Estate freeze can enhance succession, planning

A successful entrepreneur usually encounters many difficult decisions when preparing his or her succession and estate plan. One of those decisions is whether to implement an estate freeze. Let’s look in on Michelle , our case study, as she struggles with that question while developing her succession and estate plan.

Michelle is 58 years old. Many years ago she incorporated a company and transferred the assets of her successful manufacturing business to that company. Her husband, Michael, is a 56-years-old computer technician employed by a large company and has no business experience. Michelle and Michael have two children, Sharon aged 21 and Shane aged 26. Shane spent several summers working in Michelle’s business while he was at university, now works there full time in a middle management position, and hopes to take control of the business when Michelle retires. Sharon is attending university, has no interest in Michelle’s business, and does not intend to work there.

Michelle’s existing will gives everything she owns to Michael, and appoints him as executor. The will also provides that, if Michael is not alive, everything Michelle owns will be held in a testamentary trust for the benefit of Sharon and Shane. Michelle’s mother, Mary, is appointed as alternate executor of the will and as trustee of the children’s trust. She is an 83-year-old widow who has always been a homemaker. The terms of the children’s trust direct Mary to invest the trust assets and to use the income and, if necessary, the capital for the benefit of Sharon and Shane until Sharon reaches 27 years of age, at which time she is to distribute all remaining trust assets equally to the children.

Those existing will terms plant the seeds of disappointment and dissention for Michelle’s family. Michelle now realizes that, if she dies unexpectedly, she has delegated to Michael, or to Mary if Michael is not alive, the difficult decision about whether to sell the business or to continue to operate it. Neither Michael nor Mary is in a good position to make that decision because they know very little about the business. If they decide to sell rather than to make difficult and ongoing business decisions, Shane may lose his job and almost certainly would never be able to control the business.

In addition to creating the possibility of dissention between Shane and either his father or his grandmother, the existing will terms also create the possibility of dissention between Sharon and Shane. If Shane convinces his father or grandmother to keep the business, Sharon may have concerns about their ability to operate it successfully, or that they may allow Shane to try to manage the business and that he may not be successful. Sharon may want the business sold, to protect the value of her eventual inheritance.

Michelle has now also found out that she lives in a province which allows either or both Sharon and Shane to challenge the asset distribution set out in her will. If Michael is alive, they may initiate a challenge because of concern that their father may spend the wealth which Michelle created or may remarry, giving a new spouse a claim on their “inheritance” from their mother.

Michelle has decided that she wants the business retained if she dies, and that although Shane is not yet ready to take over from her, he should eventually have the opportunity to receive full control of the business. Michelle also knows that neither Michael nor Mary want to be involved in operating the business, and so she will have to arrange for interim management to take control if she unexpectedly dies. Michelle also wants to ensure that Sharon’s inheritance will not be adversely affected if Shane is given the opportunity to control the business. Overall, Michelle wants to do as much as she can to ensure that her unexpected death will not be the cause of dissention among the ones she loves.

An estate freeze can help Michelle to accomplish all of those succession and estate planning objectives. In addition, while she is alive, and without incurring any immediate tax implications, an estate freeze will allow Michelle to:

• retain the existing value of her company shares and also retain control of her business;
• freeze and defer the existing accrued capital gains tax liability respecting her company shares;
• give some or all of the future growth of the company (together with the tax liability associated with that growth) to others, either directly or through a family trust; and
• receive continuing financial support from the company through salary, dividends, redemption of shares, and increased value of shares from future growth of the business.

Michelle’s business is incorporated with only one class of shares, so an estate freeze will require a reorganization of the share structure of the company and the exchange of her existing company shares for single purpose “voting” shares and frozen “preferred” shares. The voting shares will give Michelle continued absolute control of the company. The total value of the preferred shares will equal the existing value of the company, and those shares will not increase in value as the business continues to prosper.

Michelle has determined that her existing company shares are “qualifying small business corporation shares” for the purpose of the Income Tax Act of Canada, and she has never exercised a capital gains exemption. Therefore, if a tax professional determines that there are no adverse side effects, she should be able to use all of her $750,000 enhanced capital gains exemption as part of the freeze.

By separating control of the company (through voting shares) and the existing company value (through preferred shares), Michelle is now able to give a partial or full voting interest in the company to one or more people, either during her lifetime or after her death, without including any of the existing company value in that gift. She is also able to redeem any amount of preferred shares from time to time for her own financial benefit (paying income tax on the value of the shares redeemed), and to distribute any preferred shares remaining at her death without including a voting interest in that gift. Therefore, this new corporate structure allows Michelle to give voting control to Shane (and to decide when to do so) and to give preferred shares (which hold the company value) in equal or unequal portions to some or all members of her family as an inheritance.

