Business owners use estate freeze to cut tax, but other benefits add up, too

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The economy is booming, the family business is expected to increase in value, retirement or a change in ownership is coming and you want some predictability in your estate planning.

Is this a good time for an estate freeze?

It’s a question that advisers are asked – or pose – with many entrepreneurs. Freezing the value of a company in favour of a trust can offer certainty, defer taxes and provide a mechanism to transition it and its future value to children, other family members or third parties.

But whether and how you do a freeze and manage it over time are important considerations.

“It is very individual,” says Kate Marples, a tax, trust and estate-planning lawyer who is a partner at KPMG Law in Vancouver, noting that discussions around freezes are “always driven by tax, but there are many other variables that need to be considered.”

In an estate freeze, a business owner typically exchanges common shares in the company for fixed-value preferred shares. This freezes the value of his or her participation in the company at that moment in time. A trust is set up in which the trustees subscribe to new common shares, usually for the benefit of second- or third-generation family members. These shares start with no value, but future growth – and related capital gains – accrue to them.

A freeze allows the owner to begin transferring control and to have financial stability in retirement. It also provides some creditor protection, because the trust now owns the assets, and it establishes the exact tax liability at the owner’s death, which could be covered by a life-insurance policy. If the business is eventually sold, any gain can be allocated to family members who are in lower tax brackets. They could also possibly take advantage of their lifetime capital gains exemption, currently $900,000 each, multiplying the tax benefits.

‘Refreeze’ also possible

Marples says estate freezes attract more interest when the economy surges. “It certainly is something that’s in discussion with many of my clients now.”

Peter Weissman, a tax accountant and partner at Cadesky Tax in Toronto, points out that freezes “are not just something to think about when the economy is on the up, up, up, they’re actually something to think about when the economy is down as well.” Freezing when the company is in a trough “keeps the potential exposure on death at a lower number,” he explains.

The frozen shares should typically have enough value for the retiree to live off, but as most trusts used in freezes are discretionary or flexible, he or she can be named among the beneficiaries, allowing access to the increased value. “By freezing when the value is low or has gone down, you’re limiting your estate tax but you’re not limiting your upside.”

The variables that come up with each client bring a different puzzle to unwrap. It’s about navigating the rules and navigating what the client really wants out of it.

Kate Marples, KPMG Law in Vancouver

It’s also possible to do a “refreeze” if the value of the company drops while it’s frozen, Weissman says.

“In downturns, it’s often a good time to see if you should thaw the freeze and refreeze,” he says. “This sets the bar – the potential exposure on death – at a lower number. You basically push the restart button.”

While estate tax planning is often the impetus for a freeze, it has other benefits as well, says Weissman, who is chair of the public policy committee of the Society of Trust and Estate Practitioners (STEP) Canada. “To me, it’s really a reorganization.”

For example, if you don’t know which of your children should run the family business in the future, having growth shares owned in the trust means you can decide later, he says. With a discretionary trust, although they’re named as beneficiaries, “you don’t have to make that distribution or give those shares to one child versus another — or any of them.”

Don’t forget the 21-year rule

One important rule to be aware of in an estate freeze is that the trust is deemed to sell those growth shares by its 21st anniversary.

“The government doesn’t want you deferring tax indefinitely by using a trust,” Weissman says. At that point you can take the shares back and realize any gain, “although you’ve sort of defeated the purpose of the estate freeze,” he says. Another option is to distribute them to your other beneficiaries, who will eventually pay tax on the gain. While this could mean younger children receive the value of the shares, parents can retain voting control. He points out that beneficiaries with addiction issues or special needs also don’t have direct access to the funds.

Weissman cautions that if any beneficiaries of the trust are not Canadian residents, there may be special circumstances to consider in the eventual rollout of the growth shares, and even annual foreign tax issues.

And he warns it can be easy to overlook the 21-year anniversary. “I’ve seen situations, unfortunately, where people, even accountants, just didn’t realize it was happening,” he says. Many advisers include the year the trust is created in its name to try to avoid this.

Scott Binns, a partner with Richter LLP who specializes in tax and estates, says it’s important to work on a strategy for dealing with the growth shares well in advance of the 21-year mark. Choosing the right time to implement an estate freeze in the first place depends on factors such as the business owner’s age, family profile and finances, he says. “It’s never too early to broach the topic with your business advisers.”

Tech entrepreneurs should consider it

For older people the issues can be emotional, as they focus on how they foresee their retirement, the company’s current value, whether children are ready to take control and what happens if they suddenly die. Binns says most people in this position have longstanding businesses that are doing well, they want to understand their tax liabilities, they expect future growth and they say, “I want to defer the tax on that growth from today until the day I die to my kids.”

On the other end of the scale, someone younger who thinks a relatively new business is going to “blow up” and sell for a lot should also consider a freeze, says Binns, who sees this happen especially with entrepreneurs in the tech space.

“The trust will hold the common shares, and any growth from when I’m 35 until when I sell can now be distributed amongst my beneficiaries,” he says. Assuming the shares qualify for the capital gains exemption, “then you multiply and you shelter all that tax.”

Binns cautions that a two-year minimum period is needed for the capital gains exemption to kick in. “You can’t just do the freeze setup and sell. You’re not going to get the benefit.” He suggests to founders who expect their businesses to grow exponentially: “If your intention is to sell, or go public, set up a trust right away. Because no one is going to wait two years for those shares to qualify.”

Marples notes that some people might be put off by the complexity of an estate freeze, despite the tax and other advantages it brings. “It’s not simple,” she says, and there may be special considerations province by province, such as family-law issues, to watch out for.

“The variables that come up with each client bring a different puzzle to unwrap,” Marples adds. “It’s about navigating the rules and navigating what the client really wants out of it.”

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