Your client’s business may have dropped in value over the course of the pandemic, making now a good time to consider an estate freeze or refreeze. Such a move can be part of effective tax and succession planning.
Consider a family business in which the owners are near retirement and their children are active in the business. To do a freeze, the owners exchange their common shares for redeemable preferred shares with a fixed value (in other words, they “freeze” the value), and issue new common shares to the children. The freeze reduces the owners’ tax liability upon death and defers taxes by shifting the business’s future growth to the common shares owned by the children.
(The new shares could be held in a discretionary family trust instead, allowing the parents to retain control over the common shares and enhancing access to the lifetime capital gains exemption, if applicable.)
If a client has already done an estate freeze and their business’s valuation drops materially lower — as may have happened during the pandemic — they can do a refreeze: exchange their preferred shares for new ones at the current fair market value, and issue new common shares to the children, the existing discretionary family trust or a new trust. The refreeze at the new valuation level further reduces the owners’ tax liability upon death.
The new freeze value should be high enough after tax to provide the client with enough liquidity to fund their lifestyle during retirement, says Garnet Matsuba, tax counsel with MLT Aikins LLP in Edmonton. “That is a potential pitfall if they underestimate the amount they’ll need,” he says.
Another pitfall: a lower business valuation must be supported by evidence.
“There has to be a bona fide operational decline,” says Tannis Dawson, vice-president, high-net-worth planning, with TD Wealth Advisory Services in Winnipeg. For example, she says, “You can’t pay a big dividend on common shares to reduce the value of the company below the value of the preferred [shares], to then do a refreeze.”
Matsuba suggests working with a qualified business valuator so the valuation “withstands some degree of scrutiny” from the Canada Revenue Agency (CRA), he says. “The last thing we want is [for] the CRA [to] impose taxable benefits on people because value has been shifted inappropriately — we certainly have seen that situation.” (See sidebar on corporate attribution.)
The corporation should keep records detailing how the valuation was calculated, Matsuba says. He also recommends clients include a price-adjustment clause with the corporate documents related to the refreeze (or freeze) to allow the valuation to change without adverse tax consequences should the CRA challenge the valuation.
Another important consideration is timing: the business’s value could continue to drop after the refreeze.
Your client could do another refreeze, although “you have to evaluate whether the benefits outweigh the costs,” Hu says. “If there is a significant decrease in value that is supportable today, there is no reason why you shouldn’t consider [a freeze or refreeze].”
The cost of a freeze or refreeze depends on the client’s situation, Hu says. A refreeze may cost less if the family had set up a trust already, for example.
Matsuba estimates legal fees for a refreeze would be $3,000 to $5,000. Add in valuation fees, other advisory fees and taxes, and the total cost could be roughly $10,000, he says.
If your client needs more value
After a freeze, if your business-owner client requires more value than is provided by the preferred shares (for retirement, for example, or to use the lifetime capital gains exemption), they could consider a “thaw.”
“A business owner — especially in this climate — might find that eventually they’ll need more value to live on,” Hu says. “Or they want to take back control or take on more growth of the company.”
“[Perhaps] the company has increased or sustained its value during Covid, and now [the client] needs more money and doesn’t want the current shareholders to have it,” Dawson says.
To accomplish the business owner’s objectives, the freeze shares are “thawed” in return for new common shares. The business owners would either convert some preferred shares back to common shares or undo the freeze completely, Matsuba says. Proper valuation remains important when issuing the new common shares to avoid creating a taxable benefit for the shareholders, he adds.
Alternatively, if a business had issued common shares to a discretionary family trust, business owners who need more funds and are trust beneficiaries could “allocate shares out of the trust to themselves as long as [they are] residents of Canada,” Dawson says.
Costs for a thaw would be comparable to a refreeze, because the transactions are similar. “You’re exchanging your existing shares,” Hu says. But the cost ultimately depends on the client’s objectives, she says.
Your role on the freeze team
During freezes, you work with your business-owner client’s team of accountants and lawyers, and the client’s financial plan is the basis for decision-making.
Crunching the numbers from the plan helps the client make decisions about preferred shares, including doing a refreeze, says Tannis Dawson, vice-president, high-net-worth planning, with TD Wealth Advisory Services in Winnipeg. For example, a client who doesn’t need their preferred shares from a freeze may want to do a refreeze to decrease the value of their estate when the opportunity arises, she says.
In another scenario, redeeming the preferred shares over time in what’s called a “wasting freeze” may make sense to ensure no shares remain upon death and tax liability is spread over several years. Furthermore, accessing capital gains by selling shares instead of redeeming them may provide greater tax efficiency, Dawson says.
Freezes and corporate attribution
Freezes often are done according to Sec. 86 or 51 of the Income Tax Act, which allows for a tax-deferred share-for-share exchange without having to apply the corporate attribution rules.
However, the corporate attribution rules (Sec. 74.4) would apply “when you’re trying to effectively shift value or provide benefit to someone who’s a designated person,” says Jingchan Hu, senior manager, tax, with Crowe Soberman LLP in Toronto.
According to the rules, when your business-owner client transfers property to the corporation, they may be subject to an annual deemed interest benefit on the property at the Canada Revenue Agency’s prescribed rate.
The benefit applies if the transfer was done to reduce the business owner’s income and to benefit a spouse/common-law partner, or non-arm’s length person or niece or nephew under age 18.
Sec. 74.4(4) provides one exception: when the designated person’s only interest in the corporation is as a beneficiary of a trust from which they don’t receive income or capital. A small business corporation is also excepted.
When a business owner doesn’t qualify for an exception, the company can eliminate corporate attribution by, for example, paying dividends on the frozen preferred shares. In general, “you’d rather pay taxes on real income than on phantom income,” says Garnet Matsuba, tax counsel with MLT Aikins LLP in Edmonton.
With the prescribed rate at 1%, “it won’t take much in dividends to offset the corporate attribution” relative to when the rate was higher, Matsuba says. The freeze may be “still good in the long term because you can reduce the transferor’s tax liability at death.”
With a refreeze in such a case, the deemed interest benefit would be based on the redemption amount of the original preferred shares, not of the refrozen preferred shares, according to the CRA. The client’s accountant would have to calculate whether the refreeze is advantageous.
Matsuba says clients should weigh the benefit of the lower tax liability that would be applied upon death against the cost of paying sufficient dividends to eliminate the attribution.