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Succession plans for family-owned businesses generally include a strategy for the next generation to take over the business. Logically, families want to have this transition occur in a tax-effective manner without causing undue cash flow concerns to the purchasers or the vendors. The parents could sell the shares to the children at fair market value or have the children acquire new shares from treasury at fair market value. However, given both of these options can have significant cash flow concerns, it is often desired to transition the business in a more tax-effective manner.
One solution is to implement an estate freeze, whereby the common shares held by the parent are exchanged for preferred shares, essentially transferring all of the current value to the preferred shares. Because the current value is fixed onto the preferred shares, the value is essentially ‘frozen’ at this amount, hence the name.
Once the value of the company has been tied up in the value of preferred shares, new common shares can be subscribed from treasury at a nominal amount. The value of the preferred shares is retained by the original shareholders and all future growth belongs to the new common shareholders.
An estate freeze can provide families with the following benefits:
• Income Splitting: This creates an ability to share dividend income with family members, some of whom may be in lower tax brackets, allowing the family unit to pay less tax overall.
• Future Growth Transition: As the parent has preferred shares that do not grow in value, their value is fixed at the time of the freeze, with all future growth attributed to the new common shareholders. This way, the child will create value tied to their efforts in the business.
• Ability to Control: While the parent may have preferred shares, it is possible to structure the company in a way that they retain control.
• Effective Ownership Transition: An estate freeze can help with ownership transfer, especially in a family situation.
• Relatively Inexpensive Buy-in: Children can acquire the common shares from treasury at a nominal amount, as all of the company’s value is tied to the redemption value of the preferred shares. This eliminates the need for large purchases between the parents and children.
• Redemption Ability: Preferred shares can be repurchased by the company over time. This may assist in cash flow issues and can minimize tax consequences for the parents.
• Fixed Tax Consequences: The parents have preferred shares that are fixed in value. As the company continues to increase in value, these increases belong to the holders of the common shares. Therefore, the parents have essentially fixed their future tax on death as their shares no longer increase in value. The value of the common shares will continue to grow and the tax burden on these shares will be borne by the common shareholders.
Consider the following scenario as an example of where the estate freeze may be useful. Mr. A started a business many years ago in Alberta and acquired the shares on incorporation for $100. When the company was worth $2 Million, an estate freeze was implemented to freeze his value onto preferred shares. His daughter subscribed for common shares from treasury. When Mr. A passed away, the company was worth $5 million. On death, he will be deemed to dispose of his $2 million of preferred shares, with a capital gain of $1,999,900, resulting in approximately $400,000 of taxes in Alberta.
If the freeze had not occurred and instead, the shares were gifted to the daughter in Mr. A’s will, he would have a capital gain on death of almost $5 million, resulting in just under $1 million of income tax.
It is essential to look at your tax strategy as part of your overall transition and will planning. Otherwise, your business could see costly tax implications.
Related Topics:Family; Retirement; ExitSMART™; Estate Planning
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