How Small Business Owners Can Use Estate Freeze For Wealth Transfer

An graphic showing a man holding an image of an estate above his computer.

You work all your life building assets like property, investments, gold, or incorporation, which generate value over the long term. There comes a time when you decide to retire and transfer your accumulated wealth to your family members after your demise. Under the Canadian tax system, the transfer of assets after the owner’s death is a deemed sale to the beneficiary at fair market value unless the beneficiary is a spouse (common-law partner) or qualifying spousal trust.

Why Do Small Business Owners Need To Plan Wealth Transfers?

A sale of assets generates capital gain, and 50% of the capital gain is taxable. Hence, the more successful your business and investments are, the higher the tax liability on your estate. The beneficiary may not have that amount of liquidity to bear the tax liability, forcing them to sell the company. Hence, small business owners should plan their wealth transfer so they don’t lose their company, the company pays for their retirement, and the transfer doesn’t trigger a hefty tax bill for the heir.

All three goals can be achieved through estate freeze and proper estate planning. A skilled wealth advisor can help you design an estate freeze strategy that aligns with your business, personal, and tax objectives.

What is An Estate Freeze?

As the name suggests, estate freeze freezes the value of assets until the time of death. When you know the value of your estate, you can calculate the tax liability that will arise at the time of death and accordingly plan taxes.

The future generation accrues growth in the share value after the freeze. They can defer paying taxes on the growth of the asset till they sell it and cash out the gain.

How Can Small Business Owners Freeze Their Shares?

If you are a business owner, you have common shares of your corporation that grow in value as your business grows. You can transfer your common shares to the corporation in exchange for fixed-value preferred shares. You may collect preferred dividends all through your retirement and resell some shares to the corporation, paying tax only on the cash you earned from shares.

What happens to your common shares? When you return these shares to the corporation, it issues new common shares to the next generation or the family trust for a nominal value, say $100/share. From here on, the new owners accrue any growth in the share price. So you have transferred the company’s ownership without triggering an immediate capital gain tax.

Several Ways Small Business Owners Can Use Estate Freeze

Small business owners use an estate freeze to plan their tax liability that will arise at the time of death. But there are many other benefits of an estate freeze. Let us understand them with the help of an example.

Plan tax liability:

Joey freezes his shares worth $1 million and gets $1 million of preferred shares in return. When he started the business, his cost was $0, and his capital gain is $1 million. A capital gain tax on half the amount will trigger his death. Now that he knows his tax liability, he can buy life insurance with a sum assured equivalent to his tax amount, saving his heir from the sudden tax bill.

Retirement planning:

Joey can determine how much dividend he wants to withdraw from his preferred shares depending on his financial requirement and taxable income for that year. Note: He can also resell some of the preferred shares to his company if he needs more money. But the sales proceeds will be taxed as a dividend income, not capital gain.

Reduce capital gain:

Joey can also time the freeze when the shares of his company are in a weak business environment like the pandemic. If the value of his common shares falls to $700,000, he can freeze the value and reduce his capital gain. But he needs to be careful not to freeze the value at a meager price as he will get fixed preference shares of the equivalent value, leaving a lower amount for his retirement.

Transfer control of the company:

If Joey has determined his heir, he can transfer the company shares without triggering immediate capital gain liability. However, if he wants to retain some control of the company, he can freeze the shares using a family trust and control the trust as a trustee. A trustee can determine how the rights of the common shares are exercised.

An estate freeze is a complex strategy and should be well thought out, keeping in mind the long-term implications of the freeze. Tax is just one reason for an estate freeze. As a business owner, you have to look at it from several angles, like your age, financial position, retirement, the readiness of the beneficiary to handle business, and the current tax laws. While an estate freeze might look attractive, it may not always be the best solution for your estate planning.

A skilled wealth advisor can help you review your personal and business plans, understand the options available to achieve them and design an estate planning strategy best suited for you. The advisor will timely review the strategy and suggest changes depending on the nature of your estate, tax laws, or your financial situation.

Contact Edelkoort Smethurst CPAs LLP in Burlington for Your Estate Planning Needs

Talk to a professional wealth advisor to help you design and implement an estate planning strategy best suited for your wealth. At Edelkoort Smethurst CPAs LLP, you can talk to our tax consultants and wealth advisors to understand how and when to begin planning your wealth transfer. To learn more about how Edelkoort Smethurst CPAs LLP can provide you with the best estate planning consultation, contact us online, by telephone at 905-517-2297 or click here to schedule a free consultation.