Corporate reorganizations and estate freezes are essential strategies for owners of closely held businesses with substantial retained earnings and low adjusted cost bases.
Canada imposes a capital gains tax at death. Section 70(5) of the Income Tax Act (ITA) says a person who dies is deemed to have sold all capital assets at fair market value immediately prior to dying. The proceeds are taxed as capital gains in the deceased person’s terminal tax return.
Without proper planning, shares of closely held corporations are exposed to significant tax liability in the owner’s estate.
Estate freeze basics
This strategy freezes the amount of corporate capital gain that’s taxable in a business owner’s estate. After a properly structured freeze, any further growth in the company’s value will accrue not to the principal shareholder, but to his or her successors or (more commonly) 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 at least double by the time he retires. To limit the tax payable on his death, Hugh is considering an estate freeze.
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If the estate freeze proceeds, section 86 of the ITA 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, it’s possible to know Hugh’s maximum capital gains tax on death, allowing for better planning.
Another variation of the estate freeze could proceed under section 85(1). Here, 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 for their benefit, allowing future growth of the company to accrue outside of Hugh’s death tax exposure.
For the rest of Hugh’s life, the preferred shares can be redeemed to provide funds for retirement. The share redemption will further reduce the value of assets that are taxable in his estate. But it would also erode his voting control of the company, so it’s crucial to structure the shares in the frozen company according to Hugh’s objectives.
Getting the numbers right
Setting the value of Hugh’s preferred shares is of critical importance for effectively freezing the current value of the company.
Getting an independent valuation of the corporation from a qualified business appraiser is key to the success of the estate freeze because CRA will scrutinize the stated value of shares.
In addition, voting and other rights attached to particular classes of shares affect the tax valuation of those shares. A retroactive price adjustment clause in the valuation of the preferred shares would preserve the ability to change the value of the preferred shares if CRA audits the transaction and restates the value of the company as of the freeze date.
Another important consideration is the impact of the Canadian attribution rules. Generally speaking, they result in income or capital gains attributing back to the transferor where productive assets are transferred to non-arm’s length recipients.
The rules are intended to prevent income splitting with certain related parties (e.g., spouses and minor children). However, the goal of the estate freeze is to defer the realization of taxable capital gains in the value of a family business, not income derived from it, so a properly structured estate freeze should be able to avoid attribution.
The associated corporation rules found in section 256 of the ITA also need to be considered when doing an estate freeze. They can restrict the ability of multiple corporations from taking the small business deduction when they’re deemed to be associated.
The control rules in the same section can cause problems for estate freezes unless the relationships between beneficiaries and trustees are considered in the context of their corporate holdings.
Estate freezes for U.S. citizens
Participation of a U.S. citizen in a Canadian estate freeze can mean tax headaches. Under U.S. law, tax imposed on an estate is based on the fair market value of the asset, not the capital gain accrued to a given asset.
Congress has all but eliminated corporate estate freezing strategies with the passage of section 2701, et seq. of the Internal Revenue Code. The provisions peg the retained value of preferred shares at zero for someone doing a freeze, so a Canadian-style estate freeze could result in an immediate gift tax liability of up to 40% of the fair market value of the company.
Corporate reorganizations and estate freezes are useful estate planning tools because they provide certainty around exposure to capital gains tax on death. 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 the estate.
David A. Altro is a Florida attorney and Canadian legal advisor, and managing partner at Altro Levy. 416-477-8155 or email@example.com. Jonah Z. Spiegelman is an attorney who leads the Altro Levy Vancouver practice and specializes in cross-border tax and estate planning. 604-569-1445 or firstname.lastname@example.org.