Estate freeze strategies are commonly used to defer capital gains tax, especially for business owners or those who have rapidly appreciating assets. Mainly, however, freezing the estate has the benefit of minimizing tax payments when assets are eventually transferred. Its legal basis is the Income Tax Act of Canada.
But is this technique for everyone? Here’s what you should know about this strategy.
What is the estate freeze technique?
In simple terms, an estate freeze is when an individual “freezes” the value of their assets to a specific amount. Any profit derived from that asset is assigned to children or legal heirs, essentially bypassing the added cost of estate transfer. By cutting out the middleman, legal heirs will have the benefit of inheritance without the added transfer tax.
Not all assets, however, may be frozen. This is a move that necessitates holding corporate shares on the part of the person owning the estate or the testator. Here’s a look at how this works:
How to perform an estate freeze?
Estate freeze strategies typically follow this structure:
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An owner holds 100 percent of the common shares of her private corporation valued at $1 million.
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The common shares are then converted to preferred shares. Since preferred shares hold a constant value, the $1 million amount will be “frozen.”
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The owner, through the corporation, then issues new common shares to the intended heirs. The value of common shares is subject to change.
The preferred shares shall remain at $1 million while any profit will be recognized through the common shares. Since these common shares are owned by the legal heirs or by a trust, they do not form part of the estate. In the event of death, transfer taxes will be based on the $1 million value instead of the increased amount if no freeze was made.
For additional clarity, supposes estate freeze strategies were not used. If the value of the common shares increased to $1.5 million, tax would have to be paid based on that amount. With a freeze, however, only $1 million would be the tax base because the $500,000 is already owned by the legal heir or a trust.
Exemptions to estate freeze strategies
Freezing your assets is limited only to corporate shares. Other properties like those for personal use or registered accounts are not included in the estate freeze. This is because for this strategy to work, the assets must be in the form of corporate shares. To properly secure the asset, it’s also best to keep it within a privately held corporation.
This is why estate freeze is often used by business owners who own stakes in partnerships or corporations. By enforcing a freeze, they can maintain business operations while securing their future for loved ones.
Beneficiaries of an estate freeze
The legal heirs aren’t the only persons who may benefit from an estate freeze. It can also include extended family members like nieces, nephews, aunts, uncles, and siblings. The extent of beneficiaries depends on the person whose estate is being frozen.
Some owners may also choose to create family trust. The trust will then hold the assets and then allocate it to family members accordingly. A trust offers more flexibility and works best to preserve intergenerational wealth. Structured properly, estate freeze strategies through a trust can include even great-grandchildren of the original owner.
Here’s a great explainer about family trusts:
Advantages of estate freeze strategies
So, other than the tax implication, why else would a person use this estate planning technique? Here are some of the best reasons why freezing your estate is a good idea:
Equal shares received
Since assets are converted into shares, distribution becomes easier among the beneficiaries. Values are essentially divided into specific amounts, which helps do away with fractions. This also helps create more fairness and limits the chances of estate disputes, especially if some heirs are involved in the business. In contrast, land or other properties would be difficult to divide among heirs.
Maintain business control
Estate freeze strategies help the original owner retain control of the principal asset during their lifetime. They can also maintain control of the assets outside of the “frozen” portion. This allows for easier estate planning and lets the owner maintain control for as long as they are alive.
Flexibility of trusts
As mentioned, the common shares do not have to go directly to named heirs. Instead, they can be under a family trust, which manages the use and distribution of the funds. This creates more flexibility as any fund distribution can be adjusted with each generation. It can also serve to protect finances in the event of a relationship breakdown or creditors attempting to seize the assets.
Reduce probate fees
Probate costs are different from taxes paid on the transfer of property. With estate freeze strategies, however, probate fees and even administration costs are bypassed because the assets are already owned by the legal heir. Hence, there’s really no need to undergo probation for the assets falling under the freeze.
Other benefits of estate freeze strategies are discussed here:
If you want a deeper explanation of these benefits, you can consult with our Lexpert-ranked top estate and personal tax planning law firms.
What are the disadvantages of an estate freeze?
Estate freeze strategies come with some disadvantages. The most obvious one is if the strategy is poorly executed. Done improperly, the freeze could actually make succession planning more difficult. In some instances, like failing to specify common and preferred shares, it can rob the original owner of control of the assets.
