Estate freezes are most commonly associated with businesses, where they are used to “freeze” the current value of the business in the hands of the founder, while transferring the future growth to the children or grandchildren. However, an estate freeze can also be used for any asset, such as investments, land, etc.
The purpose of an estate freeze is to avoid a large tax bill on death, by transferring the assets now in a controlled manner. A properly planned estate freeze can avoid any immediate taxation on the transfer of the assets, and allow taking the gain into income over a number of years to fund retirement.
While an estate freeze can be implemented by selling or gifting assets to family members, this will trigger an immediate capital gain where tax will be due immediately. A more useful technique is to transfer the assets to a corporation using the provisions of Subsection 85(1) of the Income Tax Act. This allows deferral of taxation to the future. In return for the assets, the corporation issues fixed value shares and a promissory note or similar consideration. The repayment of the promissory note is not subject to tax, and the shares can be redeemed over a number of years, providing an income stream to fund retirement. The redemption of the shares is taxed as a dividend, and a dividend tax credit can be claimed. With good planning, taxes payable on the redemption can be minimized.
Once the current value of the company is “frozen” in the shares and other consideration issued in the Section 85 rollover, the other family members can be issued shares for a nominal value. Then all future gain in value of the assets in the corporation will accrue to the family members. These shares can be voting or non-voting, or a mix of both can be issued.
Another advantage of using a corporation to perform an estate freeze is that control of the corporation does not have to be immediately relinquished as would occur if the assets were sold or gifted to family members. Especially when family members are still young, control of the corporation can be gradually transferred to the next generation over a period of some years, or control can be transferred at a specific date.
A family trust is often used in conjunction with an estate freeze. The trust offers protection of the family assets, for instance in a divorce assets held in a family trust do not form part of the marital property and therefore the ex-spouse of a child will not be able to claim any of the shares of the company. Another example where a family trust offers protection to the assets is the case of family members who are in long term care. The cost of long term care usually depends on the income and assets of the patient – if the assets are in a family trust, they do not belong to the patient and therefore the patient will not have to pay higher fees. The family trust is usually a discretionary trust, so the trustees can pay out as little or as much as they chose to any family member who is a beneficiary.
The timing of an estate freeze can be tricky. Usually, an estate freeze is not done until the retirement, so the maximum amount can be set up in shares to properly fund retirement. It is possible to do a partial freeze, freezing only some of the value of the assets, or to do a series of incremental freezes.
If you own a family business and are thinking of passing it on to the next generation, talk to your tax accountant. The potential tax advantages of an estate freeze can be very attractive, but the process is complex and fraught with perils.