Estate freeze: What business owners need to know for succession planning

The pandemic has prompted many business owners to think more about succession planning, including who will take over their business and how to best structure  the transition.

For some, the solution is passing a portion of their business on to their adult children, while still retaining an ownership stake through what’s known as an “estate freeze”.

An estate freeze allows a business owner to lock in or “freeze” the current value of their interest in the company by issuing a class of new, fixed-valued preferred shares representing such value. The income tax consequences on the fixed-valued preferred shares are deferred until there’s a redemption of the shares, a deemed disposition at death, or when the company is sold. The goal is to transfer the future growth of the company—and the associated tax liabilities—to the next generation.

With a freeze, the new shareholders (typically the adult children of the business owner or a discretionary family trust) are issued a new class of common shares at a nominal price that track the company’s future growth. Regardless of how the company changes in value, the value of the fixed-value preferred shares will not change.

An estate freeze is a reasonable option when the company’s value is expected to increase and when there is a clear succession plan in place, says Jag Gandhi, a vice-president of wealth planning at Gluskin Sheff.

“An estate freeze allows a business owner to freeze their economic interest in their business at its current value and crystalize the associated tax liabilities that would go with it,” she says.

Gandhi says it’s a common succession planning tool that gives business owners some tax certainty in their estate plans.

“Knowing how much tax the estate will pay on death with respect to the business owner’s interest in the company can be hugely valuable for planning purposes,” she says.

Tips to freeze and refreeze

Estate freezes have been popular during the pandemic as some business owners saw the value of their business decline but believed that the value would bounce back. The reduced business value allowed business owners to freeze their equity interest at a lower amount and thus, reduce their terminal tax liability, notes Mark Chan, a vice-president of wealth planning at Gluskin Sheff.

While the strategy works for some, Chan cautions business owners could be asked by the Canada Revenue Agency (CRA) to support the value of the company at the time they did the estate freeze.

“It’s important the business is valued in an appropriate, methodical way,” Chan says. He recommends business owners use a qualified business valuation specialist to determine a reasonable fair market value—and retain the specialist’s business valuation report.

“Having the right documentation is key in the event of any CRA scrutiny,” he says.

If the value of the business drops after the estate freeze is done, business owners can do a “refreeze” of their existing fixed-value preferred shares and re-freezing at the current, lower value, Chan says.

Income splitting opportunities

An estate freeze can also be a chance for business owners to split income with others, such as family members, by bringing them on board as shareholders, Chan says.

“By introducing a family member as a shareholder, whether directly or indirectly, dividends can be declared and paid to them—as long as they don’t run afoul of the CRA’s complex tax on split income (TOSI) rules,” Chan says.

Gandhi adds that the new nominal common shares can be issued directly to an individual or a family trust, with the business owner as a beneficiary of the family trust. She says it can give the business owners some control and flexibility, even if they’ve capped their estate tax liability. However, the amount of control given to the business owner should be carefully structured.

Bringing on new shareholders as part of an estate freeze is also a way for business owners to multiply the lifetime capital gains exemption—$913,630 per shareholder of Canadian-controlled private corporations in 2022—if they’re planning on selling the business and certain conditions are met.

“Instead of the business being wholly-owned by the business owner —which provides access to only one lifetime capital gains exemption, by having other shareholders, directly or indirectly— you’re providing an   opportunity to multiply the capital gains exemption,” Gandhi says.

What else to know about an estate freeze

While an estate freeze is a useful succession planning strategy, they may not be as ideal, if any of the new shareholders or the beneficiaries of a trust are considered U.S. persons.

Chan notes that a U.S. person who holds shares of a Canadian corporation may have more reporting disclosure requirements with the Internal Revenue Service. There are also complex tax rules and requirements for reporting income from the corporation.

“While it may be possible, business owners should be aware there are several complexities involved and counsel from both jurisdictions would need to be consulted,” he says.

Gandhi adds business owners should  be aware that while the estate freeze can be structured to help the business owner maintain control , such as by issuing nominal voting shares to the business owner, there is still some  loss of control by introducing new shareholders into the company.

“There needs to be an acknowledgement and acceptance by the business owner that they are no longer the only owner of the business, and for some business owners, that can be challenging,” she says.

Rely on professionals

An estate freeze is a complicated transaction, Gandhi adds, that requires navigation through various tax rules and must be based on a reliable and well documented valuation of the business at the time of the estate freeze.

Gandhi and Chan recommend business owners seek the advice of experts—from financial advisors, accountants, lawyers and business valuators—to ensure that the transaction is executed properly.

“These professionals can work together to understand and perform the transaction in a manner to ensure it can meet any potential CRA challenge in the future and aligns with the business owner’s professional and personal succession and estate planning goals,” Gandhi says.

“That said, it can be a great estate planning tool—when used properly under the right circumstances.”