Estate freeze

Business succession planning that puts tax on ice

There is perhaps no greater satisfaction for an individual taxpayer than to be able to tell the tax collector, “Just wait!”

This is stated with the full respect that as a society we require a properly functioning tax system to enable our economy to operate effectively. That aside, if there are legal means available to defer a payment then we would be remiss not to explore how to put tax on ice.

An “estate freeze” is a term most often attached to the succession planning activities of a small business entrepreneur. However, the same principles can apply to portfolio investors and owners of real estate in appropriate circumstances , as we’ll touch on at the end of this article.

What is an estate freeze?

An estate freeze is a commonly available wealth technique that can make the succession of selected assets more tax efficient. In this context, the term ‘tax efficiency’ may be a combination of:

- The deferral of a taxpayer’s existing inherent tax liability from a current to a future payment date, often aligned with the taxpayer’s death or a spouse’s later death
- The transfer of future growth and tax liability from a taxpayer to a child, grandchild or other person, usually extending time horizons and possibly accessing lower brackets
- The potential ongoing management of the timing and distribution of tax on the growth using currently-existing, newly-created or future-planned trusts, partnerships or corporations

While the legal structure and components may vary, the general principle of a freeze remains constant: Lock in the value of chosen assets without triggering tax (or consciously triggering a controlled amount of tax), while deferring the tax on future growth for years or even decades.

Purpose of a freeze

These tax benefits must follow from the core purpose of an estate freeze, which is to facilitate the orderly transition of selected assets to those whom the taxpayer wishes to benefit, generally being those to whom estate assets would otherwise pass in the traditional sense. (As children are the usual recipients, that will be the term used from here on, but it is certainly possible to pass on to later generations and to non-family recipients if desired.)

The bonus with an estate freeze is that, by managing the tax liability early on, more can be expected to pass on.

Ready to proceed?

The decision to undertake an estate freeze must be considered very carefully. Invariably it involves changes to legal ownership of assets – and it is often irreversible once implemented. It is important for the parent (or freezor) to ensure that there will be adequate assets remaining under his/her ownership and control to continue to live a comfortable life without the burden of tax and legal implications.

The ultimate benefit of the estate freeze accrues to the children carrying on after the parent has passed on. The goal of the freeze is to allow for the greatest value to be received by the children, and the early crystallization of tax in a freeze can assist in that regard. However, care should be taken not to place too much attention on the tax part alone – and the early timing in particular – as that could expose assets to even greater loss risks, possibly cutting off other planning options.

While it may be technically possible to freeze an estate at almost any point in time, it may be ill-advised or at least premature to do so in situations where:

- The candidate freezor is young, possibly unattached and without children, bringing into question whom the freeze will favour and whether that is a desired permanent result
- The candidate’s children are young (whether they are minors or young adults), making current asset ownership impractical, and even near future ownership an unpalatable prospect
- The candidate’s marriage is not on the strongest footing, raising the spectre of a division of assets, child support and/or spousal support, which taken together could negate the benefits of a freeze (or be exacerbated by the cost of undoing a freeze)
- Despite being at a reasonable age, the children may have marital, creditor, disability, mental health or addiction issues, any of which would tend to influence against implementing a freeze, or if doing so then would warrant very firm strings attached
- Where the candidate is at an advanced age, the tax deferral from the freeze will be somewhat limited in time, and thus the scope of a freeze may in turn be limited, or alternatively coordinated with some strategic testamentary trust planning in the Will

The motivation to reduce eventual tax liabilities must therefore be tempered with the practicality of age, life stage, maturity and vulnerabilities of both the parent as benefactor and the children as beneficiaries. Assuming that these hurdles have been addressed, what does a freeze actually look like?

The business freeze scenario

Take the classic example of an entrepreneur who has invested a significant amount of time and capital into the growth of a small business corporation. Inherent in that built-up growth can be a substantial tax liability, even with the expectation of using the lifetime capital gains exemption (LCGE) for shares of a small business corporation. As of 2024, that can eliminate the tax on up to $1.25M of capital gains. Assuming a positive outlook for business growth, that attached tax liability will only get larger.

In fact, if left unmanaged, the tax bite could inconveniently come due at the entrepreneur’s death, potentially threatening the viability of the operation as a going concern thereafter. This in turn could lead to a fire sale of the business or its assets in a desperate attempt to find liquidity to service the tax obligation, further compromising family wealth.

