CORPORATE INSURANCE

Estate Freezes

Implementation is not straightforward for some businesses

Estate freezes have been a planning staple for small business owners in the decades since the introduction of capital gains tax in Canada. As the term suggests, a freeze allows individual shareholders (typically, older parents) to cap the value of their shares at current levels. At the same time, future growth is passed to one or more succeeding generations. Capital gains tax on that growth is thereby deferred until the younger family members die or dispose of the shares.

For a couple of reasons, estate freezes may be of even greater interest at the present time: • The pandemic may have caused some businesses to temporarily decline in value. This creates even greater opportunity for future growth to be transferred to younger shareholders. In some cases, this might entail a “ refreeze ” of shares that were frozen at a higher level in a previous year. • Speculation persists that the capital gains inclusion rate will increase to 75% from its current level of 50%. If so, the value of tax deferral will increase accordingly.

There are many ways of implementing a freeze and they will not be addressed in detail here. The simplest method is for the older shareholders of an operating company (Opco),who may be the founders of a family business, to exchange their common shares for preferred shares. The latter shares would have a fixed redemption amount equal to the fair market value of the common shares, would be entitled to dividends, and in most cases would have voting control of Opco.

Properly structured, the share exchange described above would be tax-deferred, with the preference shares having the same cost base as the common shares. A fully documented valuation combined with a price adjustment clause is an integral part of this arrangement and is key to ensuring compliance with applicable income tax rules.

The parent’ s preferred shares could be held until death, with the accrued gains being taxed at that time. Alternatively, they could be gradually redeemed using a technique known as a “ wasting freeze. ” The redemption proceeds would be taxed at dividend rates, which are currently higher than capital gains rates. For this reason, a wasting freeze will usually take place only where the parents require funds for living expenses.

Opco common shares could be issued to the shareholders ’ children, perhaps only those who are active in the family business. It is, however, becoming increasingly common for the shares to be issued to a family trust controlled by the parents as trustees. The potential advantages of a trust are many:

The trustees can be given the discretion to ultimately distribute the Opco common shares to one or more of the beneficiaries in such proportions as the trustees determine. This can be done on a tax-deferred basis. Thus, children who became active in the business might eventually acquire shares in their own name to the exclusion of non-active children.

The parents themselves can be beneficiaries and can receive shares if they ultimately decide not to make a distribution to the children. This would defeat the purpose of the freeze but does provide protection in the event they do not want the shares to go to any children.

The trust would own Opco shares directly. If the shares are sold to a third party at a future date, and if they are qualifying shares for the purposes of the lifetime capital gains exemption, each individual beneficiary of the trust may be eligible to take advantage of the exemption. Potential tax savings are in the range of $235,000 per person, depending on the province.

An increasingly common technique involves the use of a family holding company (“Holdco ”) as a discretionary beneficiary of the trust. The shareholders of Holdco could be various family members, including parents and adult children. With proper planning, dividends could be paid by Opco to the trust, then allocated to Holdco as a tax-free intercorporate dividend. Holdco could use these funds for investment purposes, and, as addressed in the next paragraph, for the acquisition of insurance on the lives of given family members.

Insurance advisors who are active in the family business market will understand the many potential advantages of using life insurance for estate and business succession planning purposes. For example, joint last-to-die insurance on the parents ’ lives can be used for a variety of purposes, such as the payment of income taxes, balancing estate distribution amongst their children, and funding charitable bequests. In these circumstances, Holdco can be the owner and beneficiary of the insurance coverage, and can pay premiums from dividends received. Ultimately, the insurance proceeds (net of any policy ’ s adjusted cost basis) can be distributed as tax-free capital dividends to fulfill these planning needs.

Planners should also bear in mind the potential impact of the 21-year rule, which, if no action is taken before the trust’ s 21st anniversary, will cause the realization of capital gains inherent in the trust’ s shares of Opco. Unless there is a sale of the shares to a third party as described above, the practical effect of this rule may be to impose a 21-year limit on the duration of the trust.

While I’ ve provided a simple overview of the benefits of an estate freeze, in many cases implementation is not a straightforward process. Legal and tax advice is a must to ensure that the desired results are obtained.

GLENN STEPHENS, LLB, TEP, FEA, is the vice-president, planning services at PPI Advisory and can be reached at gstephens@ppi.ca