The tax planning method fixes assets' fair market values for tax purposes, but only if done right
The ubiquity of estate freezes, which have long been among the flavours of the day in personal tax planning, can mask their complexity.
“Estate freezes are the most basic tax planning technique for entrepreneurs and even non-entrepreneurs, but they come with several pitfalls if improperly executed,” says David Rotfleisch, founder of Rotfleisch & Samulovitch P.C., a Toronto tax boutique.
Estate freezes fix assets’ fair market values for tax purposes. After the taxpayer implements the freeze, future growth in the assets’ fair market value will accrue to others.
“This allow taxpayers to anticipate with reasonable certainty their tax liability on death,” Rotfleisch says. “It also allows taxpayers to defer tax on assets’ post-freeze growth until realized by the next generation.”
But these benefits only come if taxpayers do it right, which usually requires specialized professional assistance.
Most taxpayers opt for estate freezes using a corporate vehicle because gifting a capital property triggers immediate tax liability for the donor. Using a corporate vehicle involves taxpayers transferring the target assets to a corporation to receive fixed-value preference or special shares structured to match the asset's value (freeze shares). The corporation then issues common shares to others, usually the taxpayer’s children (growth shares).
“The taxpayer retains an ownership interest in the frozen assets through his or her freeze shares, which are structured to ensure that their value remains fixed,” Rotfleisch says. “If the assets’ value increases, the benefit will accrue to the holder of the growth shares.”
If they don’t do it right, taxpayers might trigger the shareholder-benefit rule or similar provisions in the Income Tax Act. This process can occur when the FMV of the asset does not match the FMV of the freeze shares.
“If a shareholder extracts value from his or her corporation, other than by way of dividend, return of capital or liquidation, the ITA requires the shareholder to report that value as income,” Rotfleisch says.
Taxpayers should also prepare for the prospect that the Canada Revenue Agency could challenge the valuation of an estate freeze asset.
“It’s important to obtain a professional valuation of the asset and to insert a price-adjustment clause in the relevant agreements,” Rotfleisch says. “But the CRA will respect such a clause only if the parties meet certain conditions, including a genuine intention to transfer the property at FMV.”
Mismatches can also occur when taxpayers attach inappropriate rights to the freeze shares.
“For instance, if the freeze shares pay an unreasonable dividend or provide the holder with voting control, the CRA may insist that the shares are worth more than the target asset,” Rotfleisch says.
Individuals setting up estate freezes should also be aware that the transfer of assets could realize a capital gain depending on the taxpayer’s cost base for the asset. But taxpayers may be able to defer that taxable gain.
“Section 85 permits an asset transfer to a corporation on a rollover basis, and s. 86 allow for a tax-deferred share-for-share exchange,” Rotfleisch says. “But these rules are complex and come with stringent formal requirements.”
As it turns out, some taxpayers could find it advantageous to trigger a capital gain, such as using the opportunity to crystallize their lifetime capital gains exemption.
When gifting the growth shares to beneficiaries, taxpayers may wish to consider whether or not they want to protect the assets from beneficiaries’ spouses. Ontario’s Family Law Act allows a donor to exclude a gift from the recipient’s net family property under certain conditions.
“But if this is done improperly, the donor’s ex-spouse could make a claim based on anti-fraud legislation, like Ontario’s Fraudulent Conveyances Act,” Rotfleisch says.
Apart from deferring tax and providing more certainty regarding liabilities from the deemed-disposition-on-death rule, taxpayers can resort to a “wasting freeze” to reduce liability. A wasting freeze permits the taxpayer to gradually realize and diminish the freeze shares’ taxable gain so that, ideally, they produce no taxable gain on death.
It’s a sophisticated strategy.
“A wasting freeze is complex and requires legal consultation,” Rotfleisch says. “If done improperly or without considering personal financial needs, taxpayers might incur greater overall tax.”
Finally, taxpayers contemplating an estate freeze must be aware of the ITA’s various attribution rules, which aim to prevent income-splitting with spouses or related minors.
Particularly concerning is the corporate attribution rule in ss. 74.4(2), which applies when taxpayers transfer or loan property to reduce their income and benefit a spouse or related minor. There are exceptions to the rule, but where it applies, it deems the taxpayer to have received a prescribed rate of interest income.