Estate freezes are considered by many to be the cornerstone of estate and succession planning for Canadian family businesses.
Crystallizing Capital Gains
When considering an estate freeze, you will want to consider crystallizing capital gains in order to take advantage of the lifetime $750,000 capital gains exemption.
Let’s say you opted for an internal freeze, that Maple Leaf Co.’s shares qualify for the capital gains exemption and that you haven’t used any of that exemption.
Even with an internal freeze, you have the option of filing a holding company election that allows you to shed your common stock for an amount greater than its nominal ACB. In that scenario, you might elect that the shares be disposed of for $750,000, resulting in a capital gain of that amount, which you would report on your income tax return. That gain would be offset by the exemption.
Your preference shares would have an ACB of $750,000. On a future sale of the shares, or on your death, your capital gain would be $1.25 million ($2 million FMV minus $750,000). Without the crystallization and the capital gains exemption your capital gain would be $2 million.
Fundamentally, a freeze captures all or part of the value of appreciating assets at their current value and future growth accrues to your children who will take eventually take over the business.
The primary benefit is that the growth will not be taxed in your hands, either on an actual disposition or a deemed disposition on death. Among the other benefits are:
Most commonly, estate freezes are accomplished either by creating a holding company or by reorganizing the capital structure of the existing company.
Under this method, which falls under Section 85 of the Income Tax Act, you trade your growth shares in exchange for fixed value preferred stock in a holding company. Those preferred shares have voting rights that allow you to retain control of the underlying assets. The designated children receive common shares in the holding company.
As an illustration of how this works, say you own Maple Leaf Co., holding 200 common shares with a total fair market value (FMV) of $2 million and a nominal ACB.
You incorporate Holdco and trade your Maple Leaf stock for 10,000 preferred shares in that new holding company. The new shares would:
A holding company freeze is a tax-deferred transaction, so your accountant will file an election with Canada Revenue Agency (CRA). Under that election, you choose any purchase price ranging from the adjusted cost base (ACB) of Maple Leaf’s shares, which is nil, to their FMV at the time of the transaction. If you opt for the ACB, there will be no capital gain.
Meantime, your designated children would acquire new common shares, either through a stock subscription or as a gift. Those shares would have a nominal value but would reflect all future growth of Holdco, which would amount to half the future growth of Maple Leaf.
So, if over time Maple Leaf grows in value to $2.6 million, Holdco’s shares would be worth $1.3 million. Assuming the holding company had no other assets, $1 million of that value would be reflected in your preferred stock.
The remaining $300,000 would be reflected in your children’s common shares. So the capital gains that would normally be taxable to you becomes taxable to the children.
Here, you simply exchange common shares for new preferred shares under Section 86 of the Income Tax Act. New common stock is then issued to the children, either directly or through a trust.
You would have the same benefits as with a holding company freeze without having to incorporate a holding company and without having to file the election form. The stock rollover in an internal freeze is automatic.
To illustrate how the internal freeze works, given the same scenario as above, you exchange your $2 million in Maple Leaf common shares for $2 million in new preferred shares. Your children acquire new common shares with a nominal value that would later reflect future gains in Maple Leaf’s FMV.
Your stock rollover is automatic and you realize no capital gain, unless you opt to crystallize that gain.