For high net worth individuals and families, taxes resulting from the disposition of an estate can be onerous and can impede a smooth transition of a business to the next generation. So-called “estate freezes” can be an effective way to enhance succession planning and reduce or avoid capital gains tax. But estate freezing offers a number of other key tax-saving strategies as well, including income splitting, multiplying the capital gains exemption, and creditor protection.
The upside to diverting the future growth of your business to your kids is that any dividend income or capital gains arising from the shares in the main operating business (“Opco”) will be taxed in your kids’ hands. And chances are that your kids will be subject to a lower marginal tax rate than you, which results in tax savings.
Although there are a number of income tax rules (e.g., the “attribution rules” and “kiddie tax”) that are designed to thwart this objective when your children are minors, it is quite possible to implement successful income-splitting strategies within the context of a freeze, notwithstanding these rules. Because each situation is different, it’s important to get proper tax advice when implementing an estate freeze to ensure you avoid the attribution-rule trap.
Multiplying the capital gains exemption
Another upside to an estate freeze is the ability to multiply the $800,000 lifetime capital gains exemption on the sale of certain shares of a corporation. If an estate freeze is not implemented, and you are the sole shareholder at the time of a sale (and assuming your shares qualify), any proceeds over $800,000 will be subject to tax. However, if you implement an estate freeze and introduce your kids as shareholders (or, a family trust on behalf of your kids), this $800,000 tax-free amount can be multiplied by the number of kids to whom you give shares (either directly or through a family trust). This can add up toa lot of tax savings.
Keep in mind, however, that before you can take advantage of the $800,000 exemption, there are a number of conditions that need to be met, including a 24-month holding period.Therefore, if you think an eventual sale of your business in on the horizon, consider implementing an estate freeze now, in order to meet the 24-month holding period while allowing time for enough value to accrue to the shares of the company.
If you’re concerned that you could potentially be subject to claims by creditors as a result of personal guarantees, judgment creditors, or the like, then you may be able to take some comfort in having shares held by your kids, or better yet, a discretionary family trust that holds the shares for them.
The uses of a family trust
Ofcourse, the main objective of an estate freeze is to be able to introduce your children into the family business on a tax-free basis. If you were to simply gift shares to your children, you would be taxed on such a transfer. However, an estate freeze is a legitimate tax planning structure that allows you to introduce your children as equity owners without triggering any tax. And the use of a family trust to hold the new growth shares for your children gives you the benefit of being able to control those shares (i.e., you would do so by acting as a trustee of the trust), giving you more time and flexibility in deciding when and how to distribute those growth shares among your children.
Courtesy Fundata Canada Inc. ©2016. Samantha Prasad, LL.B. is Tax Partner with Toronto law firm Minden Gross LLP. Portions of this article appeared in The TaxLetter, published by MPL Communications Ltd. Used with permission.