How Wasting Freezes Can Warm Your Children’s Hearts: Advanced Strategies for Lowering Your Final Tax Bill
Previously, I have waxed (hopefully) poetic on the potential tax benefits on the sale of the family business or upon the death of key shareholder in that business or the family holding company by implementing an “estate freeze” many years in advance. In simple English, an “estate freeze” typically involves reorganizing the share structure of the company so that the older generation swaps their shares that have previously increased in value for fixed value for preferred shares worth the same amount and with the same unrealized tax liability. As a result of these machinations, unless tax rates change in the future, mom and dad have now capped their final tax bill on their company shares. Accordingly, in some cases, keeping future growth out of mom and dad’s hands may be the difference between the kids having to sell the company or mortgage it up to its eyeballs in order to pay their parents’ final taxes versus the company successfully transitioning to the next generation.
At the same time as mom and dad swap their common growth shares for fixed value preferred shares, a new class of common shares are created and either issued to younger members of the family, or, as is more common, issued to a family trust mom and dad control that lets them decide later who will get these new shares. Thus, the future growth of the company, which will show up as an increase in value to the new common shares, will no longer be taxed in mom and dad’s hands. In addition to potentially saving the company for future generations at the parents’ death, this can also potentially save the family scads of tax dollars if the business is instead sold during mom and dad’s lifetime. By having the future growth taxed in the kids’ hands, the family can now tap into the kids’ separate lifetime capital gains exemption for small business (about $900,000 at this point for most businesses, but $1,000,000 for farmers and fishers) against this growth. For example, a family of 4 could now minimize tax on approximately $3.6 million of growth rather than just mom and dad’s combined $1.8 million. In most provinces, this represents tax savings of easily more than $400,000 for the example just shown.
Unfortunately, by the time some families get around to implementing a freeze, the value of mom and dad’s shares may have already reached stratospheric heights. Thus, although the freeze may still save the family buckets of future tax dollars, unless the family also engages in other planning, that final tax bill on mom and dad’s death or the sale of the company during their lifetime may still be enough to make stoic men swoon and brave women cry.
Today’s article talks about taking an estate freeze to the next level so that it not only caps mom and dad’s future tax bill but actually reduces it. This is what us lawyer types call a “wasting freeze”, a name tax and financial planning professionals like to use to make our jobs sound slightly sexier.
While a plain old vanilla estate freeze is typically a one-time event, a wasting freeze usually involves yearly steps after the original freeze has been completed in order slowly chip away at mom and dad’s unrealized tax bill. Just like it typically takes years for a company to grow, it usually also takes many years to systematically reduce the value of mom and dad’s shares without paying too much tax along the way.
This gradual process of reducing mom and dad’s future tax liability is accomplished each year at tax time and can often occur without triggering any or minimal extra tax along the way. For example, even though mom and dad are transferring future growth in the company to their kids, they may still want to continue receiving their typical annual income from the company in order to support their hopefully lavish lifestyles. Post-freeze, mom and dad will likely get paid exclusively through company dividends. If they were getting paid the same way and the same amounts previously, their yearly tax bill won’t change. If they were receiving a mix of salary and dividends previously and want to have the same amount of after-tax money in their pockets, the increased combined corporate and personal tax hit will still be minimal at worst.
Using dividends in a slightly different way than usual makes the magic happen. Most of us who own shares in public or private companies simply receive our dividend payments from time to time while continuing to own the same number of shares after getting paid. A wasting freeze instead involves the company retracting or the shareholder redeeming some of the newly issued preferred shares in exchange for dividend payments. It’s a lot like selling the shares back to the company but for tax purposes, the transaction is treated differently than a typical sale. In this scenario, the shareholder unloading these shares is taxed on the money received as dividends rather than capital gains. Even better, the capital gains otherwise payable is ignored. In the end, if mom and dad were receiving exclusively dividend income previously and continue getting the same amount post-freeze, their current tax bill won’t change but their future capital gains tax hit is slowly but surely going down.
