What are Common Estate Freeze Strategies?

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

When contemplating the use of an estate freeze strategy, the appropriate strategy will be determined by the assets that are to be frozen, your particular tax situation, the objective outcomes being sought, among other factors, such that an appropriate tax strategy and procedure might be pursued to realize optimal results.

A. Internal Freeze (Reorganization of Capital / Section 86 Roll-over)

This is one of the most common and direct methods of instituting an estate freeze. The existing common shares of the operating company (OpCo) held by the "freezor" (the current owner) are exchanged for new fixed-value preferred shares in the same corporation. These preferred shares are designed to have a redemption value equal to the fair market value (FMV) of the common shares at the time of the freeze. Simultaneously, new common (growth) shares with a nominal value are subscribed for by the next generation (e.g., children) or a family trust.

The freezor retains the value of their shares at the freeze date, and any future appreciation of the company accrues to the new common shareholders. This exchange is often done under Section 86 of the Income Tax Act, which allows for a tax-deferred exchange, meaning no immediate capital gains are triggered for the freezor.

The preferred shares can be structured to carry voting rights, allowing the freezor to maintain control over the business even after transferring the growth to the next generation.

Compared to setting up a new holding company, this can be a simpler structure as it doesn't involve an additional corporate entity.

B. Holding Company (Holdco) Freeze (Section 85 Roll-over)

A new corporation (a "Holdco" or holding company) is incorporated. The freezor then transfers their common shares of the operating company (OpCo) to this new Holdco on a tax-deferred basis (using Section 85 of the Income Tax Act). In exchange for the OpCo shares, the freezor receives fixed-value preferred shares of the Holdco. New common (growth) shares of the Holdco are then subscribed for by the next generation or a family trust for a nominal amount.

The value of the OpCo shares is frozen within the Holdco structure, and any future growth in the operating company's value flows up to the Holdco, and from there to the Holdco's common shareholders (the next generation).

The benefits that can be realized through a Holdco Freeze include:

• Asset Protection: The Holdco can act as a buffer, potentially protecting the operating company's assets from claims against the shareholders.

• Flexibility: It offers greater flexibility for future reorganizations, income splitting, and holding other investments separate from the operating business.

• Creditor Protection: Depending on the structure, it can offer some creditor protection for the business owner's personal assets.

However, it is also necessary to recognize the complexity in this particular approach to an estate freeze, as this strategy introduces an additional corporate layer, which means more complex annual compliance and potentially higher professional fees.

C. Estate Freeze with a Family Trust

This strategy is often combined with either an Internal Freeze or a Holdco Freeze. Instead of the growth shares (new common shares) being issued directly to individual family members, they are issued to a family trust. The family members are then named as beneficiaries of this trust.

The trust provides significant flexibility and control. The freezor can often be a trustee, maintaining control over the assets within the trust and how income and capital are distributed to the beneficiaries.

The benefits that can be realized through a Family Trust Freeze include:

• Income Splitting: Income (e.g., dividends) paid to the trust can be distributed to beneficiaries in lower tax brackets, subject to "Tax on Split Income" (TOSI) rules which need careful navigation, especially for minor beneficiaries.

• Future Flexibility: If children are young or their maturity/involvement in the business is uncertain, a trust allows for delaying the ultimate distribution of shares until they are ready.

• Creditor/Divorce Protection: Assets held in a properly structured trust can be protected from creditors or marital disputes of the beneficiaries.

•  Multiplication of Lifetime Capital Gains Exemption (LCGE): If the shares qualify as "Qualified Small Business Corporation Shares" (QSBCS), each eligible beneficiary of the trust can potentially utilize their own LCGE upon a future sale of the shares, significantly reducing overall capital gains tax.

• Probate Avoidance: Assets held in a trust generally bypass the probate process, leading to lower probate fees (although in certain provinces, such as Alberta, the probate fees are minimal) and a quicker distribution to beneficiaries.

However, it is also necessary to recognize that there are also complexities involved with a Family Trust Freezes, as well as legal requirements associated with trust, including the fact that Canadian trusts are subject to a "21-year deemed disposition rule," meaning they are deemed to dispose of their capital property every 21 years, potentially triggering capital gains tax. This needs to be factored into the planning horizon.

Common Elements and Considerations across Estate Freeze Strategies:

• Valuation: A critical step is to obtain a professional valuation of the assets (especially business shares) at the time of the freeze to establish the fair market value. This determines the fixed value of the preferred shares and is crucial for CRA compliance.

• Preferred Shares: The preferred shares issued to the freezor are typically:

  • Fixed Value: Their redemption value is set at the FMV of the assets at the freeze date.

  • Redeemable/Retractable: They can be redeemed by the corporation or pulled back by the shareholder at their fixed value, providing a source of retirement income for the freezor.

  • Voting Rights: Often designed to retain control for the freezor.

  • Dividend Rights: May carry preferential dividend rights.

• Common Shares: The new common shares issued to the next generation or trust represent all future growth in the company's value. They typically have a nominal initial value.

• Shareholders' Agreement: Especially crucial in a business context, this agreement outlines the rights and obligations of all shareholders (freezor, new common shareholders, or the trust), including buy-sell provisions, voting rights, and restrictions on share transfers.

• Attribution Rules: Canadian tax law has attribution rules that can re-attribute income or capital gains back to the freezor if certain conditions are not met, particularly when transferring assets to a spouse or minor children. Proper structuring is vital to avoid these.

• GAAR (General Anti-Avoidance Rule): The CRA can apply GAAR to transactions lacking a clear bona fide purpose other than tax avoidance. An estate freeze should have a legitimate business or estate planning purpose (e.g., succession planning).

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. Choosing the right estate freeze strategy depends heavily on the specific assets, family dynamics, control desires, and long-term financial and tax goals. 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).

Why would I implement an Estate Freeze? What are the benefits? An estate freeze is an important estate planning strategy where you have significant appreciating assets, like businesses and/or real estate, from which you are seeking to manage and minimize the tax burden on these assets, ensuring a more efficient transfer of wealth to future generations. . . .  Continue reading.

What scenarios can take advantage of an Estate Freeze? Serious analysis and investigation should be undertaken, and consideration to the implementation of the appropriate estate freeze, where you have significant appreciating assets, like businesses and/or real estate, that you are seeking to manage and minimize the tax burden on these assets, so as to ensure a more efficient transfer of wealth to future generations, in particular in the following scenarios. . . .  Continue reading..

What are Common Estate Freeze Strategies? When contemplating the use of an estate freeze strategy, the appropriate strategy will be determined by the asset(s) that are to be frozen, your particular tax situation, the objective outcomes being sought, among other factors, such that an appropriate tax strategy and procedure might be pursued to realize optimal results. . . .  Continue reading.

What are Potential Risks / Disadvantages of an Estate Freeze? 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. . . .  Continue reading.

Can an Estate Freeze be Reversed (Thawed)? As the name implies, an estate freezes effectively freezes those assets that have been subjected to the legal procedure of an estate freeze. Nevertheless, there may well arise circumstances at a later date that you no longer benefit from having those assets effectively frozen. In those circumstances, is there a legal process to reserve your original actions, such that you are effectively thawing or defrosting particular assets that were frozen pursuant to your earlier estate freeze. . . .  Continue reading.

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