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Benefits of an estate freeze

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					                                                                       April 1991 (updated November 2000)
                                                                                     Ref. 91-4 (Rev. 11/00)

                                       Benefits of an estate freeze

When one hears about “estate freezes,” “estate thaws” and “partial freezes” the lay man may wonder if he
or she is listening to a weather report instead of tax planning terminology.

Estate freezing refers to the procedure of placing a limit on the growth of an asset in a particular person’s
hands and passing on the expected future growth to the next generation. An estate is said to be frozen
when a taxpayer exchanges appreciating assets for fixed-value assets.

Effecting a freeze
There are several methods of effecting a freeze. These include:
1.      direct sale to the beneficiary of the freeze;
2.      direct sale to a trust;
3.      section 85 freeze;
4.      corporate reorganization under Section 86.

Direct sale
It is apparent that direct sale to a beneficiary is a simple way of implementing an estate freeze. However,
this procedure is not widely used because of the resulting loss of control and the immediate income tax
consequences of such a transfer. With a direct sale to a trust, not only would there be an immediate
income tax liability but there would be additional considerations such as the problem of capital assets
being held by a trust are deemed to be disposed of every 21 years and the fact that there is a minimum tax
rate for the trust. The two most popular procedures for effecting the freeze today are the Section 85
rollover and Section 86 reorganization (references are to the Income Tax Act).

Section 85
Under the Section 85 Estate Freeze, the business owner sells the common shares of his or her operating
company to a new holding company in exchange for debt and/or preferred shares of the holding company.
The common shares of the holding company will be owned by the owner’s intended beneficiaries i.e. his
spouse and/or his children. If the requirements of Section 85 are met, the transferor and transferee can
elect for immediate income tax purposes that the transfer take place at an amount agreed upon by the
parties. By virtue of the election, it is possible for the taxpayer to defer the payment of any capital gains
tax that would otherwise arise because of the increase in the value of the common shares of the operating
company.

Section 86
Under a Section 86 type of estate freeze, the share capital of the operating company is reorganized in such
a way that the owner’s common shares are converted into fixed value preferred shares with a new class of
common shares being issued for nominal consideration to the owner’s intended beneficiaries. Under this
type of reorganization, there will be no realization of taxable gain at the time of the reorganization in
respect of any increase in the value of the owner’s common shares since Valuation Day.
Tax considerations
When considering an estate freeze, consideration must be given to the capital gain exemption for shares of a small
business corporation. This exemption, which is discussed in detail in the example below, is available to all taxpayers
who own shares in the company. Conclusion and example

An estate freeze, of course, is not something that can be implemented without full consideration of all
aspects of the estate. There is an obvious loss of flexibility once the freeze is put into effect and if
circumstances should change, the freeze may be difficult to unwind. When an operating company is
involved, the client should be aware that if he or she has a falling out with the beneficiaries, he or she may
lose operating control of the business. Nonetheless, the benefit of an estate freeze is such that it should be
considered by every client who has substantial assets, no further need for capital growth and desire to pass
along major assets to the next generation
The example below addresses the tax and insurance considerations arising under a Section 85 freeze:

The assumed facts are as follows (refer to Appendix):
i)     Operating Company (Opco) was owned 50/50 by two brothers, Mr. A. Smith (“A.S”) and Mr. B.
       Smith (“B.S”).

ii)      In 1980 a typical partial estate freeze was carried out by having A.S. and B.S. roll their common
         shares in Opco to their respective family holding companies (“Holdco’s”) in return for
         redeemable, retractable non-voting preference shares having a redemption value of $2,000,000
         each. At the time, the operating company was valued at $4,000,000 and each brother’s share was
         $2,000,000.

iii)     The preferred shares of each Holdco have a paid-up capital (PUC) of $5,000. The rollover
         described in (ii) was done under Section 85(1) of the Income Tax Act such that the adjusted cost
         base (ACB) of the preferred shares is $500,000 for each shareholder (based upon a V-day value
         of $1,000,000 for Opco)

iv)      The common shares of each Holdco were issued to each of the respective families as follows:
         600 common (60%) – Brothers (A.S. and B.S.)
         100 common (10%) – Their wives
         300 common (30%) – Trusts for their children

v)       The preferred shares of each Holdco have a redemption value of $2,000,000, an ACB of
         $500,000 and a PUC of $5,000. On a deemed disposition at death, there would be a capital gain
         of $1,500,000 (Fair market value minus the ACB) and on a redemption, a deemed dividend of
         $1,995,000 (Redemption value minus PUC).