To contain that tax liability and protect future value, an estate freeze could be implemented as part of a broader business succession process. The components of the larger plan would include:

- A detailed analysis of the business itself, and specifically the technical skills required of current and future management and ownership
- A candid consideration of the soft issues motivating the founder, including an honest introspective of personal/parental motivations and expectations
- Tough love – a frank examination of the children, placing their capabilities, limitations and personalities under a bright light
- A consideration of the reactions of stakeholders within and surrounding the business, including employees, suppliers, customers, bankers – and those children who are projected to take on less-favoured roles (whether actual or perceived)
- A review of asset holdings to isolate and realign appropriate assets for tax restructuring, while preserving the integrity of the business
- The freeze date, when pending liabilities are crystallized through creation of legal structures (trusts, corporations or partnerships), execution of asset transfers and necessary tax elections
- An allocation of future growth to the successors through one or a combination of corporate share issuance, beneficial trust entitlement and partnership interest, all in such proportions and subject to such limitations built into those legal structures
- Assuring funding of later estate liquidity by obtaining life insurance coverage aligned to the determined tax liability, usually through joint-last-to-die life insurance coverage for founder and spouse, given the availability of asset rollovers at tax-cost basis between spouses at first death
- Insulating against the children’s risk events through a variety of measures including shareholder agreements, key person insurance for those with active business roles, matrimonial contracts and Will & estate planning

As this series of activities shows, the technical freeze is not so much an end-product as it is a focus feature of a lengthy and potentially very challenging process. Its ultimate form will be dictated by circumstances, being as simple or complex as needs may dictate.

Freeze mechanics

For a business to be of sufficient value to warrant an estate freeze discussion, the existing business form is almost always one or more corporations. (Partnerships may be required or desired in some professions or commercial fields, which will require adjustments to the particulars, but the principles remain the same.) The mechanical procedure is to make adjustments to the entrepreneur/freezor’s share interest so that the current value of the business is frozen, and the future value of the business can be shifted to the children.

Bear in mind that three characteristics must exist across all shares in a corporation. There may be one class of shares that holds all three of these characteristics, or they may be divided according to the needs of the circumstances:

1. Voting control
2. Right to dividends
3. Right to capital distribution/return, generally on dissolution of the corporation

The most common procedure is for the freezor to exchange current common shares (eg., having all three of the foregoing characteristics) for one or more new classes of preferred shares having a fixed value equal to the value of the original common shares at the time of the exchange. Growth in the future value of the business will accrue to one or more other share classes. The preferred shares will have features that preserve both value and control (with these two elements sometimes distributed among share classes), generally including:

- A corporate redemption option and shareholder retraction option, both aligned with the current/freeze value of the corporation
- A priority right to return of capital if there is a wind-up of the corporation – This priority is against all other share classes, but does not guarantee the full return of capital if corporate assets have been depleted or there are superior creditor claims
- Voting control (or at least participation), to allow the freezor to monitor activities and possibly re-assert management control over the business
- A dividend – the preference, accumulation and triggering features of the dividend can be catered to the freezor’s needs and desires
- Of key importance, a ‘price adjustment clause’ to provide protection (though not a guarantee) against future tax liability should the freeze share valuation be challenged by Canada Revenue Agency

The freeze shares will often remain outstanding until the death of the freezor, or last death of freezor and spouse. Alternatively, there may be a redemption schedule as part of a ‘wasting freeze’, whereby the freezor is eased out of the business, both from a financial and a control perspective. This latter approach may be part of long-term tax strategy if the freezor is at less than top marginal tax bracket in very senior years, so that some of the tax liability can be triggered in a controlled manner, rather than awaiting an inevitable large tax bill in the estate.

A progression of freeze examples

Let’s consider entrepreneur Alice Bolton and her successful distribution and retailing operation run under her corporation, CommerceCo. Alice has gone through the analysis and is ready to implement an estate freeze. She has a husband Don and adult child Eric.

Simple freeze

Alice and her professional advisors may be content that there are no serious complications to the business or the people involved. Accordingly, they’re content to have an arrangement with the least moving parts. Alice could do a basic share-for-share exchange to complete the freeze and have the growth shares issued directly to Don and Eric. Whether Don would be included in this manner would depend on valuations and respective wealth positions of Alice and Don.