Once the company is reorganized, Michelle can authorize others (such as Michael, Sharon, and Shane) to subscribe for newly created “common” shares. Those common shares will have only a nominal value at the time of the freeze but will increase in value as the company continues to prosper. Michelle may even wish to subscribe personally for some of those common shares, to ensure that she will participate to some degree in the future growth of the company.

If Michelle is uncomfortable with others having direct ownership of company shares, she can create a family trust to hold the new common shares. The beneficiaries of the trust may include Michael and would almost certainly include Sharon, Shane, and their future children. As the trustee of the family trust, Michelle will decide which beneficiaries will receive dividends paid to the trust on the common shares, and will also decide which beneficiaries will receive direct ownership of the common shares when the trust is eventually wound up.

The estate plan which Michelle develops will not include the common shares which are received by the family trust or others. But her plan will need to include the voting shares, all preferred shares which she does not have the company redeem while she is alive, and any common shares she obtains as part of the freeze.

As part of her estate plan, Michelle can update her will to include a testamentary trust to hold her voting shares. She could appoint two or three co-trustees to act as a team, exercising those votes to make all major decisions respecting the company and the operation of its business. One co-trustee could be a family representative, perhaps Michael, or Mary if Michael is unable to act. Sharon and/or Shane could be appointed as alternate trustees to represent the family perspective. One co-trustee could be a representative of the business, perhaps Shane, or a trusted executive in the business, or the company accountant, or the corporate lawyer. If Shane was not appointed, he could be appointed as an alternate trustee to represent the business if the originally appointed trustee becomes unable to act. A trust company could be appointed as a third co-trustee, to perform all administrative tasks and to resolve any disputes arising between the “family” trustee and the “business” trustee.

The co-trustees would have all powers necessary to assure the continued growth and prosperity of the business, as well as powers to reorganize the company and implement future estate freezes or to sell the company or the business assets. Michelle could also give the co-trustees the power to give the voting shares to Shane if, in the future, they decide that he is capable of running the business. In the end result, implementation of an estate freeze has allowed Michelle to ensure that, if she dies unexpectedly, the business will be retained, a competent management team will operate the business for the benefit of her family, and Shane will get an opportunity to control the business if he shows the necessary capability.

However, Michelle also wants to ensure that, if Shane takes control of the company, he does not adversely impact the value of Sharon’s inheritance by reducing or eliminating the payment of dividends on common shares and preferred shares which Sharon owns. One possibility would be to have the company documents include a right to preferred share and common share dividends. A more flexible way for Michelle to promote harmony between her children after her death would be through use of a shareholder agreement. The terms of that agreement could stipulate the payment of preferred share and common share dividends in an amount tied to the annual financial performance of the company, could give Sharon a right to have her shares bought by the company if she chooses to invest her inheritance in different assets, and could give Shane a right to buy Sharon’s shares if he wants to reduce or eliminate dividends in order to focus on company growth. The shareholder agreement may also include terms requiring the purchase of life insurance to fund various contingencies, including redemptions by the company of common and preferred shares owned by Sharon or Shane if either one dies unexpectedly.

Michelle could also include a testamentary trust in her will to hold her remaining preferred shares and any common shares she acquired as part of the estate freeze. As with the trust for the voting shares, the beneficiaries of the trust may include Michael and would almost certainly include Sharon, Shane, and their future children. Michael, or Mary if Michael is not alive, could be appointed as trustee, would decide which beneficiaries would receive dividends paid to the trust, and would also decide which beneficiaries would receive direct ownership of the preferred and common shares upon wind-up of the trust.

An estate freeze can provide many succession and estate planning opportunities, including opportunities not discussed above. When considering whether to implement an estate freeze, a tax professional should be consulted to determine whether a freeze is advantageous and, if so, how best to reorganize the company, whether available capital gains exemptions should be used, and who should receive shares after the freeze is complete.

An estate lawyer should also be consulted, to help decide whether a separate will should be used to govern the company shares at the time of death, and whether to hold shares in one or more testamentary trusts and, if so, to develop the terms of each trust. In addition, the estate lawyer can help decide whether a shareholder agreement is needed as part of the estate plan and, if so, a corporate lawyer can help prepare that agreement. Finally, an insurance professional should be consulted to determine whether one or more insurance products would enhance either the succession plan or the estate plan.

Floyd Gradley is AVP, Mackenzie Investments Tax and Estate Planning Team, and an estate and trust lawyer.