Estate Planning

Things Small Business Owners Should Consider Before An Estate Freeze

October 20, 2023

An ariel view of a neighbourhood in York region GTA

As a small business owner, you set up a business, make investments, and build an estate so you reap benefits throughout your lifetime and your family and employees after you. If you don’t plan your wealth transfer now, your family and employees will face a hefty tax bill depending on how big your estate has grown. An estate freeze is a popular tax-efficient means of transferring your wealth, and you can structure it as per your requirements. 

What Is an Estate Freeze? 

While Canada has no inheritance tax, your assets are deemed to be sold to your family at the fair market value upon your death. For instance, if you started a company with just $10,000 worth of shares and they are now worth $10 million, your family will face a tax on $9.99 million capital gain. They might probably have to sell the estate to pay the taxes. With proper estate planning, you can relieve your successors from this tax burden. One method is an estate freeze. 

In an estate freeze, the asset owner freezes the value of his estate in a trust or a holding company, depending on the asset type. 

For instance, Mary’s shares have grown from $10,000 to $1 million. She exchanges her shares for an equivalent value of fixed-priced preference shares and freezes her share value at $1 million. The company issues new common shares to the successors. Any capital appreciation above $1 million is for successors. They pay capital gain tax only when they sell the shares or on their death. What about the $990,000 capital gain on Mary’s shares? 

Since Mary froze her share value, she can live off her retirement from the dividend money and keep withdrawing her preference shares so that fewer shares are left for transfer after her death. In the meantime, she can arrange for funds to pay tax on the $990,000 capital gain by buying a life insurance policy with the sum assured equivalent to the tax liability. 

When is an Estate Freeze Beneficial? 

An estate freeze is complex and expensive. Hence, it is beneficial for those who own a significant amount of assets and can save on taxes to make estate planning costs look like a fair deal. Estate planning is a long-term strategy and should be revisited for changes in estate value, tax laws, and company and personal financial situation. You can unfreeze and re-freeze your estate. But it will have tax implications. Hence, think it through and talk to a professional tax consultant before initiating an estate freeze. 

Things To Consider Before an Estate Freeze 

You can achieve several things with an estate freeze other than deferring taxes, like earning passive income, sharing income with minors in the family, and retaining control. Here are a few things small business owners should consider before an estate freeze. 

Timing An Estate Freeze

The basis of an estate freeze is your shares and other assets will grow in value and have sufficient liquidity to give dividends and help you retire comfortably. Hence, you need to ensure your company has attained sufficient value and can grow. Doing an estate freeze too early could make this strategy inefficient. You may have to unfreeze and refreeze, which will add to taxes and administrative expenses. 

Proper Valuation of Shares 

You should get your shares and estate valued by a professional to avoid unnecessary tax liability. If you freeze your shares at a lower price, you will face capital gain tax on the difference between the fair market value and frozen value. If the frozen value is higher, you may enjoy a tax benefit. 

Consider The Impact of Inflation

If an estate freeze is a part of your retirement passive income, ensure your shares give you inflation-adjusted returns. Unlike equity, preference shares have a fixed dividend. You could consider a partial estate freeze, having a mix of growth and preference shares. For instance, Mary decided to freeze $1 million shares and get $600,000 in preference shares and $400,000 in new common shares. The preference shares will reduce the future capital gain tax, and common shares will give growth to combat inflation. 

Retain Control of The Business

While the above are straightforward considerations, you also have to consider potential scenarios. You might want to retain business control even after an estate freeze in some scenarios: 

  • Successors are children and too young to be actively involved in the business. 
  • One or a few family members might sell their shares to a third party too early, reducing the family’s ownership of the business.
  • Family members may not get along, children may get a divorce, some successors may have credit problems, or children and their partners may be uncooperative. If such problems start spreading transfer of ownership to family members could backfire and affect the company’s future and your retirement income. 

Many other reasons might require you to retain control over the corporation even after the estate freeze. You can do so in several ways, such as: 

  • The company can issue you preferred shares with special voting rights or issue family members with growth shares with limited voting rights. 
  • You could create a family trust and become the trustee. The company could issue growth shares in the name of the trust. As a trustee, you can determine which beneficiary receives what and when. For instance, family members actively involved in the business could get growth shares later, and dormant members could receive annual income. 

While creating a family trust, consider the 21-year rule. A family trust can hold assets only till 21 years. At the end of the 21st year, the assets are deemed to be disposed to beneficiaries, and they incur tax liability on those assets.

Estate planning is a complex process with several legal and tax implications. As estate planning is a long-term strategy, you need to review it for changing tax rules and personal or business financial conditions.

Contact KSSP Partners LLP in the GTA to Help You with Estate Planning 

A professional tax consultant can help you prepare a tax-efficient estate plan that meets your requirements. The experts are updated about tax changes and can help you keep your estate planning in sync with the laws. To learn more about how KSSP Partners LLP in Markham can provide you with your estate planning, contact us online or by telephone at 289-554-5997.