Paul is a close friend of mine. We don't see each other often enough, but we got together for lunch this week. "Tim, I'm freezing my assets," Paul said. For a minute, I was wondering if Paul was making a commentary on the sub-zero temperatures we've been experiencing. But that wasn't it. Paul was actually freezing his assets. And I'm not talking about the fact that he left his lawn furniture and lawn mower out in the backyard this year to face the elements rather than putting those things away for the winter (he says he got busy and forgot).
No. Paul has decided to implement a tax manoeuvre called an "estate freeze." Although it's possible to "freeze" most assets, this is most commonly done by those who own shares in a private company and want to accomplish a few things. Let me explain.
The concept
Completing an estate freeze involves identifying certain assets – perhaps private company shares – and freezing those assets at their current value. When this is done, the future growth in value of those assets won't accrue to you (the person completing the freeze), but will belong to others who you have chosen to receive that future growth. There are a number of benefits to this idea, but most notably you'll pass the tax bill on that future growth to others. That is, you will have "capped" your tax liability on the assets frozen at today's value.
The example
Paul owns the shares of a corporation that holds rental properties that he's been accumulating over the years. The value of these properties is about $5-million today (net of any mortgages). He expects these properties to continue to grow in value in the future. Paul doesn't need the income from these properties to support his lifestyle.
When Paul passes away, there's going to be a tax bill owing on the shares of his corporation. After all, the shares are worth $5-million today (since the properties owned by the corporation are worth $5-million), but his adjusted cost base of his shares is nominal, at $100. In this case, Paul will owe about $1,160,227 in taxes upon death (he lives in Ontario and is in the highest tax bracket).
As the value of the properties grows, so will Paul's expected tax bill on death. Paul decided to cap this tax liability by completing an estate freeze. How? Paul is going to exchange his common shares that he owns in his corporation for new preferred shares that are fixed, or frozen, in value (this exchange can take place without tax at the time of the exchange). These shares won't appreciate in value as the properties grow in the future. Paul is going to issue new common shares in the corporation to his children. The future growth of the company will accrue to these common shares.
In actual fact, Paul isn't going to issue the new common shares to his kids directly (although he could), but has decided to issue those shares to a family trust of which the kids are beneficiaries. This will allow Paul to continue to control those shares (as trustee of the trust) for the time being. He can distribute those shares out of the trust to the kids in the future if he chooses (this distribution can generally be done on a tax-free basis). But there are real benefits to having the trust in place to hold the shares today, including the ability to split income with the beneficiaries of the trust.
The nuances
Now, there's more than one way to accomplish an estate freeze. Exchanging shares in an existing corporation for new frozen shares, as Paul is planning, is one method. It's also possible in most cases to take assets that are currently outside of a corporation and transfer those assets to a corporation and take back, in exchange, shares in the corporation that are frozen in value. It may also be possible to place assets directly in a trust (without use of a corporation) so that the future growth will accrue to the beneficiaries, but this method may trigger a tax bill when transferring the assets to the trust if those assets have appreciated in value (in which case a corporation is likely the better route).
Freezing your assets won't eliminate the tax bill that has accrued to date on those assets, but will stop the bleeding by passing the future growth to others who will likely pay the tax on that growth at a much later date than you. More on this topic next week.
Tim Cestnick is president and CEO of WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.
tcestnick@waterstreet.ca
Tim Cestnick