An “estate freeze” is a device that is used to “freeze” the value of a business or asset in the hands of one party and transfer the future growth to another person without triggering undue tax consequences.
Here is a typical example.
Christine and Tyler purchase a rental property, let’s say a small walk-up apartment, in 1990 for $400,000. In 2014, it is worth $1,400,000 and the mortgage is paid in full. They own the building in their own personal names and it now generates sufficient rental income to fund their retirement plans.
Christine and Tyler have plans to pass on the building to their children. The Income Tax Act prevents them from doing this on a tax-free basis. If they simply gift the building to their children, the Income Tax Act will – since the children are not at arm’s length – attribute income to them equal to the increase in the fair market value of the property (in this case $1,000,000). The prospect of this income tax bill means that Christine and Tyler continue to defer transferring the property to the children which only serves to increase the taxes payable when the property is eventually transferred. In many cases, the property must be sold just to pay the taxes when it is finally transferred to the next generation.
Using an estate freeze, Christine and Tyler can transfer the property to a new corporation. For more information about incorporation click here. Christine and Tyler will hold special shares equal to the value of their gain on the property (in this case $1,000,000). No tax is payable at the time they acquire the special shares. They also subscribe to some other shares as determined by them, their accountant, and their lawyer. Through the structure of the shares, Christine and Tyler can also retain the right to receive rental income from the property.
The new corporation can then issue shares to the children. The shares issued to the children contain the right to receive all future growth in the value of the assets of the corporation, in this case the apartment building.
Christine and Tyler will of course pay taxes. They do this by paying taxes on the dividends they receive resulting from the rental income. They will also pay taxes whenever they cash in any portion of the special shares with a total value of $1,000,000. However, they can cash these shares in over many years in a manner that minimizes and defers taxes.
The children eventually acquire complete ownership of the building without triggering a massive tax bill that would occur if Christine and Tyler simply continued to hold the apartment building in their own name and transferred it to the children on their death.
This strategy can also be used for an active business. In this case, there is typically a corporation already in place. To achieve the estate freeze, the retiring owners “freeze” their value by taking special shares with a value equal to the current value of the business. The new owners can then be brought in without triggering immediate tax consequences. Once again, the retiring owner pays tax as they cash in their special shares.
An estate freeze is a very effective strategy for transferring property to a new owner, while allowing the current owner to remain involved in the business.
If you have any further questions about how an estate freeze could help you, please contact us here at Galbraith Law at 780.483.6111 or 1.866.483.6111. For more information about estate planning please visit the Wills & Estates section of our website. For more information about corporate or small business matters please visit the Small Business section of our website.