Freeze with added family trust

On further consideration, following conversations with her legal advisors, Alice might be a little concerned about the untethered wealth transfer to son, Eric. She may be especially uncomfortable with the potential that his interest in the business could be exposed to his creditors, open to matrimonial claim with a later spouse and generally be subject to his own lack of maturity. By adding a family trust as a layer that separates beneficial entitlement from legal ownership, Alice can take some solace that these risks are mitigated, particularly if she is a trustee of the trust.

Freeze with additional corporations

With input of her tax advisors, Alice may conclude that one or more additional corporations may be desirable:

- A holding corporation (HoldCo) interposed so that excess cash may be paid by tax-deferred dividend from operating company (OpCo) to Holdco – This can protect against Opco creditor claims, while preserving Opco’s tax status for Alice (and possibly Don and Eric) to be able the claim the LCGE
- A breakout of OpCo into a RetailCo and DistributeCo, based on distinctive business needs and to prepare for a potential later spin-off
- A RealtyCo may be established to isolate real estate (particularly when those assets are no longer need for business operations), based again on preserving LCGE status, as well as non-business liability exposure

As can be appreciated, the legal and tax issues become increasingly complex as dollar values, number of holdings and parties to the proceedings increase. The estate freeze can usually be scaled upward to capture such concerns. However, implementation costs will also rise, which may become difficult to justify when planning against more remote contingencies.

The investment or real estate freeze candidate

As mentioned at the outset, the principles of an estate freeze need not be limited to business situations.

- A very simple version of this would be for a portfolio investor or owner of real estate to make an outright transfer to someone else. While any as-yet unrealized capital gains would be triggered (except any spousal rollovers), this may be an acceptable trade-off if the primary goal is to push future growth into the hands of others.
- With greater complexity of assets and/or parties, corporations or trusts could be used to implement a freeze involving passive investments or real estate.
- For wealth generated within an active business corporation and migrated into a holding company, the strategies used in the business estate freeze may be transported with some limited modification into an investment or real estate freeze.

Both the formal rules and their interpretation by the Canada Revenue Agency can (and do) change from time to time, so in all cases the assistance of tax professionals is a must before taking any action.

Variations for later planning

Thaws, melts, gels and re-freezes are cute terms used to describe sophisticated planning alternatives for contingencies that may arise down the road.

The key issue to recognize is that, with the right planning, there is great latitude in how an estate freeze may be structured from the beginning, including the flexibility to build upon, re-cast or undo the process, as later circumstances may require.

Corporate investment portfolios – Opportunities and obstacles

Informing your returns by understanding passive tax rules

The taxation of passive income in corporations is a very complex topic. The intention here is to provide a general overview to help you discuss with your accountant and your investment advisor how this may apply in your circumstances.

As the owner of a corporation, you know your active business income is taxed at a rate that is usually well below your personal rate. Presumably, that’s part of the reason you are using a corporation in the first place.

Top personal tax rates are near or beyond the 50% mark, but general corporate rates are in the area of 26% to 31%, and small business corporate rates (on active business income up to $500,000 in most provinces) range from 9% to 15%. The variance depends on the provincial rates where a corporation is resident, with federal rates being consistent across the country.

Is passive income tax-preferred in a corporation?

In a single word, the answer is “no”, but it’s much more complicated than that.

For active business income, those lower corporate rates allow more after-tax cash to be reinvested in a business that is run through a corporation. The public policy purpose is to help businesses grow.

However, those low rates do not extend to non-business income earned in a portfolio – known as passive income – such as interest, dividends (Canadian or foreign) and capital gains. So, if passive income isn’t entitled to reduced tax rates, why invest in a portfolio within a corporation?

There’s more investible money if it stays in the corporation

When you use a corporation, income tax is charged first at the corporate level, with the net-of-tax amount added to the corporation’s retained earnings. Those retained earnings are eventually distributed as taxable dividends to shareholders. To protect taxpayers from double-taxation, the arithmetic is designed so that a shareholder’s personal tax on a dividend is reduced by the amount that the corporation has already paid.

Note though that a corporation is not required to immediately distribute its retained earnings. Apart from reinvesting in the business as noted above, those funds could go into a passive investment portfolio. As compared to paying a dividend (reduced by the associated tax) and investing in a personal portfolio, there will be more dollars to invest if the portfolio is at the corporate level.

But … the public policy response: Emulating top personal tax rates

As more can be invested at the corporate level, proportionately more passive income could be earned there. While this is understandably appealing to a shareholder and corporation, from the policymaker’s perspective it is an unintended consequence of this two-stage system: The use of the corporation as a more efficient form for business growth has arguably led to an extra benefit for earning passive income.