This is best explained by way of an example. Assume that mom does an estate freeze and now owns $2 million worth of preferred shares, all of which will be taxed as a capital gain upon her death. She has always received $100,000 in dividends from the company and will continue to do so going forward. Rather than merely receiving annual payments for this sum without surrendering any of her company shares, she now “redeems” $100,000 of her shares each year. She is taxed on the dividends in the same way as she’s always been taxed and the unrealized gains on the $100,000 of shares no longer in her hands is ignored. As a result, 5 years later, she has redeemed $500,000 worth of preferred shares, now only owns $1.5 million worth of shares and will have lowered her final tax bill by as much as about $130,000 if she lived in British Columbia. And all of this happened without her having to pay any more tax over these 5 years than she would have otherwise.
But, the taxy excitement doesn’t stop there. If you’ve laboured through some of my articles on how companies are taxed and the different type of dividends (available at www.colinsritchie.com) or are a tax geek, you’ll know that all dividends are not created equal. For private companies in Canada, you have your choice of three different types of dividends, all of which are taxed differently. If used strategically, correctly allocating dividends can both accelerate the timeline for reducing mom’s future tax bill and even reduce her tax bill along the way. They are as follows:
- Small Business / Ineligible Dividends. These are generated either by business income that was taxed at the small business rate of 11% in B.C. or from investment income such as either interest, rent or the taxable 50% of capital gains realized by a company taxed as investment income at really, really high rates, 50.67% in B.C. (although much of this is refundable to the company if they pay out enough dividends to shareholders.) Because this money was taxed in the company at either a really low tax rate or generates a large tax refund to the company paying those dividends, people receiving these payments get only a small tax credit to apply personally. If receiving no other income, someone getting $100,000 in non-eligible dividends in B.C. would pay less than $15,500 in tax (i..e, about 15.5%.), factoring in only the personal tax credit and ignoring things like the OAS clawback.
- Eligible Dividends. These arise from either the portion of active business income that wasn’t taxed at the small business rate (i.e., 27% in B.C. rather than 11%) or from eligible dividends the company received from other companies, including any investment dividends it receives if it owned shares in Canadian publicly traded companies. Because either your company or the company paying investment dividends to your company paid a lot more tax corporately on the money left to pay you dividend, shareholders receiving eligible dividends enjoy a much more generous tax credit personally when receiving these dividends. If receiving no other income, someone getting $100,000 in eligible dividends in B.C. would pay less than $7,600 in tax (i. e, about 7.6%), factoring in only the personal tax credit and still ignoring the OAS clawback.
- Capital Dividends. Capital dividends are tax-free to the receiving shareholder and are the holy grail of the dividend world. They were created as a way to pay tax-free money to incorporated business owners from the non-taxable 50% of any capital gain realized corporately so that they get to put that money into their personal bank accounts just like non-incorporated business owners could. Likewise, because someone personally receiving a life insurance payout on death gets that money tax-free, most of a corporately owned life insurance policy can be paid out of the company as tax-free capital dividends. Thus, someone receiving $100,000 worth of capital dividends still has $100,000 to spend any way they fit rather than having to share some of this with Ottawa.
Strategically allocating the right type of dividends each year to mom turbo charges the benefits of a wasting freeze. Although mom in our example received a fixed $100,000 per year in order to keep her tax bill to a manageable level and perhaps because she didn’t need any additional money, the family had “only” reduced her final tax bill by approximately $130,000 after 5 years or by 25%. If mom was in her 90’s rather than 60’s, the family might consider speeding up the process. On the other hand, because tax rates increase as income increases, at a certain point, it becomes counterproductive to pay mom out any more taxable dividends, as the tax rate on the last dollar paid will eventually exceed the amount of tax mom would have paid on that dollar at death if taxed as a capital gain. Moreover, paying that tax ahead of schedule only makes sense most of the time if paying at a significantly lower rate, as every dollar paid in tax is one less dollar left to grow along the way.
