Business owner? Learn about the classic estate freeze

Do you have a business for which you’re looking at transferring ownership to management or your children? If yes, you should consider some of the benefits of a classic estate freeze, a strategy to help you manage your estate tax bill.

For tax purposes, an estate freeze locks in the current value of the asset for you while passing on future growth to a transferee.

“We typically use estate freezes to fix the existing shareholder’s interest, and allow the new shareholder to effectively come into an ownership position paying a nominal amount,” explains accountant Paul Coleman, partner at Grant Thornton.

Typically, you would consider estate freezes when your company is worth at least $1 million, he says. Freezes aren’t necessary if your tax on disposition can be covered by the $824,176 lifetime capital gains exemption, indexed for inflation.

A simple estate freeze costs a minimum of $15,000 in legal, business valuation and accounting fees, he says. Costs will increase if your succession plan becomes more complicated, such as giving the company to children with varying business involvement.

How it works

A freeze locks a business’s current value into preferred shares for you, the original owner, and transfers growth to new owners through new common shares.

You exchange your existing shares for preferred shares. These preferred shares can either be in the operating company; or in a holding company that owns the operating company. In both cases, your preferred shares should have a fixed (a.k.a. “frozen”) value equal to the company’s present fair market value.

The company then issues common shares, bought by the successors for a nominal amount (e.g., $1 per share). Any further increase in the company’s value accumulates in their hands.

You may want to recognize (a.k.a. crystallize) your capital gains at the time of the freeze, says Jason Rideout, partner at ANR Accountants in St. Stephen, N.B..

He says this strategy was popular more than a decade ago, when business owners were worried the government might repeal the lifetime capital gains exemption.

“But tax legislation can change at any point in time, so it’s always a consideration,” he adds. To crystallize the gain, the shares must be either qualified small business corporation shares or in a farm or fishery. The owner would report her capital gain and offset them on her personal return using the lifetime capital gains exemption.

Once the freeze is done, you must complete T2SCH50 Shareholder Information as part of your corporate tax return, Rideout adds. It must be updated to include the new shareholders and ownership arrangement.

Common pitfalls

It’s important to notify lenders of a planned estate freeze, says Rideout. If you’ve given a bank a personal guarantee, the debt covenant may be voided or jeopardized when another shareholder is introduced.

In addition, your company’s articles of incorporation may not include the types of shares needed for an estate freeze, says accountant Sonja Chong, partner at Sonja Chong Professional Corporation in Toronto.

If that’s the case, you’ll need to file articles of amendment with the federal or provincial government to create the types of shares needed for a freeze.

Bonus strategy

If your spouse and children are issued shares, they may have their own lifetime capital gains exemptions, in effect multiplying the family’s net tax savings, notes Chong.

To qualify for the for this capital gains exemption, the company must be a qualified small business corporation, the spouse and children must be Canadian residents, and they or a related party or partnership must have owned the shares for 24 months.