Understanding estate freeze transactions for business owners
An estate freeze allows business owners to lock in their company's current value while passing future growth to the next generation. This tax planning strategy helps entrepreneurs preserve wealth within their families while maintaining control of their businesses during their lifetime.
What an estate freeze accomplishes (Section 86)
An estate freeze converts your growth-oriented common shares into fixed-value preferred shares. Think of it as taking a snapshot of your business value today and saying "this is mine" while allowing all future appreciation to flow to new common shares held by your children or a family trust. The transaction typically uses section 86 of the Income Tax Act, which permits this exchange without triggering immediate taxes.
For example, if your business is worth $5 million today, you exchange your common shares for preferred shares worth exactly $5 million. These preferred shares are designed to maintain that fixed value - they're redeemable and retractable at $5 million, meaning you can cash them out at that price. Meanwhile, new common shares are issued to your children for a nominal amount, perhaps $100. If the business grows to $8 million in five years, your preferred shares remain worth $5 million while your children's common shares capture the $3 million increase.
Planning Tip: Ensure your preferred shares have voting rights if you want to maintain control of the company after the freeze. Many business owners use special voting shares to retain decision-making power even after their economic interest is frozen.
Why business owners choose estate freezes (Multiple benefits)
The primary advantage is tax deferral. Without a freeze, when you pass away, your estate faces capital gains tax on the full value of your business shares. By freezing your value today, you cap your eventual tax liability at current values. This certainty allows for better estate planning, including purchasing life insurance to cover the known tax bill.
Estate freezes also facilitate business succession. Your children can become shareholders for minimal cost since all current value resides in your preferred shares. This removes financial barriers that might otherwise prevent the next generation from participating in the family business. The structure also multiplies access to the lifetime capital gains exemption - currently $1,016,836 per person in 2024 - as each family member who owns shares can potentially claim their own exemption on a future sale.
Additionally, the freeze protects family wealth. Shares held by children directly or through a family trust aren't subject to claims by your creditors. If structured properly as gifts, these shares may also be protected from division in your children's potential future divorces under provincial family law.
The family trust advantage (Maintaining flexibility)
Rather than issuing growth shares directly to children, many business owners use a discretionary family trust. This structure offers significant advantages. As trustee, you maintain voting control over the shares and discretion over when to distribute income or shares to beneficiaries. This flexibility is particularly valuable when children are young or when you're unsure which children will be interested in the business.
The trust structure also provides asset protection. If you subscribe for the growth shares personally and then gift them to the trust, this may shield the shares from family law claims if a child later divorces. The trust can include multiple generations as beneficiaries, allowing you to benefit grandchildren or even future generations not yet born.
Planning Tip: Be mindful of the 21-year rule - trusts must report capital gains on their assets every 21 years as if they sold everything at fair market value. Plan to distribute appreciated assets to beneficiaries before this deadline to avoid tax at the trust level.
Critical implementation considerations (Getting it right)
Valuation accuracy is paramount. The Canada Revenue Agency expects the preferred shares you receive to equal the fair market value of the common shares you give up. An independent business valuation protects against challenges and ensures the freeze achieves its objectives. Include a price adjustment clause in your freeze documents - this allows retroactive adjustments if the CRA later disagrees with your valuation.
Consider the impact of recent tax changes. The Tax on Split Income (TOSI) rules now limit the ability to pay dividends to adult family members who don't actively participate in the business. While estate freezes remain valuable for succession planning and capital gains multiplication, the income splitting benefits have been curtailed.
Family law protection requires careful structuring. In McNamee the court highlighted that shares must be genuine gifts to qualify for exclusion from family property division. Simply having children subscribe for shares at nominal value may not provide protection - instead, consider subscribing for the shares yourself and then gifting them with proper documentation.
Planning Tip: Work with both tax and legal advisors to ensure your freeze addresses all objectives. A well-drafted shareholders' agreement should accompany the freeze to govern future share transfers, establish buy-sell provisions, and protect minority shareholders.
Takeaways
Start planning early, as the best freeze is one implemented when you have time to adjust if circumstances change.
THIS ARTICLE PROVIDES INFORMATION OF A GENERAL NATURE ONLY. IT DOES NOT CONSTITUTE LEGAL, TAX OR FINANCIAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH. PROFESSIONAL ADVICE SHOULD BE SOUGHT PRIOR TO IMPLEMENTING ANY ESTATE FREEZE. THE AUTHOR ASSUMES NO LIABILITY FOR ERRORS OR OMISSIONS.
