Imagine ordering a large drink late in a steamy August afternoon after just completing a day’s toil in the sun. After several thirsty minutes waiting, watch in rapturous delight as the waitress finally brings over a tall, frosted glass, beaded with moisture . . . only to discover that it’s mostly ice. For lawyers and financial planners like me, that’s what I see when calculating actual size of the estate many of my clients will leave to their heirs after paying taxes. Although there are many ways to cut down on the ice quotient, the one I want to talk about today is called the “estate freeze.”
In simple terms, a freeze operates to cap or “freeze” the amount of unrealized capital gains on company assets that is taxed on when the grim reaper comes calling for that freezing shareholder. The freezer swaps the common shares that have grown in value for one or more classes of fixed value preferred shares that maintain control over the company but won’t participate in future growth. Instead, the company issues new common shares that are currently without value to the next generation or to a trust that the freezer controls and, when a holding company’s portfolio skyrockets higher or an active business’ widget sales go through the roof, those new common shares soak up all the new growth. Although the freezer will still need to pay tax on any unrealized gains on the preferred shares (s)he owns after their last gasp, (s)he will have at least minimized the tax (although not emotional) pain for those left behind.
Obviously, timing when to do the freeze makes a profound difference to the tax savings the freezer’s estate will eventually enjoy. If the company doesn’t continue to grow in the future or if the freezer dies within a year or two of implementing the freeze and the new common shares haven’t yet had a chance to significantly increase in value, then the whole exercise was likely a waste of time. On the other hand, for a company that doubles in value over 5 years, the savings to the deceased’s estate can be over $250,000 on every million dollars of gains that would have otherwise been taxed in their hands at this point. If amount of capital gains that are included in income and are taxed increases in the future, as many worry, the savings could be even more. For example, if the inclusion rate for capital gains increases from 50% to 75%, a properly done freeze could save the estate $375,000 per million dollars of capital gains avoided.
When to Consider Getting Chilly
Whether a freeze is worth considering depends on a host of factors. Perhaps the biggest are how much have your company shares already increased in value and how much will they continue to grow before your death if you leave well enough alone, as noted earlier. As a friend of mine once said, ask yourself if the juice (i.e., the benefit) is worth the squeeze (the cost and effort involved in extracting the relevant breakfast beverage.) The best candidates for a freeze own active businesses that they are looking to either pass down to the next generation or sell to an outsider. In the first case, minimizing the tax bill at death may make the difference between a business staying in the family poised for continued success or either a forced sale to pay the taxes owing at death or hamstringing heirs with large bank loans in order to pay that bill.
If the goal is instead to minimize taxes on an eventual sale, capping the original shareholders’ share value and transferring future gains to other shareholders allows more family members to claim the lifetime capital gains exemption on their shares upon sale. Every shareholder can avoid most of the tax on almost $900,000 in increases to the value of their shares at this point (the exempted amount increases yearly due to inflation) if they and the business satisfy certain criteria. By doing a freeze to transfer future growth to spouses and children, etc. after your own shares have unrealized gains of about $900,000 can mean hundreds of thousands of dollars in savings in some cases. For example, someone doing a freeze when her shares have grown by $900,000 in value in favour of her husband and 3 children in the expectation that the company would be worth $4,500,000 upon sale may be able to avoid capital gains tax entirely at that time. In that example, the new common shares owned in a family trust would be worth and could be apportioned equally amongst her hubby and children so each could shelter $900,000 of growth, with mom using up her exemption on the $900,000 in shares she retained after the freeze.
By contrast, if she does nothing, remains the sole shareholder and owns $4,500,000 worth of shares at sale, the tax bill could easily exceed $900,000 at today’s levels and far more if the inclusion rate for capital gains climbs in the future. As an added bonus, in some cases, a freeze might help a family save tax along the way by allowing them to sprinkle dividends to qualifying adult family members who actively work in the business but whose salaries aren’t enough to optimize the family’s annual tax savings.
On a related note, a freeze requires an accountant or business valuator to put a value on the company at the time of the freeze. Businesses hit hard by Covid may be able to turn this to their benefit if they are confident that the blip in value is short-lived by doing the freeze based on the current Covid-influenced levels so the new common shares can reap the rewards when the economy and business value both improve.
