Tax advisers often recommend that their clients implement “estate freezes”. What is an estate freeze? This article discusses estate freezes: it describes the reasons for effecting an estate freeze and how they are implemented.
Income Tax Background
The Income Tax Act (Canada) (the “Tax Act”) provides that an individual is deemed to dispose of his or her capital property immediately before death for proceeds equal to fair market value. That is, the deceased is treated as if he or she had sold the property—property such as shares, bonds, mutual fund units and real estate—for an amount equal to fair market value. If the deemed proceeds exceed the tax cost of the assets to the individual, then one-half of the gain is included in the individual’s income for the taxation year that ends at death.
For example, if Mr. X dies owning 1,000 Common Shares in the capital of BusinessCo (a fictional corporation) with a fair market value of $10,000 in total and a cost (an original purchase price) of $1,000, then Mr. X’s executors will be required to report $4,500 in his income in his final tax return (($10,000 – $1,000)*50%). He might pay tax of as much as $2,070 on that income.
In general, the Common Shares of a corporation increase in value as the net fair market value of its assets increases. On the other hand, corporate Special Shares usually have a fixed value that cannot increase because the issuer corporation will be entitled to purchase the Special Shares for the fixed value (this fixed value is usually called the “redemption amount” of the shares). (The value of Special Shares can decrease if the total net value of the assets of the corporation falls below the total redemption amount of the issued shares.)
Consider the example of Holdco, a fictional company, of which Mr. X and his son are the only shareholders. Assume that Mr. X owns all of the issued Special Shares of Holdco and that they have a total redemption amount of $1,000,000. Mr. X’s son owns all of the Common Shares of Holdco. If the total fair market value of the net assets of Holdco is $800,000, then the value of Mr. X’s Special Shares is $800,000 and the Common Shares belonging to his son have no value. If the total fair market value of the net assets of Holdco is $1,200,000, then the Special Shares have a value of $1,000,000 and the son’s Common Shares have a total value of $200,000. If the fair market value of Holdco’s net assets increases by another $100,000, then Mr. X’s Special Shares are still worth only $1,000,000, and the son’s Common Shares will increase by another $100,000 so that they are worth $300,000 in total.
What does an estate freeze accomplish? Assume that Mr. X owns the shares of Holdco, and they have a total fair market value of $1,000,000. Mr. X has decided that this value and the value of his other assets are sufficient for his needs until he dies. Assume also that the value of Holdco will increase by $200,000 between now and the time Mr. X will die. Mr. X will pay tax of about $46,000 on that $200,000 growth, and yet he does not need it (he has enough with the current value of his Holdco shares).
An estate freeze will avoid this unnecessary tax. Mr. X can exchange his Common Shares for Special Shares in the capital of Holdco with a total redemption amount of $1,000,000. Mr. X can make this exchange without paying taxes. Mr. X’s son will then subscribe for new Common Shares of Holdco. As a result of this “freeze”, Mr. X at death will own Holdco Special Shares with a total redemption amount and fair market value of $1,000,000 (the value of his shares will not increase from now until he dies). The $200,000 of growth, which Mr. X does not need, will accrue to the Common Shares owned by the son. The gain in the son’s Common Shares will not be realized (and tax need not be paid on it) until he dies, which will likely be long after Mr. X dies.
An estate freeze saves taxes by postponing them. An individual who has enough to live on comfortably in retirement can freeze the value of his assets so that any growth on the assets will accrue to the next generation. That way, the growth need not be taxed until the death of the next generation.