What Is an Estate Freeze?
When a taxpayer passes away, subsection 70(5) of Canada’s Income Tax Act deems the taxpayer to have sold each capital property at its fair market value (FMV) immediately before death. This deemed disposition results in a taxable capital gain for any appreciated assets owned at the time of death.
An estate freeze is a planning tool used to lock in the current FMV of assets, allowing taxpayers to anticipate their future tax liability and defer tax on post-freeze growth to the next generation. While an estate freeze can be implemented through gifting, most taxpayers prefer using corporate reorganizations to avoid immediate tax liabilities and retain ownership rights.
For example, a taxpayer may transfer appreciated assets to a corporation in exchange for fixed-value preference shares (freeze shares). The corporation issues growth shares to beneficiaries, such as children or a family trust. As the asset’s value increases, the growth accrues to the growth-share holders, effectively freezing the taxpayer’s capital-gain liability at the value of the freeze shares. While beneficial, estate freezes must be executed carefully to avoid several pitfalls.
This article outlines eight common pitfalls and provides updated tax tips to avoid them.
Pitfall #1: Triggering the Shareholder-Benefit Rule or Similar Provisions
If the FMV of the freeze shares does not match the FMV of the transferred asset, subsection 15(1) may apply, deeming the difference as a taxable shareholder benefit. Additionally, if the freeze relies on a section 85 rollover, a mismatch can trigger an indirect gift under paragraph 85(1)(e.2).
Tax Tip:
Ensure that the FMV of the freeze shares matches the FMV of the transferred asset by appropriately structuring the rights attached to the shares (e.g., redemption, retraction, dividend rights). Engage a qualified appraiser for valuations and consult a tax professional to structure the shares correctly.
Pitfall #2: CRA Challenges to Asset Valuation
The CRA may dispute the valuation of assets involved in an estate freeze, potentially leading to reassessments and penalties.
Tax Tip:
Obtain a professional valuation and include a price-adjustment clause in the transaction documents. Ensure that the clause reflects a genuine intention to transact at FMV and is enforceable under the terms of the agreement.
Pitfall #3: Attaching Inappropriate Rights to Freeze Shares
Inappropriate rights (e.g., excessive voting control or unreasonable dividends) can inflate the freeze shares' value, leading to taxation issues.
Tax Tip:
Tailor share rights to the specific freeze scenario. For instance, ensure voting control aligns with family or corporate governance structures without creating valuation mismatches.
Pitfall #4: Unintentional Capital Gains
Asset transfers to a corporation are generally deemed dispositions at FMV, potentially triggering
immediate capital gains tax.
Tax Tip:
Use provisions like section 85 (rollover) or section 86 (share-for-share exchange) to defer the capital gains. If utilizing a lifetime capital gains exemption (LCGE), consult with a tax advisor to optimize its application.
Pitfall #5: Vulnerability to Family Law Claims
Gifting growth shares to beneficiaries without safeguards may expose these assets to family law claims during divorce proceedings.
Tax Tip:
Protect growth shares using a family trust or ensure gifts qualify for exclusions under provincial family law legislation (e.g., Ontario's Family Law Act). Work with a tax and family law expert to structure the freeze effectively.
Pitfall #6: Failing to Update Your Will
After an estate freeze, the taxpayer holds freeze shares instead of the original asset. Failing to reflect this change in the will could lead to intestacy and unintended beneficiaries.
Tax Tip:
Revise your will to account for freeze shares and any changes in your asset distribution plan. Incorporate strategies to minimize probate taxes and estate litigation risks.
Pitfall #7: Missing Opportunities to Reduce Tax Liability on Death
Estate freezes generally defer tax on post-freeze growth but can also reduce tax liability using strategies like a wasting freeze (gradual realization of capital gains during the freezer’s lifetime).
Tax Tip:
Evaluate whether a wasting freeze aligns with your financial goals. This strategy is complex and requires careful planning to balance tax efficiency with liquidity needs.
Pitfall #8: Ignoring the Attribution Rules
Canada’s attribution rules prevent income splitting with related individuals. The corporate attribution rule under subsection 74.4(2) can impose a prescribed interest rate on property transferred to a corporation for the benefit of a spouse or related minor.
Tax Tip:
Avoid attribution issues by ensuring the transferor receives adequate dividends or interest from the corporation. Properly structure share ownership and consult a tax professional to navigate these rules.
Conclusion
An estate freeze can significantly reduce tax burdens and improve intergenerational wealth transfer. However, improper implementation may result in unintended tax consequences and legal complications.
Tax Tips Recap:
- Ensure accurate asset valuation with professional appraisals and price-adjustment clauses.
- Align share rights with tax and estate planning goals.
- Use rollover provisions to defer immediate tax liabilities.
- Protect assets from family law claims.
- Update wills to reflect post-freeze ownership changes.
- Explore tax-reduction strategies like a wasting freeze.
- Address potential attribution issues proactively.
For tailored advice on estate freezes and other tax planning strategies, consult with our experienced tax professionals.
This article is written for educational purposes.
Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at info@taxpartners.ca, or by visiting our website at www.taxpartners.ca.
Tax Partners has been operational since 1981 and is recognized as one of the leading tax and accounting firms in North America. Contact us today for a FREE initial consultation appointment.
#lifeinsurance #irp #lifeinsurancetax #incometax #cralifeinsurance #shareholderbenefits #GreatwayFinancial #GreatwayIRP #ExperiorIRP #ExperiorLifeInsurance #WFGIRP #WFGIvari #InfiniteBanking #IRPBMO #JimPatterson #WaltDisney #TermInsurance #AccountantLifeInsurance #LifeInsuranceCRA #IndependentLifeInsuranceAdvisor #InsuranceAdvisor #FSRA #FSRAAudit #WholeLife #WholeLifeInsurance #InsuranceHelp #ProtectFamily #JamiePrickett #Marlon #MarlonAntonio #Recruiting