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Using estate freeze planning as a tax deferral strategy

By 15 May 2024 11 min read

Many tax planning strategies in Canada focus on tax deferral. This refers to arranging your affairs such that a tax bill becomes due at a later date than it normally would have. The idea of tax deferral is that by avoiding a bill today, you would have a greater amount of resources available to invest and grow your wealth.

One of the more common tax deferral strategies in Canada is known as an “estate freeze.” Estate freezes are used for a broad range of purposes. In this article, we will discuss one of those purposes: how an estate freeze can help a business owner to defer tax on capital gains for their private company past the date of death.

The benefit of estate freeze planning may be even more valuable than in past years, due to some proposed tax changes in the 2024 federal budget. The budget proposed to increase the capital gains inclusion rate from June 25, 2024 onwards, for any personal capital gains above $250,000 in a given year. This means that the cost of triggering a capital gains tax bill upon death will increase for many business owners. Since the main tax benefit of an estate freeze is to defer that capital gains tax bill upon death, this style of planning may now be more attractive.

Tax at the time of death: the ‘deemed disposition’

When a Canadian resident passes away in Canada, they are treated as if they sold most of their property for a fair market value price.1 This means that any accrued capital gains on things like non-registered investments and personally held real estate become taxable upon death.

The deemed disposition applies to most types of capital property. For business owners, this would also include their shares in a private corporation. Any shares you continue to hold at the date of death are typically treated as if they have been sold immediately before your death. Since most business owners acquire shares in their companies for a very low initial price, it is common for almost the entire value of a holding company or operating company to be taxable to a deceased business owner at capital gains tax rates.

Planning to manage the tax bill on death

The deemed disposition itself is generally unavoidable. Any property that a person owns personally at the time of death will be subject to the deemed disposition. However, this does not mean that it is impossible to plan for a tax bill on death. Planning for this tax bill typically focuses on the following methods, among others:

  1. Taking advantage of post-mortem planning strategies to mitigate taxes after death.
  2. Finding tax-efficient methods of funding the tax bill, such as life insurance planning.
  3. Being proactive by using a wealth transfer strategy to reduce the size of gains or amount of property held in the deceased’s estate at the time of their death.

One of the most popular planning strategies for a person who owns shares of a private corporation is to take advantage of an “estate freeze.” This is a proactive planning strategy that, in the right situation, can help to defer tax on the future growth of a corporation by moving that growth outside of the business owner’s estate.

Estate freeze planning for a private corporation

Moving corporate growth outside of your estate

The deemed disposition can only apply to property that a person owns at the time of death. Estate freeze planning takes advantage of this by ensuring that some portion of a business owner’s wealth is held outside of their estate, instead. Since that wealth is held by somebody other than the deceased, it would not be subject to the deemed disposition on death, assuming the strategy is implemented correctly. This requires careful planning with a qualified tax professional to avoid various risks and pitfalls.

Estate freeze planning must be used proactively. Generally speaking, once your shares in a company have grown in value, it is difficult to give away that value without triggering tax. If a person were to gift their shares to their children, for example, they would be treated for tax purposes as if they had sold the shares for their full price. There are few options available to avoid tax on value that you have already created. An estate freeze instead focuses on deferring tax for the future growth of your company.

In a well-implemented estate freeze, the original business owner would exchange their common shares for fixed-value “freeze” shares. This exchange is usually arranged to occur on a tax-deferred basis, with the new freeze shares inheriting the tax cost of the old shares. The freeze shares would have special terms designed to ensure their value is fixed in place, “frozen” at their current value. Even if the company or its assets continue to grow, the freeze shares would not increase in value.

Since the freeze shares cannot grow in value, any further corporate growth must instead accrue to the benefit of a different class of shares. The company would generally issue these “growth” shares to somebody other than the original business owner, like their adult children or a family trust.

Since the growth shares are held outside of the business owner’s estate, those growth shares would not be subject to the deemed disposition on death. Effectively, this ensures that any growth of the company between the date of the freeze and the date of death is not taxable at the time of death. The tax on that growth is deferred until some later date.

Who should own the growth shares?

For an estate freeze to operate successfully, somebody other than the frozen shareholder needs to hold the growth shares (and therefore the future growth of the company). The crux of the plan is that the growth must be held outside of that frozen shareholder’s estate, after all.

Some business owners choose to have their children own the growth shares. This is common if the expectation is for these children to inherit the company after the business owner’s death. However, the decision to introduce your children to your company is one that should be discussed in detail with your tax advisor and legal counsel.

Once a person owns shares in a company, they have certain rights as shareholders. Even a non-voting shareholder will typically have the right to require audited financial statements, for example. Furthermore, once a person holds shares in your company, it can be difficult to remove them as shareholders if your relationship sours, without further planning (learn more about managing the relationship among shareholders in our article on shareholder agreements).

The decision of who should own the growth shares is a challenging one and should be discussed in detail with a tax advisor as a part of implementing the plan. The correct answer will depend on your own personal situation. In some cases, it may be sensible to introduce a family trust as the holder of growth shares.

How is the original business owner compensated?

Once the freeze is implemented, the original business owner holds freeze shares in their company. In a typical freeze, these shares can be “cashed in” or redeemed over time. Rather than having the company declare salary or dividends to compensate the original business owner, the company could instead slowly buy those shares from the frozen shareholder. These share redemptions are generally treated like dividends for tax purposes.2

By selling shares to the company, the frozen shareholder no longer owns those sold shares. This means at the time of death, there would be less property subject to the deemed disposition on death. In other words, by selling freeze shares to the company over time, the frozen shareholder is slowly chipping away at their tax liability on death by paying some of that tax during life.

