As a small business owner, at the end of the day, there are essentially only two exit strategy/succession options you need to plan and/or consider:
(1) A sale of your business, typically to a competitor, sometimes to current management or very infrequently, an actual sale to a child or other family member; or
(2) A transfer of the business to your children without a sale (for purposes of this article I will refer to this option as an “estate freeze”).
My blog today discusses estate freezes. How you can transfer your business tax-free to a successor (typically your children, sometimes to existing management) while continuing to control and receive remuneration from your business.
Next week I’ll discuss Tom Dean’s thoughts on this matter. Tom who is the author of Every Family's Business (the bestselling family business book of all-time) believes a business should in most cases be sold and never handed over to the next generation (such as done with an estate freeze) without the parent(s) adequately being compensated for the business.
What is an Estate Freeze?
The key risk in any estate freeze is that your children may partially or fully devalue these shares and your company. So while an estate freeze may be the most tax efficient way to transfer your business, it may not be the best decision from an economic or monetization perspective.
In a typical estate freeze, you exchange your common shares of your corporation on a tax-free basis for preferred shares that have a permanent value (“frozen value”) equal to the common shares’ fair market value (“FMV”) at the time of the freeze. Subsequently, a successor or successors, say your children or family trust can subscribe for new common shares of the corporation for a nominal amount.
This concept is best explained with an example. Assume Mr. A has an incorporated business worth $3,000,000 and wants to undertake an estate freeze. In the course of the freeze, Mr. A is issued new preferred shares worth $3,000,000 and his children or a family trust subscribes for new common shares for nominal consideration. Mr. A’s tax liability in relation to these shares on death, is now fixed at approximately $750,000 in Ontario ($3,000,000 x capital gains rate). Often, a key aspect of an estate freeze is a plan to reduce the tax liability by redeeming the preferred shares on a year by year basis as discussed below.
If you have access to your lifetime capital gains exemption (currently at $800,000 but indexed beginning in 2015 for inflation), your income tax liability may be reduced when the shares are eventually sold or upon your death if you still own them at that time. Finally, you may choose to crystallize your exemption when you freeze the shares.
The preferred shares received on the freeze can be created such that they allow you to maintain voting control of your corporation until you are satisfied your child(ren), is(are) running the company in the manner you desire. This maybe a double-edged sword, as you may tend to hold onto control long after your successors have proven themselves. This may become a contentious issue.
The Benefits of an Estate Freeze
1. On death (something we should all be planning for), an individual is subject to a deemed disposition (i.e. a sale) on all of his/her assets at FMV, which would include his/her shares of the business. An estate freeze sets your maximum income tax liability upon this deemed sale and as discussed above, this liability can be lowered over the years by redeeming the shares.
2. Family members will be able to become shareholders of the business at a minimal cost and be motivated to build the business (although Tom Dean's would dispute this assertion).
3. Instead of having children directly subscribe for new common shares, you can create a discretionary family trust to hold the common shares. Every year, the corporation can pay dividends to the family trust which can then allocate the dividends to family members with lower marginal tax rates. This mechanism allows for great income splitting opportunities.
One of the more critical aspects of an estate freeze is the determination of the fair market value ("FMV") of your business. In order to ensure that an estate freeze proceeds as smoothly as possible, the FMV of the company must be calculated. In the event that the FMV determined is challenged by the Canada Revenue Agency (the “CRA”) the attributes of the preferred shares will have a purchase price adjustment clause that will let the freezer reset the FMV. The CRA has stated in the past that they will generally accept the use of a purchase price adjustment clause if a “reasonable attempt” has been made in valuing the company. Engaging a third party independent Chartered Business Valuator to prepare a valuation report is generally accepted as a “reasonable attempt” in estimating the FMV.
Issues to Consider Before Implementing an Estate Freeze
An estate freeze does not make sense for all business owners. While the above benefits do sound very enticing, it depends on each owner’s personal circumstances. Issues to be considered include:
1. Are you relying on the value of the company to fund your retirement? If so, it may be best to sell and ensure you have a secure retirement.
2. Do you have an identified successor, i.e. child, able and willing to work in your business?
3. Can you bring one child into the business without creating a dispute amongst your children?
4. Are your children married and how may a divorce or separation impact the business?
Long-time readers of my blog will know that I am a proponent of family discussions and getting over the money taboo. I cannot overstate the importance of having a detailed discussion with your family if you plan to hand your business over to one or more of your children. If you pass that hurdle, you must speak with your accountant and lawyer to ensure you understand the implications of the freeze and how to properly implement the corporate restructuring. Finally, your tax advisor will want to structure the freeze such that it can be “thawed” if the business suffers a setback due to the economy, or your child(ren) prove incapable of running the company.
As noted above, next week I will discuss Tom Dean’s views. Tom feels an estate freeze is not a succession plan or the best way to liquidate or sell a business.
The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.
Can estate freezes be utilized by professional corporations? For example for accountants, spouses can not own shares within the professional corp. Is there a way to make this work?ReplyDelete
Each PC is subject to the rules and regulations of that professions college or institute. I cannot speak for each profession. For accountants PC's, I am not aware of a way to make this work.
Great source of information. Thanks.
How do you structure the freeze such that it can be “thawed” if the business suffers a setback due to the economy, or your child(ren) prove incapable of running the company. Is this accomplished by securing certain assets of the business?
Also, the gradual redemption of preferred shares over 20 years qualify for capital gains exemption up to 800k if one can access CGE.
Often the lawyers contemplate a thaw and have a conversion feature in the freeze shares. This is complicated and you would need to speak to your advisor. The redemptions are deemed dividends and do not qualify for the cap gains exemption
I have a business where I am the only shareholder. If I want to add my wife as a shareholder to the business, I would have to do an estate freeze? I'm assuming I can't just add my wife as a shareholder if there's currently value in the company?
Correct, speak to your accountant, depending upon what you are trying to accomplish there are various planning opportunities.Delete
I'm just trying to split income with my wife to save some taxes down the road.
Thanks for the great article.
Should I get a lawyer or accountant to do an estate freeze?
Typically a tax accountant does the structure and the lawyer implements it, but some people have the tax lawyer draft the plan.
I realize this is an old thread but I am seeking clarification. You make reference to using the CGE in the article yet your response on 10/10/14 states this id a deemed dividend and not eligible for the CGE. What am I missing?ReplyDelete
The CGE was in reference to the new common shares issued. The redemption of the actual freeze shares of the parent are deemed dividends. Anyways, speak to your accountant, with all the Liberal changes this article may now be dated.Delete
Is it possible to redeem the frozen preferred shares using your Capital dividend account?ReplyDelete
see this article, it addresses your questionDelete