Tax Planning in an Economic Downturn: An Ideal Time for an Estate Freeze

Posted on June 10, 2020 in Tax Planning | Wills & Estate Planning by Stephanie N. Maszko

Covid-19 has had far reaching and devastating consequences to economies around the world, and Saskatchewan is certainly no exception. While it has brought hard times for many of our local businesses, it may have also created some tax opportunities.

What is an estate freeze?

An estate freeze is a common planning tool which is often used to shift the value of a company to the next generation. Consider a family-owned business where “mom” and “dad” each own 50% of the common shares in the capital stock of the corporation (let’s call this corporation “FamilyCo”). Today, FamilyCo is worth $2,000,000.00, so each of mom and dad’s shares are worth $1,000,000.00. If mom and dad do nothing, their shares will continue to grow in value as FamilyCo becomes more profitable.

Individuals are deemed to dispose of all capital property immediately before death. As such, when mom and dad pass away, they will be deemed to dispose of their shares in FamilyCo at fair market value (note this deemed disposition can typically be avoided on the first to die, providing the shares are left to the surviving spouse).

Let’s assume that when mom and dad pass away, FamilyCo has done well and is now worth $3,000,000.00. Assuming mom and dad paid a nominal amount for their shares when they started FamilyCo, you can get a rough idea of the tax bill their estate will pay under current tax rates by multiplying the fair market value by 25%. So in this example, the estate would be required to pay tax in the realm of $750,000.00.

Now consider the same situation where mom and dad complete an estate freeze today. An estate freeze involves each of mom and dad exchanging their common shares in FamilyCo for fixed value preferred shares. A discretionary family trust is then introduced as the new common shareholder of FamilyCo. The result is that mom and dad’s interest in FamilyCo is “frozen” at the current value (being $2,000,000.00). All future growth of FamilyCo will be attributed to the shares held by the family trust. Mom and dad will be the trustees of the trust so they will retain full control over how these shares are dealt with and who receives any income from the same. In addition, mom and dad, their children and their grandchildren will be beneficiaries of the trust (note, depending on the objectives, additional beneficiaries may also be included).

Fast forward to the deemed disposition on death. Now mom and dad only hold shares worth $2,000,000.00 (rather than $3,000,000.00) so the tax bill has been reduced from $750,000.00 to $500,000.00. This can be further reduced by having FamilyCo redeem (or buy back) mom and dad’s shares during their lifetime.

When a company redeems shares, the result to the shareholder is a deemed dividend. As such, to the extent mom and dad were taking dividend income anyway, the tax treatment of their income will not change. For example, if mom and dad were previously taking (and want to continue to take) $100,000.00 per year as income, FamilyCo can buy back 10% of each their preferred shares each year, rather than declaring a dividend on their shares. At the end of 10 years, mom and dad will no longer hold any preferred shares in FamilyCo and will have completely eliminated the tax on death relating to the shares in FamilyCo.   

Now, you may be asking yourself, what happens to the shares held by the family trust? Since a trust is not an individual for tax purposes, there is no deemed disposition on death. In addition, a trust can transfer property to any of its Canadian resident beneficiaries on a tax-rollover basis (i.e. on a tax-free basis). As such, if mom and dad wish for some or all of their children to receive the shares of FamilyCo either during their lifetimes or on death, they can cause the trust to distribute some or all of its shares in FamilyCo to their children. Alternatively, if mom and dad decide they are not ready to transfer shares to the next generation, they can have the trust distribute the shares back to them. Note that a trust is deemed to dispose of its property every 21 years. As such, prior to its 21st anniversary, additional planning may be necessary.

Is now a good time for an estate freeze?

As you can see, the goal of an estate freeze it to limit the value of shares in a company owned by individuals. The less value an individual holds on death, the lower the tax bill to the estate. This is why an economic downturn (when company values may be lower) is an ideal time to complete these transactions.

Have you already completed an estate freeze when the value of your company was higher? Not to worry. If the value of your company has dropped below the value of the current issued and outstanding preferred shares, you may be able to “re-freeze” them at the current lower value.

If you would like to learn more about an estate freeze or whether it may be the right time for you to consider these transactions, please feel free to contact me or any of the lawyers in our tax planning group.

Stephanie N. Maszko
500 – 123 2nd Avenue South, Saskatoon, SK S7K 7E6
Telephone: 306-244-0132

The information in this guide is not legal advice. We encourage you
to consult with your legal advisor for specific advice.