What are Potential Risks / Disadvantages of an Estate Freeze?

Neufeld Legal PC: Chris@NeufeldLegal.com - 403-400-4092 / 905-616-8864

As with every legitimate tax planning strategy, it almost goes without saying, that there are potential risks and disadvantages with instituting an estate freeze. Nevertheless, it is through the recognition of the potential risks and disadvantages that you might be able to either avoid their occurrence or minimize their adverse impact, such that understanding these risks and concerns is an important facet in getting the most out of an estate freeze.

A. Tax-Related Risks:

  • CRA Challenges to Valuation: The Canada Revenue Agency (CRA) may dispute the valuation of the assets at the time of the freeze. If the valuation is successfully challenged, it could lead to reassessments, penalties, and unintended tax consequences (e.g., deemed shareholder benefits or indirect gifts).

  • Attribution Rules: Canadian tax law has attribution rules designed to prevent income splitting. If not structured correctly, these rules can negate the tax benefits of an estate freeze, particularly when transferring property to a corporation for the benefit of a spouse or minor children. This can result in "phantom" interest income being attributed back to the original owner.

  • Tax on Split Income (TOSI): For income received by family members from a business, TOSI rules might apply, taxing that income at the highest marginal rate regardless of the individual's actual tax bracket.

  • 21-Year Deemed Disposition for Trusts: If a family trust is used as part of the estate freeze, the trust is deemed to dispose of its assets every 21 years for tax purposes. This can trigger a significant capital gain if the assets haven't been distributed from the trust before this anniversary.

  • Future Tax Law Changes: Tax laws are subject to change. What is an advantageous strategy today might not be as beneficial in the future, requiring ongoing review and potential adjustments to the estate freeze.

B. Family and Relationship Risks:

  • Family Disputes: Transferring future growth to the next generation can lead to family disputes, especially if not all family members are treated equally or if the terms of the freeze are not clearly communicated.

  • Matrimonial Breakdown: Gifting growth shares to beneficiaries without proper safeguards may expose these assets to family law claims in the event of a divorce or separation.

  • Succession Challenges: If the intention is for the next generation to take over the business, but they later decide they are not interested or become estranged, the plan may backfire.

  • Premature Sale of Assets: If the frozen assets are sold earlier than anticipated, it could result in wealth going to the growth shareholders sooner than the original owner intended.

C. Timing and Market Volatility:

  • Freezing at a High Value: If the estate is frozen at a high valuation and the value of the assets subsequently declines significantly, it may necessitate a "refreeze" to capture the lower value, incurring additional costs and complexity.

  • Not Enough Growth: An estate freeze is most beneficial when significant future growth is anticipated. If the assets don't appreciate as expected, the costs and complexities of the freeze might outweigh the limited tax benefits.

D. Loss of Flexibility and Control (if not structured carefully):

  • Frozen Value: Once the value of your assets is frozen, you lose the ability to participate in the future growth of those specific assets. If the business or asset continues to grow significantly, that growth accrues to the "growth shareholders" (often the next generation).

  • Difficulty in Reversing: Reversing or significantly altering an implemented estate freeze can be challenging and may trigger adverse tax consequences. It's crucial to ensure the freeze aligns with long-term estate planning goals.

  • Insufficient Funds for Retirement: If an estate freeze is implemented too early, or if the value of the frozen assets isn't sufficient to meet your future needs (e.g., retirement), you might find yourself with inadequate funds.

  • Loss of Direct Control (in some structures): While often structured to allow the original owner to retain control (e.g., through voting preferred shares or as a trustee of a family trust), there's a risk of losing direct control over the growth assets if not meticulously planned.

E. Complexity and Costs:

  • Professional Fees: Implementing an estate freeze is a complex legal and financial process. It requires the expertise of lawyers, accountants, and potentially valuators. These professional fees can be substantial, and ongoing management of the freeze structure is often required.

  • Administrative Burden: There can be increased reporting and accounting burdens, especially if a family trust is involved.

Significance of Professional Advice: As with most tax planning strategies, an estate freeze is a complex technical process, which requires the application of strict rules to the particular facts and circumstances. It is highly recommended to seek advice from an accountant and a tax lawyer to ensure legal compliance and to properly structure the transaction for your specific circumstances and objective outcomes.

For knowledgeable and experienced tax law representation for estate freezes and other tax planning strategies, contact tax lawyer Christopher R. Neufeld at Chris@NeufeldLegal.com or call 403-400-4092 (Calgary, Alberta) / 905-616-8864 (Toronto, Ontario).

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