Should estates freezes be put on ice?

FOCUS ON TRUST AND ESTATES - There’s a debate among tax and estates professionals about whether estates freezes efficiently transition a business or simply avoid tax

Should estates freezes be put on ice?
Wendi Crowe

On Aug. 20, the prominent accountant Allan Lanthier — a retired Ernst & Young partner and former chair of the Canadian Tax Foundation — wrote an op-ed in the Financial Post calling for the elimination of estate freezes. The article elicited a chorus of opposition from tax professionals.

Against the backdrop of widening economic inequality, with Canada’s richest 25 families holding nearly $200 billion, Lanthier introduces the tax-planning method called an estate freeze. The tactic is endorsed by the Canada Revenue Agency — as “garden-variety tax planning,” a state of affairs he says is “baffling.”

The following is an example of an estate freeze, according to Lanthier.

A man has built a company, currently worth $10 million and a sufficient nest egg. Though it will grow significantly in value by the time of his death, if he gives the company to his children at that time, they’ll have a steep tax bill. One-half of capital gains are taxable when capital properties are left to the next-in-line and Lanthier writes that “more than 25 per cent” of accrued capital gains would be owed on the death of a taxpayer in the top income bracket.

So, the man freezes the estate. First, he exchanges his $10 million in common shares for $10 million in preferred shares with a fixed redemption amount of $10 million, meaning the value of the preferred shares cannot eclipse $10 million.

In exchanging the common shares for preferred shares, the man secures $10 million but denies himself the gains produced as the company grows. The man’s children then purchase common shares — initially with zero value — in which that growth is captured.

The man continues to control the company and lives off the $10 million, while the company grows to $100 million and the common shares owned by the successors balloon in value. Without the freeze, that capital transfer would include a $25-million tax bill, but because of the freeze, no common shares are transferred when he dies and, according to Lanthier, that’s a tax savings of $20 million. The successors will pay capital gains tax but not until they dispose of their shares, which could be 40 years later, he says.

In an article for Canadian Accountant, tax specialist Kim Moody, director of Moodys Gartner Tax Law LLP, disagreed firmly. He writes: “Estate freezes should NOT be legislated out of existence. They are a very valuable tool to assist in legitimate succession planning.” Despite Lanthier’s “clickbait” headline, freezes are “not reserved for the rich” but used by the “average business owner,” writes Moody.

Estate freezes facilitate the transition of businesses from owner to owner in an “orderly” and “tax-neutral” way, says Wendi Crowe, a Miller Thomson LLP partner in Edmonton who practises primarily in tax, M&A, business succession planning and trusts and estates.

The mechanics of the estate freeze vary widely, but they usually involve an owner who has enough value in their business to retire on and wants to sell it or bequeath it — either to family, employees, management or others with a connection to the business — allowing them to buy in at a “nominal price,” Crowe says.

Crowe says the estate freeze doesn’t reduce tax but merely defers it and is a solution to the liquidity issue arising if the shares were sold or transferred and money was owed to the tax man with all the cash locked up in the shares. These risks result in most businesses not surviving a transition in ownership, she says.

“[An estate freeze] allows us to open the door to new people, who can then get in on that ground floor without having to go and find a big pile of cash to buy the business,” she says.

Lanthier says a theme of the criticism he’s received from tax professionals is that estate freezes facilitate succession planning for small businesses.

“Small businesses are not the issue,” he says, as most small businesses have access to an exemption of $867,000 for capital gains tax on shares. Lanthier says the “mischief” with estate freezes is it allows high-net-worth families to avoid “significant amounts of tax on inter-generational transfers of capital.”

To provide some relief for taxpayers if Lanthier’s wish of eliminating estate freezes happens, the government could institute up-to-a-point exemptions on capital gains tax paid on a deceased’s estate or exemptions for small businesses if the shares are going to adult children active in the business, he wrote in an article for Canadian Accountant.

Estate freezes are one problem among many and, with a tax system that hasn’t seen a comprehensive review since the 1960s, Canada is due to take a close look, wrote Lanthier in the article.

“Estate freezes are (with no pun intended) only the tip of the iceberg. Canadian tax legislation is in need of major repair,” he wrote.

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