Looking to found a family business dynasty? Here’s a sobering statistic: Only about 10% of family-owned businesses make it past the third generation. This has a lot to do with the lack of proper planning while the founding parents are still alive. One way to give your business at least a fighting chance to go beyond the third generation is to implement something that estate lawyers call an “estate freeze.”
If you carry on a family business and are considering bringing the next generation into the business as owners, then it may be time to think about how to best accomplish this in the most tax-efficient way possible. If you are not sure your kids want to carry on the family business, a succession plan can also be an important tool in minimizing taxes on an eventual sale.
So regardless of your goals as a family business owner, consider alternative structuring for your business by implementing an estate freeze of your operating business (which we’ll call “Opco”).
What is an estate freeze?
An estate freeze refers to the transferral of future growth in the value of a business, investments, or other assets into the hands of your kids. An estate freeze typically limits the value of your estate in relation to your corporation holdings to the value of Opco at the date the freeze is implemented (don’t worry, you still retain the current value of Opco, although often in a different form). Accordingly, capital gains and other tax exposure to the future growth that would arise when the assets pass from you to your kids are avoided.
In order to get the full benefit of an Estate Freeze, your shares in Opco will be reorganized into a class of “freeze shares” that will not be entitled to any future growth (but will still get the benefit of dividends based on a pre-determined date). New growth shares can then be issued to your kids (or a discretionary family trust for the benefit of your kids) without triggering any tax hits. Any future growth in the value of the assets held by Opco will then accrue to these growth shares (and not to you).
Why do an estate freeze?
We implement most tax-related strategies to cut our tax bill. But why you would give up future growth to save on tax? Well, chances are that you may have acquired enough value in your current assets to keep you happy for the rest of your life. By putting in place an estate freeze, you will maximize the value of your estate that will ultimately pass to your beneficiaries.
Upon your death, you are deemed to have disposed of all of your assets at their fair market value, and your estate is required to pay the capital gains tax on this “deemed disposition “. The implementation of an Estate Freeze will effectively “freeze” the value of your interest in Opco to present-day value, with any future growth in Opco flowing in favour of your kids or a family trust (assuming you give them the growth in Opco).
This means that your interest in Opco will no longer grow in value. The upside, however, is that the capital gains and other tax that would otherwise be triggered on your death will be limited to the frozen value of Opco. Future growth in Opco from the date of the estate freeze to your death will be taxable only if your children sell the shares or when they pass away. Less tax to the CRA means more for your beneficiaries.
In order to maximize the benefit of the Estate Freeze, this strategy is usually implemented when Opco (or the assets in Opco) are expected to appreciate in the future. If the assets are expected to depreciate, it would usually be preferable to hold off freezing. Also, if you feel that the current value of the assets is not high enough for you to live on for the rest of your life, you may want to think twice about freezing.
Courtesy Fundata Canada Inc. ©2016. Samantha Prasad, LL.B. is Tax Partner with Toronto law firm Minden Gross LLP. Portions of this article appeared in The TaxLetter, published by MPL Communications Ltd. Used with permission.