The concept of an estate freeze has been the subject of considerable commentary for about 50 years, going back to when Canada first started taxing capital gains. An estate freeze is a transaction in which the owner of an asset crystallizes and fixes the value of that asset under an arrangement that permits other persons (usually family members) to benefit from future increases in the value of that asset. Apart from passing on entitlement to future growth, the person effecting the freeze (referred to in this article as the “Freezor”) can determine his or her liability for capital gains tax to be paid on death and to plan how to fund the payment of such tax.
The most common use of an estate freeze generally involves a family-owned business corporation that has grown in value over the years and is likely to continue to increase in value. In some cases, a freeze is used where the next generation is involved in the family business and the Freezor wishes to provide an incentive or reward for those involved in the business. This arrangement can become more complicated if some children participate in the business and others do not. There are a number of alternatives to address this situation, such as:
- the Freezor giving a portion of the future growth to the person involved in the business and the remainder of such growth to the other children
- The Freezor continuing to own shares that represent participation in a portion of future growth (sometimes referred to, tongue-in-cheek, as an “Estate Chill” since it is not a 100% freeze)
- Structuring the arrangement so that the family member involved in the business gets 100% of the growth, with the other beneficiaries receiving a larger portion of the remaining estate
The role of the adviser in these circumstances is to give paramount weight to what the Freezor wants to accomplish rather than to allow tax planning considerations to drive the structure.
One of the most important questions to consider is “When is the right time to do an estate freeze?” When the value of the business is low, the Freezor can crystallize the value of the corporation’s shares at a level that results in a lower capital gain than when the value is high, thus reducing the potential tax at death. If that reduced value is then recovered, the benefit will be realized by the beneficiaries of the freeze. However, one size does not fit every situation, and the driving consideration should be based on the estate planning objectives of the Freezor.
There are other benefits of carrying out a freeze apart from passing on the benefit of future growth to the next generation. By having a number of family members participate in the ownership of shares of the family business corporation, it is possible to create an arrangement in which those shareholders (provided they have owned their shares fro at least 24 months) may be able to claim the lifetime capital gains exemption (an exemption that is available to shareholders of a Qualified Small Business Corporation (“QSBC” – a Canadian-controlled private corporation that carries on an active business in Canada, and meets certain conditions regarding the percentage of its assets that are used in its active business). The amount of the capital gain that is available for exemption is linked to the increase in the Consume Price Index, and for 2022 is expected to be more than $900,000, resulting in a possible saving of up to approximately $230,000 of tax per person.
If one is interested in taking advantage of the Capital Gains Exemption, advance planning is required to ensure that the corporation qualifies for the exemption. One of the most important considerations is that a QSBC may not have passive investment assets that exceed certain amounts – less than 10% of total assets at the time of sale. Removing these passive assets from the corporation, usually referred to as “purification”, should be part of long term planning to be carried out well before any sale rather than be the subject of a last minute scramble.
A planning device is available to allow passive assets to be removed and transferred to a related corporation on a tax deferred basis, but this must be done before a sale becomes immanent, otherwise, the deferral may not be available. Unfortunately too many clients leave matters until urgent action is required, at which time, it may be too late to implement the tax deferred planning steps.
This Article is intended to provide general information about some of the benefits of an Estate Freeze, and how it can enhance the use of the Capital Gains Exemption. It is not intended to be legal advice that applies generally or to any particular set of facts. The reader should consult with his or her own professional advisers to determine if any of the planning concepts referred to in this Article are applicable in the circumstances.
A previous version of this article was originally published by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.