is illogical, says Coleman. As the value of the common shares increase, so will your client’s tax liability.
If the owner wants to implement a freeze but isn’t sure who her successor will be, the common shares can be issued to a discretionary trust.
Once she picks a successor, the trustee can designate the new owner as the trust’s beneficiary.
Who it’s best for
A client with an established business who wants to fund her retirement with proceeds from the company while not putting financial stress on the firm.
How it works
A wasting freeze is established the same way as a classic freeze, but instead of holding onto her stake indefinitely, the business owner redeems her preferred shares over time.
When creating the freeze, the shareholders’ agreement should include rules for how many shares can be redeemed, so the company and the original owner have predictable costs and income, says Rideout. Say a business owner freezes her company for $1 million and retires. Under the agreement, she redeems $50,000 of her shares every year. In 20 years, the company has purchased all her shares. This method spreads out the original owner’s tax liability, as she’s paying tax as the shares are redeemed. Once the company buys all the shares, Coleman explains, the owner won’t have any estate tax obligations from her former interest in the business.
If, when the company buys back the owner’s shares, the owner receives a dividend, the dividend doesn’t qualify for the LCGE (because dividends aren’t capital gains). Further, that redemption is generally taxed at a higher rate than capital gains for people in top tax brackets, Chong says. To qualify for the LCGE, the business owner could try to sell her shares to her successors, but the new owners may not have the money to buy the stock every year. And, if they take a dividend from the company themselves to pay for it, they might be subject to a higher tax rate than the original owner, Rideout notes.
The business owner must weigh the benefit of spreading out her tax liability against the uncertainty of being paid over several years.
There are two ways an owner can pay less tax on her dividend, says Coleman.
A) Use eligible dividends to qualify for a lower tax rate.
Rates vary by province; in Ontario, eligible dividends are taxed at 39.3% in 2016, compared to 45.3% for ineligible dividends. For the shareholder to qualify for the lower rate, the company must designate an eligible dividend and pay it from the firm’s General Rate Income Pool. The eligible amount of the dividend can’t exceed the funds in the pool. In setting up the freeze, the owner should ensure she continues to control the company to secure future eligible dividend designations, Coleman adds.
B) Convert the dividends into capital gains.
Since only half of capital gains are taxed, their effective tax rate can be much lower than dividends (e.g., 26.7% in Ontario’s top bracket). Instead of redeeming the shares, the owner would sell them to a connected corporation in exchange for a promissory note. The connected corporation would be owned by her successor. The successor’s company would redeem the shares and receive a dividend from the original company. As it’s a redemption between connected corporations, the successor’s company generally doesn’t pay tax. The successor’s company would then fulfill the promissory note by paying the original business owner. The original owner’s proceeds are now capital gains. Coleman warns that because the corporations are connected, the sale wouldn’t be eligible for the LCGE. He also notes that, if poorly constructed, the strategy could run afoul of CRA’s anti-avoidance provisions, so be vigilant.
Who it’s best for
A client who has already done an estate freeze, but now the value of the business has dropped and isn’t expected to recover any time soon.
How it works
Consider an Alberta energy company that was frozen in 2010 at a value of $10 million. The original owner’s children now run the business. Over time, the owner has redeemed $1 million of preferred shares. In 2016, the company’s fair market value has fallen to $5 million, but the company still owes the original owner $9 million. The company’s first obligation is to preferred shareholders, Coleman says, so it could be years before the children’s common shares have value. Should the business owner die, her estate would pay tax on a deemed disposition of $9 million, even though the shares are worth much less. To get CRA to recognize the shares’ real value, the business success may have to go to court. Instead, to bring the share value in line with the company’s actual value, the owner and the company can agree to re-freeze.
To re-freeze, the company would create a new class of preferred shares that are worth the company’s present value, Coleman says. The owner would trade her original preferred shares for the new ones. At the time of the re-freeze, “there’s no taxable event,” adds Rideout.
Re-freeze negotiations can inflame intergenerational tensions, Coleman notes. He recently worked on a case where the sons of two business partners asked their fathers to consent to a re-freeze. The company’s value had dropped in a struggling industry. The sons felt they were working hard to keep the company going, without seeing any reward in their common shares; yet the fathers felt they were entitled to the original freeze amount. “We sat down with the sons and the fathers and had to negotiate our way to a re-freeze,” says Coleman. The fathers eventually agreed to re-freeze the company at a lower value.
A re-freeze is also useful when first- and second-generation owners want to introduce new shareholders, says Rideout. Consider the case of a father who originally froze his company when he brought his daughter into the business. In that freeze, the father received $800,000 of preferred shares, and the daughter received common stock. Years later, the daughter’s son is involved in the business, and the company is now worth $1.6 million. They can freeze the company again, with the daughter exchanging her common shares for $800,000 in preferred shares, and the son receiving a new class of common shares. “If your company is always growing in value, you can just keep freezing the company,” says Rideout.
What are Qualified Small Business Corporation Shares?
A company must meet all of the following CRA criteria:
- At the time of sale, it was a share of the capital stock of a small business corporation, and it was owned by your client, her spouse or common-law partner, or a partnership of which she was a member.
- For the 24 months before the share was disposed of, while the share was owned by your client, her partnership or a person related to her, it was a share of a
Canadian-controlled private corporation and more than 50% of the fair market value of the assets of the corporation were:
- used mainly in an active business carried on primarily in Canada by the Canadian-controlled private corporation, or by a related corporation;
- certain shares or debts of connected corporations; or
- a combination of these two types of assets.
- For the 24 months immediately before the share was disposed of, no one owned the share other than your client, her partnership or a person related to her.
Estate freezes and corporate control
Business owners should decide how to structure not just ownership but also company control before implementing a freeze, says accountant Jason Rideout. For instance, if your client is passing the company to relatively untested management, even if she plans to step back from operations, she should retain voting control.
“[Often], the value they’ve built in their business is what [owners] are going to retire on,” says Rideout. “So you have to protect that—having that voting opportunity to execute transactions is important for a period.”
In some circumstances, the original owner may never want to give up control. For instance, if the owner is executing a wasting freeze, she should keep control of the company to ensure it continues to pay her dividends from the General Rate Income Pool, qualifying them for the eligible dividend tax rate. Further, if the original owner ever wants to execute a re-freeze, that could be difficult without voting.
During a freeze, if the owner has no plans to redeem or sell shares, control can be maintained by giving more voting power to preferred shares than to common ones, says accountant Paul Coleman.
If the owner plans to eventually dispose of the shares, control can be separated from ownership by creating separate classes of voting shares and non-voting preferred shares, says Rideout. The voting shares wouldn’t have a nominal value, and the preferred shares wouldn’t have voting power. That way, if preferred shares are disposed of later, the balance of power stays the same.
Rideout cautions that even pure voting shares have value for tax purposes.