What is an Estate Freeze and How Can it Be Used to Help a Family Business?
A commonly cited statistic is that only about 10% of family-owned businesses make it past the third generation. Generally, this arises from improper succession planning while the original business owners are still around. Business owners who are considering passing the business on to their children or other family members can consider implementing an estate freeze.
An estate freeze is a sophisticated tax planning strategy that can have significant benefits for Canadian business owners from a succession planning perspective, including potentially reducing future estate litigation or family litigation.
Three Types of Estate Freezes
Estate freezes are utilized by business owners for two main reasons: firstly, to transfer future growth of the company from one business owner to another, and second, to limit capital gains tax for the business owner that is transferring the shares.
There are three types of estate freezes:
- Full or “classic” estate freezes;
- Partial estate freezes;
- Wasting freezes.
What type of freeze is best for a business owner will depend on the particular circumstances.
Business owners generally trigger an estate freeze where there is enough equity in a business in order to support their desired lifestyle. Once that occurs, they can freeze/keep that value for themselves while transferring future growth/value to a successor.
Full/Classic Estate Freezes
A full or classic estate freeze is the most popular type of estate freeze.
An estate freeze locks in the current value of a business for the business owner, while also passing along future growth to a successor (often a child or other loved one). Generally, shares that are likely to increase in value are exchanged for shares whose value is fixed or frozen. This allows the successor to enter into an ownership position inexpensively.
A classic estate freeze works by keeping a business’ current value into preferred shares for the original owners. The successor owners obtain benefits of growth from new common shares. The preferred shares can be either in the operating company or a holding company that owns the operating company.
In either situation, the preferred shares should have a fixed value equal to the fair market value of the company at the time. The successor owners then purchase the common shares for a nominal amount, and all future increases in the company’s value benefit thus benefit the successor owners.
Partial Estate Freezes
A partial estate freeze functions like a full/classic estate freeze. However, when the common shares are issued, both the original business owners and the successor business owners purchase the shares for a nominal amount.
This allows the original business owner to lock in the present value of the company, while also profiting from the future growth of the business via the common shares.
A wasting freeze is set up in the same way as a full/classic freeze. However, instead of holding on to his or her stake in the company, the original business owner redeems their preferred shares in stages.
If you have questions about estate freezes and how they can help your family business, contact Financial Litigation. We regularly help business owners, entrepreneurs, and professionals manage some of the largest legal landmines threatening their continued success: commercial disputes and family law. Schedule your consultation online, or by calling us at 416 769 4107 x1.