Following our discussion around ways to optimize estate planning in the wake of COVID-19 and the value of a corporation’s Capital Dividend Account (CDA); discussed below is another way business owners can implement to take advantage of the downturn in the economy: an estate freeze, or if an estate freeze was completed in the past, a refreeze.

Overview of an estate freeze

An estate freeze allows a business owner (the individual) to fix – or freeze – the value of his or her interest in a business. It is completed by the individual exchanging common shares for fixed-value preferred shares. The value of the preferred shares is equal to the value of the common shares (and the value of the business) at the time of the exchange and, because the redemption value of the preferred shares is fixed, the value of preferred shares remains fixed at that value going forward. In other words, exchanging common shares for preferred shares freezes the individual’s interest in the business. All future growth and value in the business accrues to new common shares, which can be subscribed for at a nominal amount immediately after the freeze. Generally speaking, the individual’s other family members (i.e., spouse, children, etc.) or a family trust would subscribe for the new common shares.

Completing an estate freeze provides several tax advantages. First, freezing the value of the individual’s shares in the business fixes the amount of the individual’s capital gain when the individual either sells the preferred shares or when the individual dies (on death, an individual is deemed to have disposed of all capital property at the fair market value of the property immediately before the individual’s death). If the preferred shares are ‘qualifying small business corporation shares’ (as defined in the Income Tax Act) (QSBC shares) and the value of the preferred shares is at or below the individual’s lifetime capital gains exemption (LCGE), the freeze has the effect of ensuring that the individual will not pay tax on the disposition or deemed disposition of the preferred shares.

Second, because each individual has a LCGE limit of $883,384, having the future growth in the business accrue to the new common shareholders allows for more capital gains to be sheltered from tax when the QSBC shares are ultimately sold. For example, if the individual’s spouse subscribes for the new common shares, the next $883,384 of business growth will be sheltered from tax when the spouse sells the common shares.

Third, having multiple family members own shares in the corporation allows the family to split income, as the corporation can pay dividends to the low income-earning family members. However, income splitting in this way may be subject to the tax on split income (TOSI) rules, which have the effect of taxing the income at the top marginal rate. For more details on TOSI, read RSM Canada’s Tax Alerts that provide insights on TOSI and the application of TOSI rules.

When completing an estate freeze, it is important to ensure that any GST/HST/QST elections and group entity filing frequencies that were in place before the freeze (e.g., elections for closely related corporations) remain valid.

Estate freezes and refreezes in a struggling economy

A struggling economy is an opportune time for business owners to consider an estate freeze because business valuations might be materially less than they were before the economic crisis. As a result, a business owner can freeze his or her interest in the business at a lower value. As the economy recovers, the value previously lost plus any growth thereafter would accrue to the new common shares, thereby positioning the family to more fully benefit from an estate freeze and, in particular, deferring and sheltering capital gains.

If a business owner already completed an estate freeze in the past, but the value of the business has dropped below what the value of business was at the time the estate freeze was completed, the business can thaw the frozen preferred shares and complete a refreeze at the lower value. One way to effect a thaw and refreeze is for the individual that owns the preferred shares to purchase the common shares. Because the redemption price of the preferred shares exceeds the depressed value of the business, the fair market value of the common shares is nominal. As a result, the individual can purchase the common shares from the other family members for a nominal amount and, although the family members will have to report the disposition of their common shares, the disposition will not trigger any capital gains. Once the individual owns all the shares of the corporation, the individual would then exchange all the shares (including the preferred shares issued as part of the previous estate freeze) for a new class of preferred shares with the new, lower fixed value equal to the current value of the business. The other family members would then subscribe for new common shares at a nominal amount and the future growth and value in the business would accrue to the new common shareholders.

If, in the prior estate freeze, a family trust subscribed for the new common shares, a thaw and refreeze to capture the reduction in the business’ value presents a further potential opportunity. Specifically, it might allow the family to reset the 21-year clock for the trust deemed disposition rule. The 21-year deemed disposition rule provides that a trust is deemed to dispose of its capital property and recognize accrued gains every 21 years. The rule exists because a trust never dies and, therefore, without the rule, a trust could defer the realization of a capital gain indefinitely. If a trust does not dispose of the capital assets before the 21-year deemed disposition rule comes into effect, the trust may have tax liability without sufficient liquidity to pay the tax liability. In an estate thaw and refreeze, the family trust would dispose of its common shares, but, as set out above, would not realize a capital gain due to low value of the common shares. A new family trust would then be created to subscribe for the new common shares in the corporation after the refreeze. The new trust would have its own 21-year clock for the deemed disposition of its capital assets, thereby extending the deadline for the 21-year deemed disposition of the new common shares.

Make the best of the current situation

The estate freeze and refreeze are useful planning tools at all times, but especially when the economic conditions result in a reduction of a business’ value. Making the best of a bad economic environment allows business owners and their families to set themselves up for significant tax savings in the future.