Other drawbacks of this tax minimization move include:
Cost and complexity
Using estate freeze strategies always requires the input of a professional, preferably an estate lawyer. This is because the process of setting up a corporation, establishing trust, and consolidating with agencies requires technical expertise. This is not something that individuals can DIY with the help of a YouTube video.
Following this, the process is naturally expensive. Regardless of its purpose, establishing a private corporation follows the same process as any other company. Submitting documentary requirements and following legal requirements are still necessary. This is where most of the work comes in as the estate essentially gets legal life.
Loss of future gains
Once the freeze happens, the original owner loses any right to the growth. This now belongs to the new shareholders who can do what they want with the stocks. The original owner, however, may still impose conditions on its use during their lifetime. If transferred directly instead of through a trust, control becomes more limited.
Exceptions to the rule
There’s also the fact that not all properties can be the subject of estate freeze strategies. Personal property such as your residential estate is often excluded. Adding them also doesn’t have any tax benefits, which means that adding them in an estate freeze is unnecessary.
For registered accounts and other personal property, there are laws that specifically exclude them from estate freeze strategies. These variations in how property is treated can often cause confusion, requiring the input of a qualified lawyer.
What is the 21-year rule for estate freeze?
The 21-year rule is a limit imposed by the government to prevent indefinite deferment of capital gains. This applies to estate freeze strategies that utilize family trust. Essentially, a family trust is deemed to have disposed of all its assets at the 21-year mark. This way, taxes will have to be paid on that 21-year mark even if no sale happened.
This is why before the 21-year mark, holders of the common shares will have to dissolve the corporation and wind up its assets. Simply put – the corporation is extinguished, and the assets are finally distributed to their intended owners. Combined with an excellent tax lawyer, this move could significantly delay and even lower tax costs.
Common pitfalls in estate freezes and how to avoid them
Estate freeze strategies are a complicated maneuver that requires coordination from all parties concerned. This means not just the owner and their estate lawyer but also all the intended beneficiaries. Typical pitfalls associated with the move and how they can be avoided are:
Improper asset valuation
Assigning a value to the asset is a critical first step in estate planning. You’d want to make sure that the preferred shares are valued as accurately as possible. Overvaluing or undervaluing shares may be flagged by the Canada Revenue Agency (CRA). This can lengthen the process as the government ensures that they get their cut of the estate.
This is best avoided by getting professionals who understand the value of property and can pin an acceptable amount. Typically, this is a process that requires deep knowledge of the financial market. This is why getting the services of local lawyers is often advised. For example, if your estate is in Québec, then it makes sense to get estate planning lawyers from Québec.
Attribution rule
The attribution rule is a legal concept that looks through the control of the common shares or the shares that are not frozen. If control of the unfrozen assets is still primarily left on the owner or the spouse, then the law “attributes” those shares to the owner. Hence, the owner and not his legal heirs will be taxed.
This rule prevents owners from assigning assets to others while still exercising all rights of ownership over them. However, a good lawyer should be able to create a structure that prevents this from being triggered. Safety nets or by-laws at the corporate level could be created to ensure that control is evenly distributed among stakeholders.
Forgetting other assets
Estate freeze strategies should not be the single estate planning strategy you employ. Instead, it should be part of a holistic approach designed to minimize payable tax at every level. Even after an estate freezes, other assets must also be investigated. In these cases, the law allows the use of other minimization techniques depending on the property.
A good estate planning lawyer should be able to offer help at every level of this plan. This way, you’re getting a coordinated attack designed to preserve funds for the next generation.
Family conflict
The human element must not be ignored in these cases. Communication issues or disagreements can arise during the planning process. Feelings of unfairness could occur especially if some family members are directly involved in the business. In these cases, it helps to have an impartial professional mediate between family.
Securing the future with estate tax planning
Ultimately, estate freeze strategies are a viable way of preserving assets and ensuring that they endure through decades. However, meeting these goals is only possible with the help of legal professionals who can help consolidate different tax laws. Through proper planning and preparation, property owners can maximize funds left to their loved ones.
For more information about estate freeze strategies, look up some of our Lexpert-ranked best personal tax planning and estate lawyers in Canada. Secure your family’s future today.