Estate Freeze 101
Estate freezes can seem daunting, given the numerous options, varying degrees of complexity, and unique situations of the individual, and this rings especially true for business owners. Choosing the correct type of freeze is therefore crucial in early planning stages. To help simplify this, we can group the majority into four main categories as follows.
Classic Estate Freeze
This is ideal for those with an established business, wanting to transfer ownership of the company to their children or management, while simultaneously reducing estate tax. This will lock in or “freeze” the current value for the owner, in order to pass on future growth to the transferee. Normally the transferee pays a nominal amount in order to take ownership. This would usually apply to businesses worth $1 million and up, whereby the lifetime capital gains exemption of $835,714 wouldn’t cover the owner’s tax on disposition. This type of freeze locks in the current value (fair market value) of the preferred shares for the original owners, and transfers growth to the new owners by issuing new common shares.
This is ideal for a mid-career stage business owner who wants to add successors or employees, but still would like to participate in the company’s future growth. It’s very much like the classic estate freeze, except that in issuing the new common shares, both the original and new owners purchase them for a nominal amount. This therefore allows the original owner to still lock in the current value of the company in the preferred shares, while also participating in future profits in the new common shares. This scenario obviously isn’t ideal if the goal is to also limit future estate tax.
This is ideal for an established business owner who wants to fund their retirement with business proceeds, without putting financial pressure on the business itself. Again, this is similar to a classic freeze, but instead of retaining ownership indefinitely, the owner redeems their preferred shares gradually over time. This arrangement would need to include setting out specifics in a shareholders’ agreement on the amount and timing of shares that can be redeemed, so that both existing and new owners will have predictable costs and income amounts. This also spreads out the tax liability of the owner, whom is gradually paying tax as the shares are redeemed as opposed to all in one lump sum.
This is suitable for someone that’s already completed a prior estate freeze, where the value of the business has dropped and isn’t likely to recover in the short-term. As an example, the company’s fair market value has fallen, yet they still owe the original owner a significant amount. The first obligation of the business is to its preferred shareholders, so this could significantly delay any value attributing to the common shares. If the original business owner were to pass away, their estate would still owe tax on the full prior market value when the share exchange was completed (despite that the company is now worth far less). To “re-freeze”, the company would have to create a new class of preferred shares which reflect the current value. The original owner would then exchange their original preferred shares for the new ones. This exchange would be considered a “non-taxable” event.
Business owners should conduct a thorough review of their ownership structure and management in great detail before proceeding with any variation of an estate freeze. Consulting one’s lawyer, accountant and financial advisor will aid greatly in arriving at the most optimal scenario for both the existing owner and for the continuity of the business.