In response, additional corporate tax is imposed, making it less appealing to invest corporately. The additional tax takes the corporation approximately to the top personal tax bracket rate.

Much of that extra tax is refunded to the corporation (see RDTOH below) when later dividends are paid – but not necessarily all of it. Again, it varies by province and also by the type of income earned. For example, the combined corporate and personal tax can be 4% to 8% higher on interest earned through a corporation, as compared to earning interest in a personal portfolio.

The (intended) equalizer: Refundable-dividend-tax-on-hand

Historically, that extra tax has been tracked in the corporation’s refundable dividend tax on hand (RDTOH) account. In truth there are two RDTOH accounts, depending on whether the original income was charged the general corporate rate or the small business rate, but for simplicity in this article we’ll refer to it in the singular. Either way, RDTOH is effectively a deposit with the Canada Revenue Agency (CRA) that earns no income. Most taxpayers aren’t so generous to make such interest-free loans to the CRA, and that’s why it’s usually a priority to get that money back – refunded – so that it can be put back to work in the corporation, whether that’s as a business reinvestment or an addition to a passive portfolio.

When a taxable dividend is paid to a shareholder, a portion of the RDTOH balance is refunded to the corporation. The current refundable rate for present purposes is 38 1/3%, but a simpler way to express it (as a rough estimate) is that for every $5 dividend paid from the corporation to a shareholder, about $2 comes back to the corporation from its RDTOH.

Previously, any taxable dividend could recover refundable tax. As of 2019, refunds are generally only paid on dividends where the original corporate income was charged the small business rate (non-eligible dividends) or where it arises out of the corporation’s passive investment income.

What’s a shareholder to do?

As much of a challenge as all this presents, all is not lost for corporations and their shareholders.

First, your corporation pays no tax on Canadian dividends that are passed through to you as shareholder. Those dividends maintain their preferred tax treatment, the same as if the security had been in a personal portfolio. And as more dollars are available to be invested at the corporate portfolio level, as discussed above, more of those Canadian dividends can be generated.

Second, a corporate portfolio that grows through unrealized capital gains defers income realization. This in turn delays application of the passive rules. Ideally the portfolio would remain intact until there is a personal need for the funds. By cashing out the investment at the same time as an intended dividend, there will be minimal, if any, inefficient refundable tax balance.

Third, only a portion of capital gains are taxable, with the non-taxed portion able to be paid as a tax-free dividend. Until recently, that non-taxable dividend was equal to 1/2 of the capital gain, but now it’s 1/3. That’s because the 2024 Federal Budget increased the income inclusion rate on capital gains to 2/3 for trusts and corporations, while preserving the 1/2 rate for individuals on the first $250,000 of annual capital gains before the 2/3 rate applies. While the case is not as compelling as it was before the change, a shareholder will still have more after-tax spendable dollars personally if capital gains are earned corporately, rather than through a personal portfolio.

And finally, a shareholder is likely to be at a lower tax bracket in later years. By consciously leaving an appropriate amount in a corporate portfolio, tax can be both deferred and reduced.

As always, tax should not be the primary consideration when investing. It can however have an especially large impact when income is originally earned in a corporation. With awareness of the passive tax rules, you can have a more informed conversation with your accountant and your investment advisor about how to manage your corporate portfolio.

Dividend sprinkling among family shareholders, and its limits under TOSI

A primer on the TOSI “tax on split income”

There are many tax benefits to running a business through a corporation.

Operationally, corporate tax rates are generally lower than your personal marginal tax rate. Though personal tax will eventually apply when dividends are paid out of the corporation, in the meanwhile you are able to reinvest more dollars into that business within the corporation.

At the ownership level, you can control the amount and timing of dividends to yourself as shareholder. This allows you to defer the personal income and associated tax until you need cash for personal spending purposes.

If you bring in other shareholders and possibly more share classes, you can also control who receives those dividends. And when those additional shareholders are lower income family members, you may be able to ratchet down the household tax bill. Years ago, it was almost that simple, but today there are increasingly complex rules that must be navigated.

TOSI emerges in 2000 as the ‘kiddie tax’ for minors

A couple of decades ago, it was routine tax planning to pay dividends to family, including minor children. Whether a child owned shares directly or was a beneficiary of a trust that held shares, dividends could be taxed to that child. With little to no other income, the tax would be correspondingly low, and practically the net-of-tax money ended up under the same roof.

