We know death and taxes are a certainty. Just as certain is that planning can minimize the pain.
An estate freeze is a way to fix the value of your current business and investment assets, and to pass future growth on to children or other designated beneficiaries.
An example:
Spouses John and Jane had built up the retail business they founded with disciplined entrepreneurship to the point where the company and personal investments were valuable. The couple was fully satisfied with their lifestyle, and they were getting to the point where they found themselves increasingly contemplating the legacy they would bestow on their children and the community that had been so good to them.
They brought their musings to the attention of their chartered accountant, who explained the rationale and the mechanics and then the benefits of an estate freeze.
An estate freeze is a practical and relatively simple way for a business owner to render predictable the tax ultimately due on his or her death, minimize that tax, and achieve various other personal goals for the benefit of survivors and beneficiaries. Any business or investment portfolio that has accumulated significant value can benefit from a full or partial estate freeze. You don't have to wait until retirement is being contemplated to entertain the idea.
In the business environment, an estate freeze is accomplished by having common shares held by the owner exchanged for preferred shares. The value of the preferred shares is fixed at the fair value of the common shares for which they were exchanged. The adult children or other beneficiaries subscribe for new common shares at a nominal amount. (Note that even though the subscription price of the new common shares can be just a nominal amount, it does not confer a benefit on the new shareholders because all the value of the corporation is held at the time in the preferred shares.)
Future increases in the value of the business accrue to the new common shares, which is why they are often referred to as "growth shares." Because the value of the preferred shares never increases, the parents' value is "frozen." With a correct designation of values by the chartered accountant, capital gains taxes may now be deferred for many years, or even for decades.
An estate freeze is also effective for fixing the value of an investment portfolio. The mechanics are much the same as freezing the value of a business. The investor and his children or other beneficiaries incorporate a company, with the parent transferring his investments into the corporation, taking back preferred shares, which will have a value equal to those investments. The children subscribe for common shares at a nominal amount, to which future growth in the value of the portfolio will accrue. Again, capital gains taxes may be deferred for a very long time.
With this large asset value now fixed, the couple's chartered accountant could now estimate the tax ultimately due on their death. Don't underestimate the value of the advance determination of that final tax amount -- it permits your affairs to be structured for eventual payment. And since it's not often that even the best planning can make tax completely "go away," part of the estate freeze plan may be to seek the advice and assistance of an insurance expert.
One of the important, and often overlooked, purposes of an insurance program is to determine a sufficient amount with which to pay the tax due on the parents' ultimate death.
But the exercise of predictability and deferral of capital gains taxes may be only one of the benefits determined during sessions with a professional adviser. Significant cash and legal protections are available by including family trust provisions in the freeze transaction.
A family trust is a method of managing a family's assets and incomes. It is created for tax, legal, and estate planning purposes, usually by a senior family member. The settlor may be a trustee and/or a beneficiary, depending on the purpose of the trust. But unlike the situations described above, instead of the children subscribing for the new common shares of the corporation at the time of the freeze, the common shares are purchased by the family trust.
The parents are still able to direct the trust to pay them as they require through their preferred shares, which they hold directly.
The family trust is tax-efficient because of its infinitely variable income-allocation ability. It is also flexible in that the annual income generated by the business or investment portfolio may be directed to one or more of the beneficiaries on an as-required basis.
The ratio of the total payout to the beneficiaries can be varied from year to year. As an additional advantage, funds paid to the beneficiaries can often be targeted to the type of income allocated.
All of this has significant implications for after-tax income - and really, it is only after-tax amounts that really count.
For example, in the normal course of events, a top tax-bracket individual who earns a $35,000 investment income must add that income on top of other incomes. So the after-tax investment income available for the family will only be approximately $19,250. But if that same individual had created a family trust, the same amount of investment earnings judiciously allocated and now taxed in the lowest tax bracket would result in approximately $28,000 in income available for the family.
It can be used to help fund your child or grandchild's education, or to provide financial assistance to a family member cstressed by medical or marital problems.
Although amounts paid to young adults will most likely be at a rate lower than the marginal rate of tax of the parents, beware the "kiddie tax" trap: Allocation of income to minor children will attract the highest applicable rate of personal tax, most likely defeating the tax minimization purpose of income allocation.
The practical advantages of the family trust range beyond reasons of cash maximization and selective allocation of funding, for the legal protections may be just as attractive as the tax rationale. The assets of the trust will always be beyond the reach of former and future spouses, and shielded from attack by creditors.
Considering the unfortunate reality of the current divorce rate, the legal protections afforded by a family trust may be considered just as important of a protection as its tax avoidance and income maximization potential.
This is the second part of a two-part series. Read the first article here.
Special to the Globe and Mail
Stephen C. Bark, CA, is co-author of The Estate Planning Toolkit for Business Owners: Building and Preserving Your Wealth , published by the Canadian Institute of Chartered Accountants. For more information or to order a copy please go to www.cica.ca/estateplan.