In an estate freeze, you freeze the value of your wealth, so that future growth goes to your children (or others you wish to benefit). Why would you do that? You may reach a point where you feel that you have sufficient wealth, and you are more concerned with cash flow. If you have a successful incorporated business, and your business continues to grow, the income tax payable on your death when you are deemed to dispose of all of your assets, including your shares of the company will continue to increase with the value of those assets. By freezing the value of assets now, you limit the tax payable on your death to any capital gains or other taxes payable in respect any gains up to the date of the freeze.
Any future growth will accrue to your children, who will likely outlive you. This will allow a deferral of tax until they dispose of the assets or die.
Lets say you and your spouse own all of the shares of the company, being two class A voting common shares. The value of those shares is a total of $5 million. The company’s business is still growing, and you anticipate that the shares will continue to increase in value.
One way of doing an estate freeze is for you and your spouse to exchange those shares for different shares. These new shares would be redeemable, preferred shares. With these shares, you would have the right to require the company to redeem the shares at any time for a specified amount. For example, in the exchange, the company might issue to you and your spouse 5000 shares redeemable for $1000 each.
The new redeemable, preferred shares soak up the value of the company.
The company can then issue new common shares to your children, for a small amount of cash. Initially, the value of these common shares will only be the amount that your children pay for them.
The share features are structured so that if the company is wound up, the redeemable, preferred shares are paid out first, but you and your spouse will only receive the redemption amount (plus and unpaid dividends that have been declared on them). The common shares issued to your children will receive the rest of the value of the company.
If in our example the total value is $9 million, and you and your spouse have not redeemed any of the redeemable, preferred shares, then the value of your children’s common shares will have grown to $4 million in our example.
But often the holders of the redeemable shares will redeem them gradually for cash flow. This will result in some tax when they are redeemed but will reduce the tax otherwise payable at death. Depending on your other income, you may be able to redeem them at a lower tax rate, than the tax payable on your death.
For an estate freeze to work, the redeemable, preferred shares should have certain features. These include ensuring that they have priority over common shares. Dividends should not be paid on any other shares unless the company has sufficient assets to pay the full redemption amount for all of the redeemable, preferred shares.
There should also be a price adjustment clause in respect of the redeemable, preferred shares, in case Canada Revenue Agency disagrees with the valuation of the common shares at the time of the exchange. Such a clause would allow for an increase or decrease in the redemption amount of the shares if it is later determined that the common shares were worth less or more than the original valuation.
Instead of issuing the new common shares directly to the children, you can have a trust own the shares. You can ask someone else to settle the trust, in the trust document appoint you and your spouse, and perhaps a third trustee, as the trustees to manage the trust property, which will be the initial property settled on the trust (such as a coin or cash), and the new common shares. The beneficiaries of the trust can include your children, and grandchildren. The trustees can have discretion to make payments or distribute the shares to the beneficiaries. In this way, you and your spouse may retain control over the new shares during your lifetimes.
Although the concept is straightforward enough, there are a number of potential pitfalls if an estate freeze is not implemented properly. My practice is to work closely with tax accountants when implementing an estate freeze.