The benefits of an estate freeze

As a shareholder of a corporation (original shareholder or freezor) becomes older and wishes to pass the future growth of the business to the next generation or key employees, (s)he can implement a common reorganization known as an estate freeze.

What is an estate freeze?

A typical estate freeze transaction involves an exchange of existing common shares of a private corporation held by the original shareholder for fixed value redeemable and retractable preferred shares (the freeze shares). The exchange usually occurs on a tax-deferred basis. Immediately after the exchange, members of the younger generation, a family trust with the freezor’s family members as beneficiaries, or key employees will subscribe for new common shares (the growth shares) of the corporation for a nominal amount. The following diagrams show examples of some of the more common post-freeze organizational structures:

Click on the image to enlarge.

What happens upon death?

Upon death, an individual is deemed to have disposed of all his/her capital property for proceeds equal to the fair market value of the property at the time of death. In addition, depending on the province and certain other factors, the estate may be subject to probate fees based on the fair market value of the property. The estate freeze locks in the value of the corporation’s shares so that the individual’s income tax liability upon death, as well as potential probate fee, can be quantified, and future appreciation of the corporation will then accrue to the younger generation(s) of family members or key employees.

Other benefits and considerations

Reorganization undertaken as part of the estate freeze may also be used to achieve certain income splitting objectives, as future appreciation will be taxed at the growth shareholders’ marginal tax rate and potentially be sheltered by their lifetime capital gains exemptions (assuming shares of the corporation meet the definition of the Qualified Small Business Corporation shares). Prior to considering income splitting objectives within the context of estate freeze, it is important to review the tax on split income (TOSI) rules to ensure that there are no unexpected negative consequences.

The estate freeze also allows the freezor to manage financing of his or her terminal income tax and probate fees liability upon death.  For example, the freezor can obtain a life insurance policy with the death benefit equal to the income tax liability to be realized upon death.

The original shareholder will lose control of the corporation when receiving the freeze shares. If retaining control of the corporation is required, it can be achieved by subscribing for a special class of voting shares of the corporation, which has no value or would not be eligible to receive any income from the corporation.

In addition, if the freezor ordinarily receives an income by way of a dividend from the corporation, then the income stream can still be maintained by way of the corporation redeeming a portion of his or her freeze shares during his/her lifetime. This is known as a so-called vanishing or wasting estate freeze plan. With such planning, as the years go by, the freezor will slowly reduce his or her interest in the corporation. This will result in less (or, ideally, no) tax arising on his or her death because the number and the value of the freeze shares at the time of death has been reduced or eliminated through prior redemptions. If it so happens that all of the individual’s freeze shares have been fully redeemed before death, the value of the individual’s estate will have effectively been reduced because that individual will no longer have any shares in the corporation to be included in the estate upon his/her death.

Please feel free to reach out to the Fuller Landau Tax Group to get your estate freeze in place today or to answer any questions you may have.

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About the Author

Nadia Pulla, CPA, CA, is a Senior Manager in our Tax Group.  She can be reached at (416) 645-6543 or npulla@fullerllp.com.