An estate freeze is one of the more common estate planning tax strategies. When an individual shareholder holds shares of a private corporation, a “freeze” can be used to lock in the current value of the individual’s estate, which ultimately defers tax when the shares of the company pass to the next generation. The future growth of the business can then be transferred from the original owner to their heirs, effecting estate planning and an intergenerational transfer of wealth.
Benefits of an Estate Freeze
An estate freeze is commonly undertaken where the intention is to transfer ownership of a company to the next generation. The freeze is a tool that allows a parent to plan the transfer of wealth to their children or grandchildren, while fixing the amount of capital gains that will be taxed on death. This provides a planning opportunity and eliminates unknown variables regarding estate value upon death.
The mechanics are usually quite simple. Generally, the parent owns common shares of a family corporation. As the corporation increases in value, the value of these shares increase in value as does the eventual capital gain on death. The estate freeze is put in place by having the parent exchange the common shares for preferred shares of the corporation which have a fixed value equal to the value of the common shares. Members of the next generation or a family trust purchase new common shares and all future growth of the corporation’s value will attach to the new common shares.
Since the amount of capital gains taxed at death is pretty well fixed at this point, often life insurance is purchased for that amount at the same time as the estate freeze.
An estate freeze also allows a shareholder to crystallize his or her capital gains exemption. If the shares qualify for the exemption, the shareholder may eliminate tax on all or a portion of the gain on disposition. If the shares do not qualify for the capital gains exemption at the time of the estate freeze due to the type of assets it holds, it is sometimes possible to restructure holdings at that time to ensure eligibility.
Access to the capital gains exemption may also be multiplied among family members depending on the structure of the estate freeze. Opportunities for income splitting may arise as well.
Key Estate Freeze Considerations
The shareholder should consider whether an estate freeze will sufficiently provide for his or her needs and lifestyle for their lifetime in conjunction with the rest of their wealth planning. If a freezor is young, for example, it may be too early to forego the future growth of the business. In this case, a partial estate freeze may be worth considering.
It is also important for the shareholder to consider whether he or she intends to maintain control of the family business. If so, the characteristics of the shares the freezor receives can be such that he or she maintains voting control. Drafting a proper shareholder agreement is also advisable.
If any member of the family lives in the United States or other jurisdictions, the estate freeze is more complicated in nature and other estate tax planning options may be preferred.
Tax counsel should be engaged in order to ensure there are no unfavourable outcomes, such as attribution of income back to the original shareholder or unintended shareholder benefits.
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If you have any questions about estate freezes, drafting a shareholder agreement or any other topic related to estates and trusts, please do not hesitate to contact a member of our team.