11 Jun Estate Freeze: Will You Ever Find a Better Time?
Over the past few months, the entire world’s economy has changed drastically. Millions of businesses have closed or had significantly reduced revenues. Millions of employees have been laid off and are currently accessing government benefits. Stock markets have decreased drastically.
Depending on who you listen to, many people feel the economy will pick up in the next 3 to 12 months as more restrictions are lifted, new norms are created, and eventually a vaccine is developed. Not all businesses will rebound, though, as some will permanently close, such as retail stores, restaurants, and personal services businesses.
Regardless of when you think the economy will rebound, one thing is probably certain: Your company (other than a few certain sectors) is probably worth less today than it was 3 months ago. This will allow for a fairly unique opportunity for some businesses to take advantage of this decline in value (even if temporary) to restructure their shareholdings.
Freeze of Shares
An estate freeze is a transaction where you fix or “freeze” the value of an asset with the intent to pass the future growth of the asset to someone else. This could be of an investment (i.e. stocks or real estate) or shares of a company. In our context, we will use the shares of a company.
A typical estate freeze of a company is undertaken where a common shareholder exchanges their common shares for preferred shares with a fixed value based on the current fair market value of the shares. This transaction is typically done on a tax-deferred basis, meaning no tax is triggered. The company then issues new common shares to a new shareholder for a nominal amount. The future growth of the company would then accrue to that new shareholder.
The benefits of the freeze:
- Stop the growth accruing for a specific shareholder (i.e. aging parent), typically for estate planning purposes to limit growing tax obligations
- Might allow for some income splitting through dividends (subject to the TOSI rules)
- Potentially multiplication of the capital gains exemption
The preferred shares received on the estate freeze are typically then redeemed over time to reduce the value owing to the old shareholder, which can ultimately reduce the tax liability on those shares.
You typically want to freeze at a low valuation if you are undertaking a freeze to limit your estate tax liability. This is because the amount “frozen” would be taxable in the shareholder’s hands should they pass away. Whereas, the bias if you were to sell to a third party is for a higher valuation.
A valuation of the shares is required for the freeze. Typically, businesses would use a professional such as a Chartered Business Valuator (CBV) to value the company, though you are not required to use a CBV. A professional takes into consideration a company’s past performance, future projections, and current economic situations.
Typically when doing freeze transactions, the shares received will have a price adjustment clause should the CRA propose to adjust the valuation of the shares.
A Family Trust is a great vehicle that could hold the new growth shares on behalf of a family or group of people. Family Trusts have a lot of benefits and offer a lot of flexibility versus direct ownership. We would encourage you to check out our recent article on Family Trusts.
Joe is the sole shareholder of Joe’s Hardware Ltd. Joe is married to Kelly and they have 2 adult children that are active in the business. Joe’s Hardware had a historical net income of approximately $600,000 per year. As a result of COVID, their 2020 income will be quite a bit less as they were closed for a couple of weeks in April, and even once re-opening they have noticed their sales have decreased by about 25% from prior years.
A couple of years ago, Joe engaged a CBV to perform a valuation of the business. They had valued the business at $2,400,000 at that time. Based on a brief recent discussion with the CBV, they expect that the current value is only approximately $1,800,000 in light of the current economy.
Joe is turning 62 soon and is looking at wanting to slow down. Further, he is getting worried about the pandemic and what happens if he passes away. Based on a valuation of $1,800,000, the tax exposure is approximately $240,000 (assuming capital gains exemption) or $470,000 (without capital gains exemption) if he were to currently pass away. This is approximately $155,000 less in taxes as a result of the revised valuation.
There are a few different options for the reorganization. We could consider having Joe exchange his existing common shares for preferred shares with a fixed value of $1,800,000. The family would then create a Family Trust to hold the new growth common shares on behalf of his family.
Going forward, the Company would redeem a certain number of Joe’s preferred shares on an annual basis in lieu of salary and other dividends. Further, the Company would pay dividends to the Family Trust, allocated to his adult children.
By the time Joe actually passes away, hopefully the tax exposure on his preferred shares has been reduced to a manageable level. The common shares of the Family Trust could be transferred to his adult children with no further tax consequences.
How We Can Help?
The Clearline Tax Team can help you implement your restructuring to take into consideration your estate planning objectives.
Note: These types of transactions are extremely complex and the risks should be discussed with a tax professional prior to implementation.
Disclaimer: Information is current to June 2, 2020. Tax legislation, interpretations, and administrative positions change constantly; therefore there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. The information contained in this document is of a general nature. It is not intended to address the circumstances of any particular individual or entity. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.