A tax planning prompt for business owners[1]
For a few years beginning in 2020, the COVID-19 pandemic caused tremendous disruption and pain in both the personal sphere and in business activity. Owners of closely-held small businesses were especially vulnerable, with both their primary income source and invested capital at risk.
The stops and starts of multiple waves of the virus wreaked havoc and sewed uncertainty. Ironically though, this strange economic rollercoaster opened a window of tax opportunity for business owners who may have been hemming-and-hawing about succession. At the time it was the pandemic, but any economic condition that causes a dip in business value could present a ripe opportunity to proceed with an estate freeze.
Tax exposure on succession
Think of an entrepreneur who established a business corporation years ago, and now wants to bring adult children into ownership. The problem is that a direct share transfer would be a disposition. The capital gain is calculated as the difference between the fair market value and adjusted cost base (ACB). That could be a hefty tax bill for the parent, with a 1/2 income inclusion on capital gains up to $250,000 in the year such a transfer happens, and 2/3 inclusion on gains beyond that.
Whether the parent intends to make a gift or to have the children buy their way in, quite often the children don’t have the cash at present anyway. That means the parent will have to use other cash to pay that tax bill. A more likely reality for many business owners is that the bulk of their wealth is tied up in the business, so there is little if any readily available cash.
Thus, the prospect of paying that tax could be paralyzing. Business growth would continue to accrue to the parent as current full owner, as would the associated growing tax ty.
Enter the estate freeze
An estate freeze offers a more tax-efficient way to go about it. Future business growth is transferred to the successors, and the past growth is frozen in a way that ensures that no tax is incurred by the current owner in the present.
A familiar scenario is for the parent to exchange their common shares for preferred shares with the same value. These new ‘freeze’ shares won’t increase in value but will usually carry voting control and dividend rights. Often, it’s possible to increase the ACB on the shares using the lifetime capital gains exemption (LCGE), which stands at $1,250,000 in 2024 . Whether or not the LCGE is used in this way, no tax arises at the time of the exchange.
Tax is deferred until the parent disposes of these freeze shares. Sometimes the shares are redeemed by the corporation over a course of years, providing cash to the parent and spreading tax recognition. Otherwise, there’s a deemed disposition at the parent’s death, or on the later death of a spouse if the shares are rolled over to the spouse on that first death.
A new class of ‘growth’ shares is issued to the children for nominal cost. Alternatively, a trust may be set up to hold these shares for the children as beneficiaries, with legal control left in the hands of the parent as one of the trustees. No tax arises on this part of the plan either.
Future growth has been pushed down a generation, allowing for years or decades of deferral before future gains are exposed to tax.
Why freeze on a dip? Or re-freeze?
Apart from the terrible health crisis of COVID-19, it also had a negative impact on the financial value of many businesses. But with that downturn came opportunity. While there was no guarantee when and how much a given business may recover, those who executed a freeze at a depressed value were able to push a greater amount of future growth to their next generation.
Consider as well the LCGE, this time looking at the successors. The exemption applies on a per-person basis, allowing for a multiplication of its total benefit based on the number of new shareholders. And if the value falls so far that the parent is not able to use the full LCGE on the share exchange, the parent could choose to take some of the growth shares and thereby also participate in the upswing.
What about those who undertook a freeze years ago at a much higher value before the economic downturn (pandemic or otherwise) ate away at the business value? In that case, a thaw and re-freeze might be in order, effectively resetting at the current depressed value, again in anticipation of the recovery of the business itself.
As to determining the appropriate value, it needs to stand up to scrutiny should the Canada Revenue Agency inquire, so the best approach is to have a professional valuation.
Implications for life insurance
Upon a freeze, the parent’s taxable gain becomes both known and capped. This is an ideal application for life insurance on that parent, or a joint last-to-die policy on the parent-couple. Of course, less insurance is needed with a freeze at a lower value, but that’s only half the story.
The successor children will now expect to reap a greater proportion of the gain. Allowing that the amount of the gain is unknown (unlike for the parent) and that the LCGE may reduce the tax, this is a still a good time to open the insurance dialogue. If the child’s entrepreneurial drive matches the parent’s, greater growth may yet be ahead, and the insurance put in place today will feel like a bargain in hindsight when the child considers their own estate freeze down the line.
[1] A version of this article appeared in Advocis Forum.