On the other hand, freezes are not just for active businesses. Doing a freeze for your holding company can still save your family a host of potential taxes on your eventual passing, particularly if combined with some of the other options I talk about in my next article on “wasting freezes” and share redemptions on death using life insurance. As I will also discuss, investors with large non-registered portfolios or perhaps rental properties might even consider setting up a new holding company, then rolling those assets into the company on a tax deferred basis (but do watch out for property transfer tax) to cap the future tax bill owing at death. This strategy works best if the plan is for the children to keep the assets, such as a real estate portfolio, for the long term after your death but can even mean huge savings if that isn’t the plan in some cases. If nothing else, it may provide your heirs with the flexibility to wait a few years after your death for the real estate or stock market to improve rather than forcing them to sell as soon as you’re in the ground in order to cover your final tax bill.
Reasons for Giving Freezes the Cold Shoulder
Admittedly, freezes are not for everyone. Besides taking into account the cost of doing the freeze and any additional annual expenses that might result, particularly if creating a family trust to hold the new common shares or setting up a new holding company, I suggest taking the following into account:
• A freeze may only delay the day of reckoning. Although shifting part of the potential tax bill from one generation of taxpayers to another is often great tax planning, it might not be so beneficial if the kids will need to wind up the company in short order anyway. It still may be worth proceeding if the freeze provides the heirs with some discretion regarding when to sell assets like real estate or if there are still tax savings to be had despite the desire to wind thing up shortly after your death.
• A freeze only works if the company continues to grow or you use the aftermath of the freeze to decrease the value of the freeze shares. If you plan to draw down the value of any company during retirement and suspect that it will eventually be worth less than it is now, then a freeze is not for you. The only exceptions may be if you also do a “wasting freeze” during retirement, as I discuss in my next article, to more actively transfer some of the capital gain tax bill to the next generation.
• Are you too young? If doing a freeze using a family trust, realize that the trust has an effective lifespan of 21 years in this situation, as all unrealized gains inside the trust are taxed on its 21st anniversary. Although the shares can be transferred out of the trust on a tax-free rollover basis at any time prior to then, some parents may not be keen to gift the shares directly to the children at that point, particularly children with rocky marriages, financial issues or similar problems. On the other hand, 21 years is a long time for children to get their act together and the parents can always just allocate the common shares to back themselves if that has not happened. This would undo the benefits of the freeze but it is always good to have this option if life does not turn out as expected.
• How much does control matter? How solid are your children’s lives? Practically speaking, doing a freeze doesn’t mean having to give up control of the company if the freezers retain all of the voting shares and control the family trust that also owns the new common shares. This allows them to continue with business as usual inside the company and to continue to pay themselves as many dividends and as much salary as their hearts desire and the Income Tax Act allows. If shares are gifted to the children directly, there is less control, which increases the chances of problems if a child is divorced or has creditor issues. Even if the shares are held in a trust, there are at least theoretically potential problems if one of your children divorces. One way of minimizing that risk is making it a precondition of the freeze than any married children get prenuptial or marriage agreements excluding the value of any shares from any divorce settlement.
• Are there other tax fighting weapons in the armoury? A freeze can be a silver bullet in the right circumstances but a empty shell in others compared to some of the other tax minimizing options available. Corporate life insurance can help minimize, reduce or pay the final tax bill, particularly if there is a big tax-free payout on the first death. Loaning money to a family trust (assuming most of your capital gain assets are outside of a company) at 1% so you can actually sprinkle income to your descendants now can be a really effective strategy in many situations. Even if you have to pay more tax now to get a critical mass of assets into the trust, it might be a blessing in disguise if the taxable amount of capital gains increases in the future anyway. Unfortunately, the trust idea may not be a particularly useful one if most of your assets are held corporately.
The tax bill faced by many estates on their corporate assets or non-registered holdings often takes a very big gulp out of what taxpayers want to pass along to their heirs, but proper estate planning can often reduce that large gulp into a small sip. Implementing an estate freeze many years prior your final passing may be one way of making that happen. In my next article, I’ll discuss some ways to supercharge the benefits of a freeze to hopefully make that final sip of taxes into a mere moistening of the lips.