Tax Planning Silver Lining for Small Business Owners during COVID-19

As my colleague Jeff Noble notes in this excellent May 2020 guest blog post on The Business Owner’s COVID Contemplation, small business owners have had a herculean task navigating thorough COVID-19 for a myriad of reasons—ranging from lost revenue to keeping staff employed to accessing relevant government programs.

Some small businesses have been fortunate to occupy sectors that have thrived during COVID, including technology, health care, and some retail segments (the grocery chains and big box stores). However, many more have suffered during COVID, which in turn has caused their business to lose financial value and, as consequence, likely caused many business owners to delay the sale of their business until they can regain their value post-COVID.

As discussed in this BDO Tax Alert (see the final heading, “Tax Planning when the business value has declined”), this decline in value may have provided a silver lining in that you can potentially reduce your tax liability at death through either an estate freeze or re-freeze, or an estate thaw, where you have previously undertaken an estate freeze.

Estate freeze

As noted in the Tax Alert, “an estate freeze is a process where you take steps to ensure that the future growth of your estate accumulates in the hands of your intended beneficiaries in a tax effective manner. By freezing the value of your estate, you will effectively lock-in the tax that will arise on your death (subject to changes in future tax rates).”

For example, say your business was worth $2 million pre-COVID. If you did not undertake an estate freeze and therefore died without a freeze in place, the tax on your death would have been based on the $2 million value (If your leave the shares to your spouse there is no tax until your spouse passes away). In Ontario, for example, this works out to about $535,000 of personal tax if the entire value is taxed as a capital gain at the highest marginal rate. As noted in the Tax Alert, the “freeze will allow you to pre-determine the taxes that will arise on your death so that you can ensure that cash will be available to pay that tax (for example, by taking out sufficient life insurance).”

If you undertake an estate freeze during COVID when the value of the business is depressed, you can reduce the tax liability upon your death. Using the example above, say your business value has fallen during COVID from $2 million to $1.3 million. If you “freeze” your shares now, the $535,000 tax liability on death would be reduced to approximately $350,000.

When you freeze your shares, your strategy will usually be to redeem these shares over time. The proceeds received from the redemption of the freeze shares will be treated as a dividend for tax purposes. As shares are redeemed, this will lower the value of the shares you would hold on death.

If you are interested in learning more, I have previously written on this subject here, here and here.

It is critical to understand that by freezing your shares, you are giving the “bounce-back” and future growth in your business to your children. So if the value of your company bounces back to say $2.3 million by the time you pass away, you have effectively deferred tax on $1 million of value to your children ($2.3 million value less freeze value of $1.3 million).

Finally, it is very important that the freeze share value, your yearly salary and your other assets will provide you more than you need for your retirement, or the freeze may not make sense. 

There are many tax complexities in undertaking a freeze, please ensure you obtain professional advice.

Revisiting a freeze: The estate re-freeze and estate thaw

But let’s say you already executed an estate freeze. Now you are faced with a business the value of which has declined – at least in the short term. Is there a way to undo that freeze to take full advantage of the current economic downturn?

There is, and more correctly there are – two ways. One is an estate re-freeze; the other is an estate thaw.

As noted in the Tax Alert on estate re-freezes, “If you have already undertaken an estate freeze, but the value of your business has declined in the current environment, it is worth considering whether the freeze could be ‘undone’ and you should ‘re-freeze’ your business at the current value of your business. This could make sense if the value of your business is less than its value at the time the original freeze was undertaken, and therefore the value of the fixed value shares you took back on the original freeze is more than the value of the business. A re-freeze would allow you to reset the freeze at the value of your business today and further reduce the amount of taxes your estate would have to pay on your death.”

 Using the example above, assume you had frozen your shares for $2 million in 2007. If the value of the corporation has dropped to $1.3 million, a re-freeze will save you the tax on the $700,000 drop in value, or around $185,000.

Again, you must keep in mind the re-freeze value and your other assets will need to provide you more money than you need for your retirement, or a re-freeze may not make sense. 

An estate thaw works a bit differently.

“You may also decide that you want to undo an estate freeze done in the past due to the decline in value," says the Tax Alert. "Known as an estate ‘thaw,’ this would be possible if you or your spouse are beneficiaries of the family trust that own the common shares of your business. Implementing a thaw would mean that you would transfer the common shares out of the trust to you or your spouse. Whether this makes sense depends on your own situation, and the interests of the other intended beneficiaries.”

Estate freeze vs. estate thaw

As noted above, a thaw is different from a re-freeze. In a re-freeze you just reset the value of your initial freeze shares, lowering your tax liability on death and allowing the future growth from the lower freeze value to accrue to your children. In a thaw you are reversing some or all of the original estate freeze and possibly, depending upon the circumstances, effectively nullifying the prior estate freeze, such that the freezor is put back in the same position as they were before the original estate freeze. Under a thaw, you now lose most if not all the benefit of any bounce-back in the shares going to your children.

Re-freezes and thaws are even more complex than an estate freeze and for all these transactions, I reiterate, you need to seek professional advice.

Fair market value of shares

Determining the fair market value of shares for a freeze or re-freeze during COVID is complex. I would suggest it is mandatory that you engage an independent certified valuator to determine the revised value of your company.

COVID has provided little good news to small business owners. However, if your business has been affected, you may want to speak to your tax advisors about the benefit of a freeze, re-freeze or thaw.

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

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