Authors: Garnet Matsuba, Q.C., Ariel Lekas, Justin Di Liello
The opportunities for taxpayers to put their estates in a better economic position during a financial crisis are few and far between. However, just as a savvy investor will “buy the dip” by purchasing equities following a decline in price in an attempt to capitalize on an eventual return in value, a business owner can implement what is called an “estate freeze” or, if such a freeze is already in place, an “estate refreeze”.
Both freezes and refreezes were used by Canadian business owners during the global financial crisis of 2008 to successfully reduce and defer capital gains tax. Similarly, the global economic decline caused by the spread of COVID-19 may pose an opportunity for Canadian business owners to freeze low market values and prepare for the growth that will be experienced as the economy recovers.
The Estate Freeze:
An estate freeze occurs when a business owner (the “Freezor”), with the guidance of a tax professional, reorganizes a corporation to “freeze” the value of the shares of the corporation at their current fair market value. This freeze transfers the value of the Freezor’s common shares into redeemable fixed-value preferred shares, such that the value of future growth of the corporation accrues on new common shares held by another person; typically the Freezor’s heirs or a family trust for the benefit of such heirs.
A well-timed freeze can be an effective strategy for using the “Lifetime Capital Gains Exemption” (available on shares of certain Canadian-controlled private corporations and on qualified farm and fishing property), reducing probate fees in certain Canadian provinces, and implementing income splitting opportunities. However, an estate freeze is a particularly effective mechanism for minimizing and deferring capital gains on the death of a business owner. An estate freeze allows the Freezor to cap the amount of deemed capital gains arising on death, effectively locking in capital gains based on the value of the shares at the time of the freeze. These tax benefits are best demonstrated in the following example:
Margaret owns all of the common shares of a corporation through which she runs a bakery (“BakeryCo”). In 2017, BakeryCo was valued at $1 million. Joanne, Margaret’s daughter joins BakeryCo in the same year. Sadly, Margaret falls ill and passes away in 2022 leaving all of her shares in BakeryCo to Joanne. At the time of Margaret’s death, the value of BakeryCo had increased to $2 million.
Upon Margaret’s death, subsection 70(5) of the Income Tax Act deems Margaret to have disposed of all of her assets immediately before her death for proceeds equal to the assets’ fair market value. As such, in 2022, Margaret is deemed to have disposed of all of the common shares in BakeryCo for $2 million. Based on current tax law, half of the capital gains associated with such a deemed disposition will be included in Margaret’s income for the year and consequently, her estate will incur significant tax liability.
But what if Margaret had implemented an estate freeze in 2017? When Joanne decided to join the family business, Margaret could have exchanged her common shares of BakeryCo for redeemable fixed-value preferred shares with a value of $1 million in anticipation of future growth. As the then-value of BakeryCo would be locked into these preferred shares, Joanne could purchase common shares of BakeryCo for what they are worth at the time: a nominal value. All of the future growth in BakeryCo would be attributable to Joanne’s common shares, and Margaret’s equity in BakeryCo would be “frozen” at a value of $1 Million.
Upon Margaret’s death, there would be the same deemed disposition, but given the estate freeze, such a disposition would be limited to the $1 million worth of redeemable fixed-value preferred shares. Consequently, Margaret would have significantly less capital gains included as income on her terminal return and less tax liability. These gains also may be eligible for the “Lifetime Capital Gains Exemption”, resulting in potentially little or no income taxes on the deemed disposition.
Successfully Timing an Estate Freeze:
A well-implemented and successful estate freeze is premised on a corporation subsequently increasing in value after the freeze. Implementing a freeze when the value of a business is at its lowest will maximize the amount of tax savings for a Freezor’s estate by minimizing the capital gains incurred upon death. In many economic climates, this low point can be difficult to predict. However, as the global economy is currently experiencing a significant downturn caused by COVID-19, the value of many corporations are very likely to be lower now than they will be in the coming years once the economy recovers.
Some business owners may be hesitant to undertake an estate freeze despite the current economic climate being conducive to do so. Often, business owners have heirs whom they feel are too young or not ready to take control of their business by holding common shares therein. However, with the proper planning, an estate freeze can permit a business owner to maintain control of the corporation through his or her newly-acquired redeemable fixed-value preferred shares, special voting control shares, or by implementing only a partial freeze wherein the business owner continues to hold some common shares with voting rights.
In addition, the use of a discretionary trust can also allow for control over the allocation of future growth in value – this can be a particularly effective method if the freeze or refreeze value (discussed below) is below the value that the current shareholder would like to realize in order to fund their retirement or utilize the full lifetime capital gains exemption.
A trust can also be useful in these circumstances when the Freezor is hesitant about assigning all future growth to the next generation. In the example above, after the estate freeze was implemented and the value of BakeryCo increases, Margaret would own shares with a value of $1 million and her daughter would own shares worth an equal amount. If Margaret was uncomfortable with her young daughter holding on to such valuable shares, a tax professional could have helped Margaret to reorganize BakeryCo in such a way as to allow Margaret to maintain control over the business while Joanne transitioned into the role as business owner. Joanne’s common shares can be held in a trust until Margaret felt Joanne was ready to hold them directly.
The Estate Refreeze:
So what does this mean for small business owners who have already undertaken an estate freeze? The good news is that these Freezors can still take advantage of the depressed economy by implementing an “estate refreeze”. This form of corporate reorganization is usually undertaken when the redemption value of the frozen fixed-value preferred shares exceeds the current fair market value of a Freezor’s business.
To effect a refreeze, a tax professional can restructure the fixed-value preferred shareholdings, on a tax-deferred basis, resulting in a lower fixed value which is supportable by the current value of the corporation. Once the value of the owner’s assets have been re-frozen at a lower value, the capital gain triggered upon death would be even further diminished.
Continuing with the example above, if BakeryCo suffers the impact of the COVID-19 economic downturn and is valued at $800,000 in early 2020, and then returns back to its pre-COVID-19 $2 million valuation once the economy rebounds, Margaret’s subsequent death in 2022 would still result in a deemed disposition of $1 million worth of shares. However, if Margaret undertakes an estate re-freeze before her death when BakeryCo is valued at only $800,000, she can take advantage of this decreased value of the corporation and further minimize capital gains incurred upon her passing.
Making the Best of an Economic Downturn:
The shockwave of COVID-19 is making its way through Canada’s economy, depressing the valuations of most businesses. However, like an investor “buying the dip” when the markets crashed and subsequently recovered during previous recessions, a properly timed estate freeze or refreeze can turn the adversity of a significantly depressed economy into a tremendous opportunity for Canadian business owners looking to plan for the future of their families and businesses.
We recommend consulting a professional tax planner to discuss if an estate freeze or refreeze may be beneficial for your business. There are a variety of methods that can be used to implement these reorganizations, with techniques tailored for each individual’s estate and tax plans, to establish the most advantageous position for a rebounding economy.
Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.