Deferral benefit

It is important to note that this strategy only defers a tax bill. By moving share growth outside of a business owner’s estate, that growth would not be taxable upon their death. However, it would still be taxable at some point in the future. When the holders of the growth shares withdraw that growth from the company, sell their shares, or pass away, the growth would be taxable to them at that time, instead.

This means that estate freeze planning is not equally useful in every situation. The value of deferring a tax bill is greatest when the bill is deferred for a very long period of time. The benefit of estate freeze planning depends, at least in part, on what the growth shareholder expects to do with their shares after the original business owner passes away.

For example, if the growth shareholder simply winds up the company immediately after the original business owner dies, the tax on that growth would become taxable very soon after death. There would be little value to tax deferral in such a circumstance, so other strategies may be more useful than an estate freeze. On the other hand, if the growth shareholder expects to continue maintaining your company for many years after your death, the value of deferral would be much higher.

It is very important to discuss your overall estate plans and family dynamics with your tax advisor and legal counsel to ensure that your tax strategy aligns with your estate planning goals and your beneficiaries’ intentions.

Example: Albert’s investment holding company

Albert Johnson is a 65-year old entrepreneur who previously ran a trucking business in northern Alberta. The business was highly successful and Albert slowly built up an investment portfolio in his holding company worth around $10 million, which is growing at an after-tax rate of around 5% per year. He is the sole shareholder.

Albert knows he can fund his retirement purely from his personal savings, so he is unlikely to spend this corporate wealth during his life. He expects to pass it to his one daughter, Julie, when he dies. Julie plans to continue operating the company for many years after Albert’s death.

On the advice of his tax advisor, Albert has decided to implement an estate freeze on this holding company. As a result of the freeze, Albert owns $10 million of “freeze” shares and Julie owns “growth” shares with no value.

Albert passes away at age 85. Between the date of the freeze and the date of death, the company’s investments continued to grow, rising from $10 million to $26.5 million. At this time, Albert’s “freeze” shares are still worth $10 million, since they were frozen in place. Julie’s “growth” shares, on the other hand, have grown to $16.5 million in value:

Description Albert Julie
Share value at the date of freeze $10,000,000 Nil
Share value at the date of Albert’s death $10,000,000 $16,500,000

When Albert passes away, he is treated as if he sold those shares for their full value of $10 million. Based on the capital gains rates proposed to take effect on June 25, 2024, the first $250,000 of gains may be taxed at up to 24%, with any gains above that amount taxable at up to 32%. His estate would potentially become liable for taxes of around $3.18 million. Julie’s shares, however, are not taxable at that time.

If Albert had not used an estate freeze, he would have held the entire $26.5 million of share value at the time of death. Rather than only paying $3.18 million in tax in his estate, he would have had a tax bill of as much as $8.46 million. While Julie will eventually owe tax on her share value, the use of an estate freeze was able to defer taxes of up to $5.28 million past the date of Albert’s death:

Description No Freeze Freeze Scenario
Total value of the company $26,500,000 $26,500,000
Value of Albert’s shares at the time of death $26,500,000 $10,000,000
Capital gains tax rate
(first $250,000 of gains in the estate)
24% 24%
Capital gains tax rate
(gains above $250,000)
32% 32%
Capital gains tax in the estate $8,460,000 $3,180,000
Tax deferred - $5,280,000

Some risks and drawbacks to consider

Estate freeze planning is quite popular and well understood among tax professionals. However, there can be a range of disadvantages to consider before implementing this type of planning. We outline a couple of examples here, but this is not intended to be comprehensive. You should seek advice from your tax advisor and legal counsel about the possible risks and drawbacks of estate freeze planning in your situation.

One drawback of estate freeze planning is that it can expose the frozen shareholder to some of the risks of the growth shareholders. A key example of this would be the risk of matrimonial breakdown or insolvency of the growth shareholder. If your child holds shares in your company, that property will typically be exposed to their creditors, including an ex-spouse in the course of a matrimonial breakdown. While some of that risk may be mitigable through a range of methods, it is important to discuss your specific case with your advisors to understand whether and how best to protect yourself.

Another potential drawback of estate freeze planning is the risk of implementing it too early. Once a shareholder has frozen their interest in a company, they have a fixed pool of assets available to use during retirement. If those assets (along with your other resources) are not sufficient to fund your lifestyle, it is possible to run into financial troubles late in life. This can place a frozen shareholder into the uncomfortable position of relying on the kindness of the growth shareholders for retirement funding. It is vital to ensure your retirement resources will be sufficient to fund your lifestyle when contemplating an estate freeze. You may wish to request a detailed financial plan from your financial advisor, to get a picture of how your resources will support your retirement plan. The ATB Wealth Financial Planning Roadmap also offers helpful insights. 

The benefit of estate freeze planning also relies on the future growth of your company. As noted earlier, the historical growth up until the date of the freeze will inevitably be taxed to the current shareholders. It is only the future growth that can be deferred through a freeze. You should discuss with your tax advisor whether the future growth of your company will be large enough to justify the cost and complexity of implementing a freeze.

There can be many other tax and non-tax disadvantages to consider, such as the attribution rules and the 21-year rule for trusts, depending on how your estate freeze is implemented. You should discuss the full range of risks and disadvantages with your tax advisor and legal counsel before implementing an estate freeze.

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