Estate freezes: Tax planning for business owners during a market downturn
By ATB Financial 20 April 2020 5 min read
Tax planning may not be top-of-mind when we are faced with the uncertainties around COVID-19. It may come as a surprise, however, that the economic impacts of a global pandemic can actually create a time-sensitive tax planning opportunity for many business-owners. Estate freezes can be useful in both good times and bad, but can be especially valuable during a market downturn for a business-owner who expects the value of their company or its investments to recover in the future.
What is an estate freeze?
An estate freeze is a well-known and popular tax planning strategy that can help to reduce the capital gains tax a taxpayer will owe in the future. Estate freezes can be used for many reasons, but they are often used by business-owners to reduce the tax their estate will owe at the time of death.
When a Canadian-resident individual passes away, they are deemed to have disposed of their capital assets for fair market value, with some exceptions. This includes, among other things, shares in a private corporation. In other words, a business-owner is treated, for tax purposes, as if they sold their company shares to a third party immediately before dying. The estate would then owe capital gains tax on any capital gains on those shares. For individuals resident in Alberta in 2020, the tax rate on capital gains can be up to 24 per cent.
The size of your tax bill depends, in part, on the value of the shares that you own at the time of death. An estate freeze is designed to manage this tax bill by “freezing” your share value on the date of the transaction, preventing it from increasing in the future. Since the share value is locked-in, the tax bill on those shares is also locked-in. In an effective estate freeze, the original business-owner will still owe capital gains tax on any growth up until the date of the freeze, but any growth after implementation will accrue to somebody else, often at a much later date.
The steps to implement an estate freeze will depend on your circumstances, which you should review with your tax advisor. In most cases, the plan involves converting the “common” shares of your company into fixed-value “preferred” shares in some manner. If done correctly, there is minimal or no tax triggered on this conversion, and the new shares inherit the same tax cost as the old shares. Your new preferred shares would have special terms designed to ensure that they cannot increase in value, even if the value of the corporation’s investments or its business continues to grow.
Putting an estate freeze in place
Once the freeze has taken place, the company would normally issue new common shares to some other person. The decision of who should hold these shares can be difficult, and we recommend that you seek advice from your advisors. This is because the person who holds the new common shares will be the one who benefits from the future growth of your company’s value. This person is often the business-owner’s children, but it is also common to use a family trust.
Family trusts are a popular option in the context of an estate freeze because they can help business-owners to achieve their tax planning and estate planning objectives more flexibly, without necessarily reducing the business-owner’s control over their company.
Estate freeze planning can be especially attractive during an economic slowdown. Many companies have fallen to an unexpectedly low value during COVID-19, often because either the business itself has slowed down or because the company holds an investment portfolio that has lost value. If you expect these values to recover in the future, this creates an opportunity.
Since an estate freeze locks-in the value of your shares at the time of implementation, it is often possible to freeze at a low value during a market downturn. If the freeze is implemented correctly, then when the market recovers, that recovery growth will fall outside of the business-owner’s estate. This planning is time-sensitive, however. If the transaction occurs after the market has already recovered, that recovery growth would be taxable to the business-owner in the future, instead.
Whether used during a market downturn or not, an estate freeze can be a useful tool to help manage your estate tax’s liability. By preventing corporate shares from continuing to grow in value, a freeze effectively limits the taxpayer’s tax exposure at death, since that tax burden depends on the growth of the deceased’s assets.
Some business-owners may have already frozen their corporations prior to the events of 2020. In some cases, those businesses may be worth less now than they were at the time of the freeze. This can be contrary to the goal of an estate freeze, since the benefits of freeze planning are primarily about the growth of the company after implementing the estate freeze. When a company has instead reduced in value, a re-freeze may be a useful solution.
Re-freezing works exactly as it sounds. A business-owner can generally freeze their corporation again, even if it has been frozen before. This can be used to “reset” the value of the frozen preferred shares, lowering them to the current value of the business without triggering significant tax consequences. Just like with a regular freeze during a market downturn, this would have the effect of ensuring that any growth from the recovery of the market would instead grow outside of the taxpayer’s estate.
If you wish to consider an estate freeze or re-freeze for your business, we recommend that you plan a discussion with your tax advisor to explore your options, determine whether this may be a useful strategy in your circumstances and determine next steps in a timely manner. We’re also here to provide you with the good advice you need to develop an estate plan that will help protect you and your loved ones while also fulfilling your wishes.
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