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Using the Estate Freeze

Estate freezes are done to avoid taxes, primarily capital gains taxes that apply on the transfer of assets to beneficiaries at the decease of the parent.

An estate freeze is an estate planning strategy undertaken to minimize the tax liability in an estate when passing to children or grandchildren. An estate freeze will restructure the beneficial ownership of certain types of assets such as real estate, or shares of a private corporation. The result of an estate freeze is that the existing equity is ‘frozen’, i.e. its value for tax purposes is fixed, while the benefit of future growth is transferred by way of shares or a trust into the hands of named beneficiaries. An estate freeze usually limits the value of the parents’ (or freezors’) estate to the value at the date the freeze is implemented.

Purpose

Estate freezes are done to avoid taxes, primarily capital gains taxes that apply on the transfer of assets to beneficiaries at the decease of the parent. Tax liability is determined by fair market value of property at time of death. By implementing a freeze beforehand, the value of one’s estate that is subject to tax is reduced and the value of assets received by beneficiaries is maximized. An estate freeze makes sense in cases where the value of estate assets is expected to appreciate. As well there may be other advantages to an estate freeze:

• Income splitting; An estate freeze can place capital gains and income in the hands of family members who are in a lower marginal rate than that of the Parents. This includes corporate distributions as well as gains from the sale of shares taxed in the hands of lower-income family members.

• Estate Freeze can offer protection from creditors in the case of shares held by children or in a family trust.

• Reduction of probate fees; an estate freeze will ’fix’ the value of an estate and result in lower calculated probate fees.

• Estate Freeze can limit the size of family assets that may be subject to claims arising from a marital breakup.

Implementation and Organization

An estate freeze is simply a transfer of assets. It is a technique whereby the current fair market value of growth assets (common shares or other property) is frozen by exchanging them for a corporation’s preference shares (preference shares are non-growth assets because don’t grow in value). The corporation then issues new common shares at a nominal value to the next generation.

The estate freeze accomplishes four immediate objectives for the owner:

• It transfers estate assets into the hands of beneficiaries,

• It freezes the value of his own taxable interest and allows future growth in value to accrue to his heirs,

• It avoids any taxes at the time of estate freeze,

• It retains a degree of control over the transferred assets.

The most common form of estate freeze involves the transfer of estate property to a corporation, or the reorganization of an existing corporation, often combined with a family trust. The corporate structure will allow for the estate freeze to be done on a tax deferred basis and specify the assets to be transferred while defining degrees and limits of control over the trust property.

For example, the implementor of the estate freeze transfers all of his common shares, without tax impact, to a holding company. As consideration he takes back voting, preference shares that are redeemable and retractable, giving him control of the company. Common shares of the company would then be issued to his children for a nominal value. The preference shares will not appreciate; if the value of the asset increases due to earnings or appreciation, the increased value will be wholly reflected in the common shares now in the hands of the children.

The corporate organization is such that the freezor transfers growth assets to a holder corporation in return for preferred shares and possibly some non-share consideration. The preferred shares have the following rights and restrictions:

• Voting rights (enough to retain control over the corporation);

• The right to fixed dividends (at a reasonable rate);

• Price adjustment mechanism in effect in the event of a dispute with the CCRA as to the correct value of the corporation at the time of the freeze;

• Redemption equal to the fair market value of the growth assets transferred;

• Retractable at the option of the holder;

• Non-impairment, i.e., no dividends can be declared on any classes of shares if the ability to retract would be interfered with (such provisions are often inserted notwithstanding corporate law remedies which might be available to shareholders in such event).

Other provisions regarding the estate freeze shares are often added. For example, the articles might specify that dividends can be paid on freeze shares without participation by the common (growth) shares and vice versa (i.e., so that a waiver would not be required in the event that common shareholders are to receive a dividend).

