How freezing your estate can reduce your taxes

A technique for small business owners

An estate freeze is a tax planning technique that allows a small business owner to freeze the growth of their interest in their company in order to reduce capital gains that would be triggered upon their death.  Implementing an estate freeze is common when a business owner has accumulated a significant amount of wealth and wishes to have it accumulate to the benefit of their family.

What You Need to Know

article continues below

In Canada, taxpayers are deemed to have disposed of their assets immediately before death. This can result in a significant taxable event and possibly even deplete an estate’s asset. An estate freeze can help minimize the amount of tax paid at the time of a taxpayer’s death.

The business owner, or shareholder, transfers his/her common shares back into the company in exchange for dividend paying, fixed rate preferred shares with voting rights. This allows the shareholder to maintain control of the company and pay themselves a dividend, if necessary. 

The shareholder’s family is then allowed to subscribe to the common shares of the company. Any increase in share value is now in the hands of the family, and the business owners’ interest in the company is now “frozen” at the value of the preferred shares.

Example:

John started a company 15 years ago by subscribing to 100 common shares for $1 a share. The business has done exceptionally well and is now worth almost $1,000,000. John has recently had the business valuated. The valuators estimate that the business will be worth almost $2,000,000 in the next 10 years.

John is almost 50 years old and he has significant retirement savings. While he doesn’t plan to retire, he does intend to slow down in the next 15 years or so while still maintaining control of the company.   John’s three children have expressed interest in getting involved in the business when they are finished their schooling.

He realizes that if he simply leaves the business to the children upon his death, there could be a capital gain of almost $2,000,000 which would significantly deplete the business.

An estate freeze allows John to carry out his wishes. By implementing the freeze, John would exchange his 100 common shares for fixed rate preferred shares with voting rights and maintain his interest in the company at $1,000,000. His three children would then subscribe to the common shares that John transferred back into the company and therefore the children would benefit from the future appreciation in value.

If John dies in 15 years, his estate would be responsible for the capital gain on only $1,000,000 interest in the company, as opposed to the predicted $2,000,000. This cuts the potential capital gain in half. His children would then be able to take control of the business and carry on operations.

The Bottom Line

Estate freezes are one of the most complex tax planning strategies and should only be done after much thought and with the guidance of financial planning professionals. However, if used in the proper situation, an estate freeze can significantly reduce a taxpayer’s tax burden at their death and allow for the smooth transfer of a company to the next generation.

 

Harley McCormick is a financial advisor at Keystone Wealth Management

The information provided in this article is intended for informational purposes only

and is not intended to constitute financial, accounting, legal or tax advice.

For information specific to your situation you should consult a professional.

Mutual funds provided through FundEX Investments Inc.

Research provided by ADVISOR Research Group, January 25, 2019

© Virden Empire-Advance