Subsection 70(5) of the Income Tax Act provides that individuals are deemed to have sold all capital property (like a house, or shares in a company) at fair market value immediately preceding death. This is called “deemed disposition”.
Now, I’ll go off on a tangent for a moment.
For a house, if it was the deceased person’s principal residence, then the “principal residence exemption” applies so that federal tax does not have to be paid on the increase in value of the house (“capital gains”) from the date of purchase till the date of death.
However, at death, it is assumed that the deemed disposition referred to above was to the estate of the deceased, which conveniently for the government, is a separate legal entity for tax purposes. So, capital gains tax would be payable - by the estate - from the date of death till the date the house is sold. The exception is if the house is given to an adult child who has no principal residence, so that it continues as someone’s principal residence in an unbroken chain.
That is the end of my tangent. Now, what if we are looking at company shares?
Well, for shares, there is no “principal residence exemption” of course, but if we are talking about the shares of a small business, there is the “lifetime capital gains exemption” - which as of 2019 stands at around $850,000.
Say you started a business from the ground up, and back then you took $100 in shares, and the business is now worth a tidy $3,000,100, you’d have three million dollars in capital gains. Instead of being taxed on that amount at the time you sell the business, the lifetime capital gains exemption would let you reduce that amount by about $850,000.
You would still have to face paying capital gains tax on $2,150,000 however. Of course, you are still working at your business, so its value will keep increasing. One day, it might well be double what it is today. Well, the lifetime capital gains exemption won’t double just because the value of your shares in your small business have. As a result, your capital gains tax exposure will be higher still!
For small business owners, this can mean an outsized tax burden at some point in the future. An estate freeze is a handy way to halt this “taxation creep”, at least as it applies to you. It also has the added benefit of transferring control of the business to the next generation while you are still alive and can mentor them. Thirdly, it provides a way to fund your retirement by ensuring you can “cash out” of the business at some point.
So, what exactly is an estate freeze?
An estate freeze is an estate planning technique that locks in the current value and tax liability of capital property, like company shares, and attributes the value of future growth to another individual or trust. The current owner can still have some say in how the business is run, but the beneficiaries of the freeze - usually the children but possibly a family trust - can take active control, as well as reap the benefits of future growth from, and pay future taxes on, the capital property following the date of the freeze.
So, remember your small business corporation’s shares? They keep increasing in value as your business is successful year after year, right? And that keeps increasing the capital gains tax you’ll have to pay one day, right? Well, swap those “value-increasing” shares (typically called common shares) for “fixed value shares” (typically called preferred shares) in the same corporation, and presto, you’ve locked in what you’ll take out of the company and the next generation can take over the “value-increasing” shares.
The handing over of control that this process entails means that it can only happen once the “next generation”, for the purposes of the business, have been identified and are ready to take the helm.
An estate freeze doesn’t mean you sell the “fixed value shares” right away. It just means they won’t increase in value. By keeping them, you can still participate in dividend distributions. At some point however, you may want to sell them, and the corporation will then pay you out of the accumulated liquidity it has available. If you do sell, you’d owe capital gains tax at that point.
Secondly, assuming you don’t sell the shares, an estate freeze gives you the added benefit of knowing, with great certainty, what your estate’s tax liability will be at the time you pass on. This is great for estate planning, since it means you aren’t thinking of how your estate might write a cheque to the “Receiver General of Canada” for a moving figure.
Thirdly, an estate freeze gets the next generation started at little cost, and ensures they don’t have to worry about capital gains tax themselves until they are ready to sell, or until much after they put an estate freeze in place themselves.
It is important to know that once implemented, it is very difficult to undo an estate freeze. With that in perspective, it must be seen as bringing together retirement planning and estate planning for owners of small businesses.
Also, an estate freeze can be tricky. It must be done right. There are trip-wire Income Tax Act rules that would need to be avoided.
If you feel as though an estate freeze may be a good option to include in your estate plan, and you are resident in Ontario, we can readily assist as estate planning lawyers. We have offices in Ottawa and Toronto, and can provide services in most other parts of Ontario. We can be reached by phone at 1-888-59-WILLS.