Estate freezes are a handy estate planning tool that helps avoid taxes, primarily capital gains taxes that apply on the transfer of assets to beneficiaries at the death of the parent.
An estate freeze restructures the beneficial ownership of certain types of assets. As a result of the freeze, the value of the existing equity is fixed, while future growth is transferred through shares or a trust into the hands of the named beneficiaries. This usually limits the value of the parents’ estate to the value on the date of the estate freeze.
Tax liability is determined by fair market value of property at time of death. By implementing a freeze beforehand, the value of one’s estate that is subject to tax is reduced and the value of assets received by beneficiaries is maximized.
An estate freeze makes sense in cases where the value of estate assets is expected to appreciate. The most common form of estate freeze involves the transfer of estate property to a corporation, or the reorganization of an existing corporation.
It locks in the corporation’s current value, leaving it in the hands of the founders. Their children are brought in as the new owners and will reap the benefits of any future growth of the corporation.
Typically, when the corporation is created the original holders receive shares with a nominal value from $.01 to $1 each. Years down the road, when the founders want to pass on the operation of the business to their children, those shares are usually worth considerably more. Now assume the parents want to stop working and need money to finance their retirement but the beneficiaries may not have the money or want to take on high debt to acquire the stock.
Adding to the conundrum are the tax consequences. Because the shares will be sold to a related party, the Lifetime Capital Gains Exemption on qualified small business corporation shares is affected. The parent can claim the exemption, but the tax cost of the shares to the child is reduced by the amount claimed. As a result, the children may have to pay taxes if they sell the shares.
An estate freeze can solve both the financing and tax issues. The parents swap their voting shares for preferred shares with a redemption amount equal to the value of the company at the time of the swap.
Section 85 of the Income Tax Act allows the swap to be recognized at any value between the fair market value of the new preferred shares and the tax cost of the old voting shares. The exchange value that is chosen is normally one aimed at letting the lifetime exemption shelter the resulting capital gain from taxes.
Typically, the founders also receive new voting shares with no redemption value that are then sold to the children. Because all the value of the corporation lies in the preferred shares, the voting shares have only nominal value and can be sold to the children without significant tax consequences. If the children sell the shares, they can claim their own lifetime exemption.
The founders then redeem the preferred shares as they wish. The redemptions are financed by the profits of the business rather than money the children borrowed.
Redeeming the shares produces a taxable dividend added to the parents’ income. That reduces the capital gain on the redemption and any resulting capital loss can be used to offset other capital gains.
Estate freezes are complex, but can be advantageous. Talk to your accountant about this or other methods that can help minimize taxes in your estate.