In order to achieve the full intention of the estate freeze, it is essential to ensure that the value of the shares received by the freezor on the reorganization is equal to the fair market value of the assets in question. If, at the time of the estate freeze, the fair market value of these shares is not equivalent to that of the underlying corporate assets, various provisions of the Income Tax Act could result in tax liability for the parties to the reorganization. This is the purpose of the attributes regarding retractability, the price adjustment mechanism, the dividend feature, provisions that no dividends can be declared if the ability to retract is impaired, as well as the preference on liquidation or redemption.

The Beneficiaries receive “growth” or common shares-i.e., shares whose value would reflect all the equity growth and dividend payouts after the freeze was accomplished. Because the existing value of the corporation would be reflected in the estate freeze shares, the growth shares would initially have a low or nominal subscription price. The subscription or purchase would be arranged in such a manner as to not trigger attribution rules. For example in Ontario it is allowed for the shares to be gifted to the beneficiaries or family trust by a third party. Another possibility is to fund the shares through an interest bearing promissory note.

Family Trust

Often the freeze shares of beneficiaries are held through a family trust that provides a degree of security against the potential for mismanagement of the split assets. The trust commonly includes provisions that allow some continued control by the freezor:

• The trustees are given wide discretionary power with respect to the allocation of income and capital among the beneficiaries of the trust.

• It is common that one or both of the parents retain the power to dismiss and/or appoint trustees.

• The trust is irrevocable.

• The trust is discretionary, meaning the trustee can decide what amount each beneficiary should receive.

• The trust may contain a clause that protects family property from distributions in the event of a marital breakup.

• The trust may have the authority to transfer part or all of the trust assets to another trust.

The trust can allow for the freezor to gift to the trust in the name of a specified beneficiary.

• The trust provides for penalties against beneficiaries if they threaten or engage in litigation against the trust or its trustees.

• To avoid tax complications the trust must remain a resident of Canada. The majority of trustees must be resident or the trust might require that all meetings of trustees be held in Canada.

• The trust beneficiaries, usually children or grandchildren, are clearly specified. Children of a previous marriage to either freezor or spouse may be excluded, as may adopted or illegitimate children. Beneficiaries’ spouses may be included, as might more remote relatives.

• A trust may provide that a majority rather than unanimity of trustees can make decisions.

• A trust may contain a flee clause that conveys the right of trust to change jurisdictions.

A settlor establishes (or settles) a trust with initial trust capital. The terms of the trust are set out in a signed trust document. The trust document sets out what capital settles the trust, who will run the trust (the trustees), whom the trust is for (the beneficiaries) and when income and capital is to be paid to the beneficiaries.

A revocable or reversionary trust situation is deemed to occur when the settlor retains control through one of the following 3 methods. If one of the following 3 criteria is met, the trust is a reversionary trust under the law. Income Tax Act s. 75(2)

• The transferor is a beneficiary of the trust.

• Property may pass to a person to be determined by the transferor subsequent to the creation of the trust. (e.g. the transferor is the sole trustee and the trust is discretionary).

• The transferor has consent or direction over the disposition of property (e.g. the transferor is the sole trustee and the trust is discretionary).

If the above applies to any of the assets of the trust, all income, capital gains and losses attribute to the transferor while he/she is alive, and the property cannot be rolled out to beneficiaries on a tax-free basis while the transferor is alive (except in the case where the settlor receives the property). This rule applies to all property of the reversionary trust, not just the property caught under the above criteria.

To avoid this pitfall, the settlor should not be a trustee or should be one of 3 trustees so he/she can be out-voted. For the same reason it is important that the trustee not contribute property to the trust nor be in a position to determine the disposition of property transferred to the trust.

A partial estate freeze is possible whereby the transferor receives some equity (growth) shares. As well it is often the case that one parent is included as a beneficiary of a discretionary trust, providing ‘bail-out’ capabilities to the trust (shares can be distributed to the parent as a means of unwinding the estate freeze). In the event of a conflict among heirs, redeeming the children’s shares at fair market value can unwind the estate freeze.

If you have any questions on the issues discussed above, or on estate planning in general, please contact Chad Sheppard (204) 467-7142 or email www.chadsheppard.ca

Article reproduced from www.professionalreferrals.ca