Tax benefits and tax traps with estate freezes

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Ultra-high-net-worth individuals who have accumulated significant wealth for their heirs can consider an estate freeze strategy.

“It’s a way of essentially controlling the amount of tax payable on death, and then deferring the tax on the additional growth into a future time. That’s a tax benefit,” says Richard Weiland, a partner in the tax group of Clark Wilson LLP, a law firm in Vancouver.

In Canada, when a person dies and their assets are passed to the next generation, there is a deemed disposition, at fair market value, of the assets held, which then triggers a capital gains tax, explains Michael Louie, a partner with D&H Group LLP, a Chartered Professional Accountant firm in Vancouver.

Freezes typically involve a first-generation owner of property, usually business assets consisting of real estate or other investments, that have experienced growth and for which further growth is expected. The estate freeze will stop the growth in the value of the property in their hands, and allow future growth to accrue in the hands of the children, says Weiland.

When to consider an estate freeze

An estate freeze can be effective when “their assets have grown to the point where the first-generation owner has enough to live off of for the rest of their own lives, and they intend to pass on the excess growth to their children or future generations,” he elaborates.

Another advantage of an estate freeze from the standpoint of the parents’ generation is the potential to structure the freeze to retain control and income generation, including the ability to decide how to invest, and also direct funds while they are still alive, says Craig Baun, a senior investment advisor and senior portfolio manager with Wellington-Altus Private Wealth Inc. in Calgary.

Weiland provides an example of a successful family business owner nearing retirement with three children, only one of whom is involved in the business. The owner wants to treat each of their children equally for estate planning purposes, but also ensure the child working in the business gets the benefits from those efforts. An estate freeze can allow both of those things to happen simultaneously.

“By freezing at the current value, you can pass that on to your children equally, and then put the future growth into the hands of the child who’s involved in the business,” Weiland explains.

Capping an estate size will save on probate fees in provinces like Ontario and British Columbia which require probate fees, notes Louie.

An estate freeze is also an excellent mechanism for parents to begin the conversation with their children about what they are going to inherit.

An optimal time for a family to consider an estate freeze is when there is a life event. That might come about as a result of changing dynamics in families, such as health, economic, or business concerns. “Lots of possible scenarios could trigger a good timing of it,” says Baun.

What are disadvantages of an estate freeze

There are, however, several potential disadvantages that need to be avoided when establishing an estate freeze.

“I’ve seen families who do it too early and did not build sufficient flexibility into their estate freeze. You want to make sure that as a parent you’ve effected the estate freeze at a value which is sufficient for your lifetime and for your lifestyle,” says Louie.

He recalls seeing one instance where the parents executed an estate freeze, which involved redeeming all of their shares and entitlement in the family business, with too much life still to live, and they ended up running out of money.

Another potential liability is double taxation. That could happen if, say, the parent’s estate consisted of shares purchased for a nominal amount, but with unrealized capital gains worth much more at fair market value. That could lead to a capital gains tax personally at death, and then a further corporate tax when the underlying assets are eventually sold, says Louie.

There are means to avoid that double tax, but that entails a fairly complicated tax-free organization after the parents die, which needs to be done within a certain period of time after death, as allowed under current tax rules. The family needs to be aware of that option, he explains.

If the asset values used in an estate freeze are too low, the shift in value from the first generation to the next generation could result in an immediate tax liability which would defeat the purpose of the estate freeze. Therefore, “one of the keys to a successful freeze is obtaining an accurate current valuation for the assets that are being frozen,” says Weiland.

“The freeze involves a number of legal steps that need to be planned and implemented carefully by knowledgeable accountants and lawyers because there are a number of technical rules and potential traps in carrying out a freeze if it’s not done properly,” he stresses.

There are tax attribution rules associated with minor children, whereby the person doing the estate freeze will be required to include a certain amount of income every year in their own hands. Therefore “you want to make sure that you’re doing the estate freeze properly to try to avoid this,” Louie warns.

If the estate freeze is improperly structured, CRA could also potentially go back to assess taxes, plus interest and penalties on the estate, “so it definitely has to be set up correctly,” says Baun.

Another potential disadvantage of an estate freeze is that it could reduce flexibility in the ultimate use of family assets, so a family needs to “make sure they’re not just making changes for tax purposes and they have other lifestyle reasons they would want to separate out this part of their net worth,” Baun advises.

An example would be a scenario where wealth was separated out in an estate freeze but was ultimately required for the individual who created the freeze to pay for funeral expenses or go toward healthcare, he elaborates.

Family conflicts, such as divorce, could also interfere and create potential disadvantages with an estate freeze, highlighting the need for a family to be proactive and take steps to protect its business assets, such as through prenuptial marriage agreements, says Louie.

What families should understand about estate freezes

It is important for families to have discussions about the planning around the estate freeze so that everybody understands the reasons for the freeze, along with how it is being implemented, and what everyone’s interests will be going forward, says Weiland.

“That can, and does, cause friction if that’s not done carefully,” he stresses.

Some people fail to take the time to structure their estate freeze properly. “I think a lot of people look upon an estate freeze as being a very simple task. This is not a do-it-yourself kind of thing,” says Louie.

An estate freeze involves a complex web of issues around governance, family entitlements, and shareholder rights. If, for example, parents wish to retain some control over the family’s business assets, along with rights and entitlements to be able to make decisions, even if they don’t have any more equity in the family business, that requires a careful and thoughtful planning approach, he adds.

Amidst all of its potential advantages and disadvantages, many wealthy individuals have considered whether the estate freeze strategy is right for them.

“I look upon an estate freeze like a hammer to build a house. It’s part of a toolbox for a family succession,” says Louie.

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