An estate freeze can be a good idea

Many of you have clients who implemented estate freezes in previous years.

The planning strategy involves exchanging company shares— whether a family business or an investment holding company— for fixed value preferred shares, and then having other family members, or in many cases a trust for those family members, subscribe for nominal value common shares. The freeze effectively fixes the future value of the company to the owner, at the value at the time of the freeze, and permits future growth to pass to other family members.

By implementing a freeze, the company owner can lock in the tax liability that will arise on death (subject to future tax rate changes) in relation to the frozen assets. Consequently, taxes on death can be minimized and the owner is then able to take steps to ensure cash is available to pay that tax (perhaps through life insurance). Other advantages of an estate freeze include income and capital gains splitting, multiplying the capital gains exemption, minimization of probate fees and facilitation of business succession.

But due to the economic downturn, the value of the private operating company or investment holding company may now be less than the redemption amount of a client’s freeze-preferred shares— which represent the company’s value at the time of the exchange— and the common shares owned by family members (or a family trust) may be worth less.

But due to the economic downturn, the value of the private operating company or investment holding company may now be less than the redemption amount of a client’s freeze-preferred shares— which represent the company’s value at the time of the exchange— and the common shares owned by family members (or a family trust) may be worth less.

Your clients may now be questioning the validity of the initial strategy, and asking if they have to wait until the value of the company recovers in order to gain any benefit from the freeze.

Fortunately, your clients can actually take advantage of the decline in value of their corporations by implementing a refreeze that reflects the companies’ current reduced values. The refreeze could involve the purchase, by the freezer, of the outstanding common shares currently held by either family members or a trust, followed by a tax-deferred exchange of all shares for new preference shares that are redeemable and retractable at the current lower value of the company.

The other family members or a family trust can then subscribe for new nominal value common shares. The refreeze lets the owner reduce tax exposure on death by setting the redemption value of the new preferred shares at the lower current value. Likewise, the possibility of passing on value to family members is increased, since company growth starting from the new lower value will accrue to them.

The refreeze may also facilitate earlier income splitting, with the resumption of dividends paid on the common shares. And finally, using a new family trust as part of the refreeze, allows the family to effectively extend the life of the trust. Family trusts must generally undertake some sort of planning or distribute all assets by their 21- year anniversary, otherwise they are taxed as though they had disposed of all assets at that time. A properly structured new trust resets that clock.

As with all tax planning, the refreeze strategy isn’t for everyone. Keep in mind that resetting the redemption value of the preferred shares means the owner will have less future value in the company. If the plan was to redeem the preferred shares on retirement and use that capital to fund retirement needs, the reduced redemption value may not provide sufficient funds to meet those goals.

So, to avoid unexpected tax consequences, it’s important to ensure the new valuation of the company is reasonable and supportable.

Gena Katz, FCA, CFP, an executive director with Ernst & Young’s National Tax Practice in Toronto. Her column appears monthly in Advisor’s Edge.