That’s where capital dividends might come in. Assume that the company sells a building or bank shares inside its investment portfolio at a profit, triggering a capital gain. In such years, the company might use some of this tax-free money generated from the sale to retract more of mom’s shares than it normally does, since it won’t impact her current tax situation but can profoundly reduce her bill at death. Likewise, if there was a life insurance policy inside the company on dad that paid out, the company could then redeem a bunch of mom’s remaining shares in one fell swoop if desired, or even some of the shares she inherits from dad. Although I could easily write an entire article on using life insurance both as part of a wasting freeze and to also reduce mom’s own tax bill at death if there was also a policy on her life, I’ll leave that for another day. For now, I’ll just say that corporately owned life insurance has some surprising tax advantages if used correctly and it’s usually worth a second look, no matter your views on the life insurance industry.
Wasting Freezes and Selling the Family Business
As noted earlier, a family can save an enormous pile of money if it is able to tap into several family members’ separate lifetime capital gains exemptions at sale, if the unrealized gain at sale is significantly higher than can be otherwise sheltered under the original shareholder(s)’ exemption. If the freeze is implemented after the value of the original shareholder(s)’ shares are already well above that mark, mom would still be stuck with a large and potentially unnecessary tax bill. Secondly, it may take several years for the new common shares to grow in value, so that the new family members can tap into a significant amount of their capital gains exemption.
A wasting freeze can help with both problems. Imagine a business worth $3 million at the time of the freeze and unrealized gains of the same amount, with mom and dad each owing $1.5 worth of shares. They hold the new common shares in a trust that names them and their 3 adult children as discretionary beneficiaries. They plan to sell the business in about 5 years and each of the parents typically takes out $100,000 per year in dividend income. Assume that the business is worth $4.5 million at the time of sale. If they took no further steps, only the $1.5 million in future growth in the company can be sheltered using the kids’ capital gains exemptions, with mom and dad facing a combined tax bill on $1 million of gains (approximately $267,500 if at the highest BC tax rate, assuming that the lifetime exemption has increased to $1 million per person by the time of sale ($3 million in total gains minus $2,000,000 of gains sheltered under the lifetime capital gains exemption.)
If mom and dad get wasted (i.e., use a wasting freeze strategy) instead, they will be able to avoid the potential $267,500 tax bill completely. They will have redeemed $1 million of their preferred shares along the way. Each dollar of preferred shares redeemed simultaneously boosts the value of the kids’ common shares. Accordingly, at the time of sale, mom and dad’s shares have decreased by $1 million to $2 million, which they can shelter under their own exemptions, and the value of the kids’ shares has increased by the same $1 million. Accordingly, the kids would collectively declare $2.5 worth of gains, all of which can be sheltered under their own capital gains exemptions. When the dust settles, the family now keeps an extra $267,500 without having to pay any extra tax along the way to make this happen.
Wasting Freeze and Holdcos
In some cases, it might actually be worth creating a holding company to hold a non-registered portfolio with significant unrealized capital gain both to cap the future gains and in order to use a wasting freeze to whittle away at the future unrealized tax bill produced by of decades of buy and hold investing in blue chip stocks. The existing portfolio can be rolled into the new holdco without triggering any taxes due to another wrinkle in the Income Tax Act, although the shares will still be taxed on their existing gains when eventually sold inside the company. There are a lot of pros and cons to this strategy, plus other options to consider, but if the plan is to keep the portfolio intact for the next generation without having to sell too many RBC shares at your death, this is one potential way of making that happen.
Although an estate freeze can be a wonderful tool for minimizing a family’s taxes and increasing what is left behind for future generations, sometimes it needs a helping hand. By annually redeeming freeze shares after the freeze has come and gone, diligent shareholders can systematically lower their eventual tax bill on their corporate assets at death or sale. Insurable shareholders can even take it one step further by purchasing insurance on themselves that can be used to redeem freeze shares on death by paying out capital dividends (although more so on the first death) to reduce the tax pain eventually faced by their estates. Although these options need to be considered carefully with the help of seasoned number-crunchers, the savings and benefits can be enormous.