vi)      Opco is now worth $7,000,000 and growing. A deemed disposition today of the 600 common
         shares of a Holdco owned by one of the brothers would trigger an additional capital gain of
         $900,000. Since the common shares of each Holdco have a nominal cost, the capital gain would
         be calculated as follows:
         Example: 50 per cent of Opco (and therefore each Holdco) is worth:               $3,500,000
                 Preferred shares of Holdco                                               $2,000,000
                 Net value of commons (1,000 shares)                                      $1,500,000
                 60 per cent of above (600 shares)                                          $900,000
vii)     The total potential capital gain to each of A.S. and B.S. is:

         On preferred shares                                        $1,500,000
         On common shares                                              900,000
                                                                    $2,400,000
         Taxable portion – 2000 (50% inclusion rate)*               $1,200,000
         Each brother’s potential tax liability (45%-50%)           $540,000 to $600,000

viii)   As Opco continues to grow, this potential tax liability continues to increase.
*Note: The reduction in the capital gains inclusion rate was announced in the October 2000 ‘mini’
budget. This budget, as of the date of this writing has not been passed into law.

                                             SMITHCO LTD.

                                            Corporate Structure



 Mr. A. Smith – 600 Common                                    Mr. B. Smith – 600 Common
 Mr. A. Smith – 2,000,000 Preferred                           Mr. B. Smith – 2,000,000 Preferred
 Mrs. A. Smith – 100 Common                                   Mrs. B. Smith – 100 Common
 Trust for Children – 300 Common                              Trust for Children – 300 Common




        A. SMITH HOLDCO INC.                                       B. SMITH HOLDCO INC




                         50%                                             50%

       50 Common                                                                     50 Common


                                           SMITHCO LTD




                                        WORTH $7 MILLION
Income tax considerations

Small business corporation
Each brother can reduce the above tax liability on a sale or deemed disposition of his shares in Holdco, if
his particular holding company and the operating company, Smithco, qualifies as a small business
corporation for purposes of the $500,000 capital gains exemption. The ability for either A.S. and B.S. to
claim the exemption will reduce their potential tax liability by up to $125,000 ($500,000 x ½ x 50% of
tax).

Upon the death of either A.S. or B.S., the executors should ascertain that the shares of Holdco qualify
and, if they do, ensure that a deemed disposition is reported sufficient to use the full $500,000 exemption.
This is desirable even if it is intended that the balance of the shares are to be rolled over to a spouse or
spouse trust.

There are a number of fairly strict rules that the company must meet in order for it to qualify as a small
business corporation (SBC). Meeting these tests can be considerably onerous. In the event of a sudden
death a deemed disposition may occur at a time when the companies do not qualify and significant tax
savings may be lost. Such being the case, the shareholders should consciously plan to what extent they are
going to take the necessary steps to meet the required tests.

The tax savings can be very significant if each family member can obtain the benefit of the maximum
$500,000 exemption. If each of five members of a family can save $125,000, that is a total of $625,000.
With two families involved, the aggregate saving becomes a potential $1,250.000.

Tax deferral
An obvious method of tax deferral on the remainder of the capital gain arising from a deemed disposition
on the death of A.S. or B.S. is for them to leave their shares of the Holdco to their respective spouses or a
spouse trust. The benefit from such a deferral is dependent upon how long the spouse survives her
husband. If she predeceases him, this tax deferral opportunity will be lost.

Eventually, there will be a deemed disposition upon the death of the surviving spouse. In addition to the
tax calculated above, there will be additional taxes payable on the gains accrued on each spouse’s shares
plus any gains accrued since the death of the first spouse.

The need for life insurance
In this particular case, the amount of income tax that will eventually be payable on the death of the
surviving spouse will be significant and the executors will have to determine where the cash will come
from. There may be sufficient cash resources in the estate, but if it is used to pay income taxes, it could
restrict the ability to pay specific bequests. If the funds were to come from Holdco, say on redemption of
preferred shares, there is a potential double tax problem that could result in additional tax having to be
paid by the estate or the beneficiaries. Firstly, there will be a capital gain to be reported in the deceased’s
final tax return. Secondly, redemption of the preferred shares of Holdco by the estate will result in a
deemed dividend that is taxable and a potential capital loss (subject to reduction by the stop loss rules
introduced in 1995). Thus, both the deceased and his or her estate will pay tax on the same amount unless
the redemption takes place within one year of the date of death, and Sec. 164(6) of the Act can be applied
to carry the capital loss back to offset or partially offset the deceased’s gain on the deemed disposition.

If Holdco is not in a liquid position, the estate might be forced to sell some of its assets to pay income
taxes. If this is not desirable, it would appear appropriate that life insurance coverage be considered to
remove the impact of the tax liability arising upon the death of the last survivor. The use of corporate
owned life insurance would permit the tax-free redemption of preferred shares by utilization of the
Capital Dividend Account generated form the death benefit proceeds.


The above should not be taken as providing legal, accounting or tax advice. You should obtain your own independent professional
advice from your lawyer and/or accountant to take into account your particular circumstances.

Great-West and the key design are trademarks of The Great-West Life Assurance Company.

				
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