In 2000, the TOSI was brought into law to prevent this kind of dividend sprinkling. It applied (and still does) to dividends paid to a child under the age of 18 throughout the year. Despite such dividends being legally paid to the recipient, TOSI causes them to be taxed at the highest bracket rate, essentially ignoring the recipient’s own tax rate.

This is an important distinction from being an attribution rule, where tax is imposed on a person who would have otherwise been entitled to certain income, being the parent in this example when dividends are paid to a minor child. With an attribution rule, it would be a no-better-off scenario if a higher bracket parent was taxed on the dividend. But things are especially unpalatable under the TOSI where tax is automatically imposed at the highest rate, making it a worse-off deal if the parent’s income level is anywhere less than top bracket.

TOSI comes of age in 2018, extending to adults in the family

In 2017, the federal government proposed a variety of changes for private corporations and their shareholders. While some of the proposals were shelved, the TOSI changes proceeded into law in 2018, with TOSI now extending to adults, capturing both adult children and spouses. Fortunately, these new rules for adults are not as unbending as the kiddie tax version. Where there is sufficient economic substance to the involvement of the adult child or spouse, TOSI may not apply.

Make no mistake though, these rules are very (very!) complex. There are new definitions, layers of application, and multiple exceptions. Some of those exceptions have objective criteria, while others require an exercise of discretion on the particular facts. To help, the government has collaborated with external stakeholders to publish examples to guide the application of TOSI in its Guidance on the application of the split income rules for adults, found at https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/federal-government-budgets/income-sprinkling/guidance-split-income-rules-adults.html.

What follows is a high-level outline of the TOSI and its exceptions, using some of the technical terms, but with streamlined phrasing in order to convey the core points. Readers should consult a qualified professional to determine applicability in individual circumstances.

Continuing planning that is not affected by TOSI

It is worth noting that the TOSI rules do not prohibit family members from owning private corporation shares. Though the original 2017 proposals cast the net widely to encompass the lifetime capital gains exemption (LCGE), that part was dropped. Accordingly, it is still possible to plan for sharing future capital gains with family, including the LCGE – of course with qualified professional advice.

Also, TOSI has no effect on the bona fides employment of family members. As long as the wages paid are reasonable in relation to the services rendered, this is simply treated as taxable employment income of the recipient. This is true even for minor children.

Who and what is potentially open to the TOSI rules?

TOSI may apply if a person receives “split income” and is either an adult resident of Canada, or a minor (under the age of 18) who has at least one parent who is a resident of Canada.

“Split income” includes taxable dividends, shareholder benefits and interest payments, from or related to a private corporation. It may also include distributed capital gains where underlying income would have been split income, but generally not capital gains arising on the sale of farms, fisheries or small business shares. Income from a partnership or trust that arose out of rental property may also be caught.

It does not apply to securities or debt of public corporations, government debts, or to mutual funds that hold those listed sources. Deposits with banks and credit unions are also clear of TOSI.

Exclusions from TOSI

The rules are targeted at circumstances where unintended advantage may be gained. As there remain plenty of reasons and arrangements where family members may hold shares and legitimately be entitled to dividends, the rules allow for several exclusions. For simplicity, we’ll refer to dividends within the following explanations, understanding that split income is in fact broader, as noted above. See the Flowchart on the next page for a graphic representation of the key decisions.

All adult recipients

The recipient has been “actively engaged” in the business in the current year, or in any five years leading up to the year the dividend is paid. The five years do not have to be consecutive. This will generally be met if the person works an average of 20 hours per week. If the business is only active part of the year (eg., seasonal), the working time would be applied to the portion of the year when the business operates. A lesser time commitment may suffice, but that would depend on the facts and circumstances of the case.

Adult recipients age 25 or over

Even if the actively engaged threshold is not met, a dividend may be considered a “reasonable return” based on a combination of factors, including labour contribution, property contribution, risks assumed and historical payments. Importantly, this exclusion is not available where the business is principally a service business or a professional corporation.

Adult recipients age 18 to 24

Younger adults may also be able to claim a reasonable return, but based only on property contributed by that individual, and with the size of the return subject to a ceiling prescribed by formula.

Principal shareholder is over 65, recipient is spouse

Many business owners will have planned their retirement on the expectation of being able to share with a spouse in those later years. Accordingly, if the principal shareholder is 65 or over, dividends paid to a spouse will not be subject to TOSI. This is specifically intended to align with the age for pension income splitting.