Moving corporate growth outside of your estate

The deemed disposition can only apply to property that a person owns at the time of death. Estate freeze planning takes advantage of this by ensuring that some portion of a business owner’s wealth is held outside of their estate, instead. Since that wealth is held by somebody other than the deceased, it would not be subject to the deemed disposition on death, assuming the strategy is implemented correctly. This requires careful planning with a qualified tax professional to avoid various risks and pitfalls.

Estate freeze planning must be used proactively. Generally speaking, once your shares in a company have grown in value, it is difficult to give away that value without triggering tax. If a person were to gift their shares to their children, for example, they would be treated for tax purposes as if they had sold the shares for their full price. There are few options available to avoid tax on value that you have already created. An estate freeze instead focuses on deferring tax for the future growth of your company.

In a well-implemented estate freeze, the original business owner would exchange their common shares for fixed-value “freeze” shares. This exchange is usually arranged to occur on a tax-deferred basis, with the new freeze shares inheriting the tax cost of the old shares. The freeze shares would have special terms designed to ensure their value is fixed in place, “frozen” at their current value. Even if the company or its assets continue to grow, the freeze shares would not increase in value.

Since the freeze shares cannot grow in value, any further corporate growth must instead accrue to the benefit of a different class of shares. The company would generally issue these “growth” shares to somebody other than the original business owner, like their adult children or a family trust.

Since the growth shares are held outside of the business owner’s estate, those growth shares would not be subject to the deemed disposition on death. Effectively, this ensures that any growth of the company between the date of the freeze and the date of death is not taxable at the time of death. The tax on that growth is deferred until some later date.

Who should own the growth shares?

For an estate freeze to operate successfully, somebody other than the frozen shareholder needs to hold the growth shares (and therefore the future growth of the company). The crux of the plan is that the growth must be held outside of that frozen shareholder’s estate, after all.

Some business owners choose to have their children own the growth shares. This is common if the expectation is for these children to inherit the company after the business owner’s death. However, the decision to introduce your children to your company is one that should be discussed in detail with your tax advisor and legal counsel.

Once a person owns shares in a company, they have certain rights as shareholders. Even a non-voting shareholder will typically have the right to require audited financial statements, for example. Furthermore, once a person holds shares in your company, it can be difficult to remove them as shareholders if your relationship sours, without further planning (learn more about managing the relationship among shareholders in our article on shareholder agreements).

The decision of who should own the growth shares is a challenging one and should be discussed in detail with a tax advisor as a part of implementing the plan. The correct answer will depend on your own personal situation. In some cases, it may be sensible to introduce a family trust as the holder of growth shares.

How is the original business owner compensated?

Once the freeze is implemented, the original business owner holds freeze shares in their company. In a typical freeze, these shares can be “cashed in” or redeemed over time. Rather than having the company declare salary or dividends to compensate the original business owner, the company could instead slowly buy those shares from the frozen shareholder. These share redemptions are generally treated like dividends for tax purposes.²

By selling shares to the company, the frozen shareholder no longer owns those sold shares. This means at the time of death, there would be less property subject to the deemed disposition on death. In other words, by selling freeze shares to the company over time, the frozen shareholder is slowly chipping away at their tax liability on death by paying some of that tax during life.

Deferral benefit

It is important to note that this strategy only defers a tax bill. By moving share growth outside of a business owner’s estate, that growth would not be taxable upon their death. However, it would still be taxable at some point in the future. When the holders of the growth shares withdraw that growth from the company, sell their shares, or pass away, the growth would be taxable to them at that time, instead.

This means that estate freeze planning is not equally useful in every situation. The value of deferring a tax bill is greatest when the bill is deferred for a very long period of time. The benefit of estate freeze planning depends, at least in part, on what the growth shareholder expects to do with their shares after the original business owner passes away.

For example, if the growth shareholder simply winds up the company immediately after the original business owner dies, the tax on that growth would become taxable very soon after death. There would be little value to tax deferral in such a circumstance, so other strategies may be more useful than an estate freeze. On the other hand, if the growth shareholder expects to continue maintaining your company for many years after your death, the value of deferral would be much higher.

It is very important to discuss your overall estate plans and family dynamics with your tax advisor and legal counsel to ensure that your tax strategy aligns with your estate planning goals and your beneficiaries’ intentions.