What Are The Benefits Of An Estate Freeze?
Corporate shakeups and estate freezes are vital strategies for the owners of closely held businesses with considerable retained earnings and little adjusted cost bases. In Canada, the government imposes a capital gains tax at death. Section 70(5) of the Income Tax Act (ITA) states that “a person who dies is deemed to have sold all of their capital assets at the fair market value directly prior to dying.” The proceeds are then taxed as capital gains in the deceased person’s terminal tax return. Without appropriate planning, shares of closely held corporations are unprotected from significant tax liability in the owner’s estate.
Defining the Estate Freeze
Estate freezes are an asset-management strategy where an estate owner will transfer assets to his or her beneficiaries without suffering tax consequences. The estate owner allocates assets in many estate freezes, typically common stock, to a business in exchange for preferred shares. The company then issues new common stock to the estate’s beneficiaries at a token value.
Breaking Down the Estate Freeze
As stated above, an estate freeze is often implemented to avoid capital gains tax. When the owner trades assets for preferred stock, there will not be any capital gains on the exchange. The company will bestow the beneficiaries with new common shares at the current market value, which means no capital gain occurs for the receiving parties. Because the preferred shares are non-growth securities, the owner will not acquire future capital gains taxes on said instruments.
Estate Freeze Basics
This strategy freezes the total amount of corporate capital gain that is taxable in a company owner’s estate. After a correctly structured freeze, any further growth in the company’s value will not accumulate to the principal shareholder, but to their successors or— more often—to a flexible trust set up with the freeze.
Getting the Numbers Correct
Setting the value of a person’s preferred shares is of the highest importance for successfully freezing the current value of the company. A legal business appraiser should conduct an independent valuation of the corporation, which is crucial to the success of the estate freeze since the Canada Revenue Agency (CRA) will scrutinize the specified value of shares.
Another significant consideration in an estate freeze is the effect of Canadian attribution rules. Commonly speaking, they result in income or capital gains accrediting back to the transferor where productive assets are transferred to the recipients. The rules are meant to prevent income splitting with some related parties (spouses or minor children). However, the aim of the estate freeze is to prevent the realization of taxable capital gains in the value of a family business, so a well-structured estate freeze should be able to elude attribution.
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