Section 10 – Estate Planning

Estate Freeze

Tax legislation provides that taxpayers are deemed to dispose of all of their property at FMV immediately prior to death (see Section XI). This can produce a significant income tax liability in the year of death, thereby eroding the estate that is passed on to the beneficiaries. If the patrimony includes shares of a small business, the lack of funds to pay this liability may even force the liquidator of the estate to sell the shares or liquidate the company, which may undermine the deceased’s objective, i.e. to keep the business in the family. While this deemed disposition can be deferred when assets are left to a spouse or a spousal trust, this is only a temporary solution to the problem and does not solve the issue of transmission to the children.

The purpose of an estate freeze is to transfer to other persons (children, grandchildren, key employees) the future increase in value of the assets (generally shares of a small business corporation) that an initiator of a freeze (the transferor) owns. The transferor retains the current value of his/her shares and defers the income taxes on the capital gain to the time of their actual or deemed disposition.

The freeze brings in new shareholders who will enjoy the benefits of the future growth of the business. This will result in a lower capital gain on the deemed disposition when the transferor dies. The primary reason for a freeze is to transfer the business to the next generation while allowing the transferor to retain control of the business and, if he/she wants, provide a source of income by paying dividends on his/her freeze shares.

Example: Fifteen years ago, Mrs. Travis incorporated a consulting business (Genius Ltd.) by subscribing for 100 common shares at a price of $100. The company is doing well. It is worth more than $950,000. Her valuators told her that at the current annual rate of return for the business, her shares should be worth more than $2,000,000 within eight to ten years.

Mrs. Travis is nearly 50 years old and hopes to leave the business to her son Terry, a university student. He has shown an interest in the business. Mrs. Travis’ other investments, as well as her RRSPs, will enable her to maintain her lifestyle after she retires, without having to have any significant income from her business.

As owner of Genius Ltd., she is very satisfied with her financial position. Her son is the universal legatee of her will. Furthermore, as her other sources of income will ensure her a lifestyle to which she is accustomed, she is letting the company prosper and is happy to leave her son a highly valuable business. But is this really the ideal solution? If Mrs. Travis dies in ten years, there will be a deemed disposition of all her property, including the shares of Genius Ltd., which would generate a capital gain of nearly $2,000,000 on these shares alone. Would her estate be able to pay the income taxes and keep the wealth intact?

If Mrs. Travis were to decide today to carry out an estate freeze, she would retain freeze shares worth $950,000 and her son, by holding new common shares of the company, would benefit from the future appreciation in value. If Mrs. Travis were to die in ten years, the capital gain at that time would be cut in half. Furthermore, the freeze would make it possible to determine the amount of the tax liability with a certain degree of certainty and develop financing strategies for it, where applicable, by making use, for example, of insurance.

An estate freeze requires that you prepare or revise your will to ensure the objectives of the freeze are achieved when the transferor dies.

When new shareholders are brought in pursuant to an estate freeze, a shareholders’ agreement should be prepared. This agreement should ensure, as a minimum, that there are provisions for the disposal of the company’s shares (purchase, redemption or transfer) as well as the financing for such transactions and the main situations that could trigger them.

An estate freeze is one of the most complicated areas of tax planning. A number of matters relating to tax, corporate law and matrimonial law may come into play. Accordingly, specialists should be consulted when any plan for an estate freeze is developed.

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