Example — a “Section 86” freeze
This is the simplest estate freeze. Section 86 of the Income Tax Act allows an exchange of one class of shares in a corporation for another class with no tax consequences, as long as all of the shares of the first class are being exchanged.
Suppose you run an incorporated business, XYZCo. The corporation has 1,000 issued common shares, all registered in your name. You originally invested $1,000 in the corporation ($1 per share), and the shares are now worth $200,000. You expect that in a few years they may be worth as much as $1 million. You have an adult daughter who works full-time in the business, and you want her to inherit it.
If you simply leave your shares to your daughter in your Will, the deemed disposition on your death will trigger a substantial capital gain. If the shares are indeed worth $1 million when you die, your estate might have to pay up to $270,000 in tax.
Let’s look at how you can use an estate freeze in this situation.
You exchange your 1,000 common shares in XYZCo for 1,000 preferred shares (with share conditions that we’ll explain below). Your daughter then invests $100 in 100 new common shares of XYZCo, at $1 each.
The object is to “freeze” the value of your investment at $200,000, which is what the shares are worth now. Any increase in value above the $200,000 level will accrue to your daughter, and not to you. Therefore, your preferred shares need to be set up to have a value of exactly $200,000 — a value that does not increase even though the value of the company as a whole increases.
However, you want to keep control of the business as long as you are alive.
With this in mind, here is how you might design the preferred shares that you will own:
- The preferred shares will be voting shares. Each preferred share should carry 1 vote, and each new common share could carry 1 vote (although the common shares could be non-voting). Since you will have 1,000 votes to your daughter’s 100, you can elect the board of directors, and thus you will continue to control the corporation.
- The preferred shares should be retractable, at the option of the holder (you), for $200 each, or $200,000 in total. In other words, you will have the legal right to force the corporation to pay you $200,000 for your shares at any time. That makes it clear how much the shares are worth — since you can cash them in whenever you want.
- Preferred shares must pay a dividend in preference to the common shares. The dividend could be in the discretion of XYZCo’s directors, or could be fixed at, say, $6 per year per share (i.e., 3% of their value), payable quarterly. The dividend can be made “non-cumulative”, so that if XYZCo chooses not to declare a dividend in any given quarter, the unpaid dividends will not accumulate to prevent dividends from being paid to your daughter on the common shares.
The specific details should be worked out with your professional advisers as part of your customized estate plan. Everyone’s situation is different.
Now, what have you accomplished?
- First, because of section 86 of the Income Tax Act, there is no cost to exchanging your common shares for preferred shares. In other words, the $199,000 accrued gain on your shares isn’t taxed for now. (The preferred shares take on the cost base of your original common shares, so they have a deemed cost to you of $1,000.)
- Second, you have “frozen” the value of your investment at $200,000, since the preferred shares will be worth only that much in the future. (They can’t go up in value because of the fixed dividend.) So if the value of the business increases, the growth will be allocated to the common shares. On your death, if the business is worth $1,000,000, you have a capital gain of just under $200,000 instead of just under $1,000,000, so the tax cost is far less. (We’re ignoring the capital gains exemption on small business shares for purposes of this example.)
- Third, you have kept control of the business. You can continue to elect the board of directors that hires employees and runs the company. And you can continue to be the sole director, if you wish.
- Fourth, if you need income, you can cause the directors of the corporation to declare dividends on the preferred shares, in addition to any salary, bonus or consulting fees the corporation pays you. Since the dividends are non-cumulative, you can also choose to have the corporation not pay them, as long as you are not paying dividends on the common shares during the same quarter.
- Fifth, if you ever need the capital, you can require the corporation to redeem the shares for $200,000. (This will result in a “deemed dividend” to you of $199,000, on which you will pay tax of up to about 40%.)
The possibilities are endless…
The above is only one example. Estate freezes can be much more complex, and can involve such features as: family trusts owning shares for your children; “section 85 rollovers” whereby you transfer shares or assets to a holding company; crystallization of the capital gains exemption on small business corporation shares; and many other techniques.
There are many technical traps and pitfalls in the Income Tax Act to watch out for, however. These include attribution rules, the Tax On Split Income, deemed dividends, stop-loss rules, surplus stripping rules, capital gains stripping rules, and others too numerous and arcane to mention.
If you have significant assets that are or can be incorporated, you should definitely explore ways of protecting your estate from severe tax costs on your death.
