Estate Freezes & Your Business: Capitalizing on Proactive Tax Planning

The Valuations Team
| 1/7/2021

"Never let a good crisis go to waste,” said Churchill.

Unexpectedly, the world-wide disruption caused by the COVID-19 outbreak has created an opportunity for many business owners. Businesses negatively affected by COVID-19 likely have valuations lower (and maybe even significantly lower) than they had in early 2020 due to greater uncertainty as to the timing and amount of future cash flows. Investors dislike possible lower cash flows, they dislike uncertainty, and they pay less for both.

It is anyone’s guess as to when COVID-19 will be vanquished and the economy will recover, but it inevitably will. The intervening period represents an opportune time for proactive business owners to capitalize on lower values by preparing family tax plans now rather than waiting until some distant future date. By performing an estate freeze (or an estate re-freeze if one has already occurred) business owners can take advantage of lower valuations to minimize taxes.

Estate Freeze

What is an estate freeze?

An estate freeze or re-freeze occurs when a business owner seeks to lock in the current value of the business and transfer the future growth in value to others, usually the business owner’s children. The business owner exchanges common shares, which typically grow in value, for preferred shares that have a fixed value. New common shares are then issued to those intended to benefit from the future growth of the business.

A well-timed freeze can be especially lucrative when combined with the lifetime capital gains exemption. In 2020, an eligible individual selling shares of a qualifying Canadian business can be exempt from paying taxes on capital gains of up to $883,384. 

How a valuation can work for your company

Estate FreezeAssume, for example, that Tony is the sole shareholder of a successful Canadian business with an estimated fair market value today of $850,000. Tony’s valuation experts advise him that his shares could be worth more than $1,500,000 in a few years given certain growth expectations and a vaccine for the Coronavirus. Tony wishes to take advantage of his lifetime capital gains exemption and transfer the future growth in value to his daughter Michelle. He asks his advisors to perform an estate freeze where he exchanges his common shares for preferred shares equal to the current fair market value of the business of $850,000. Because he qualifies for the lifetime capital gains exemption, Tony will not pay capital gains tax on this transaction. Immediately following, new common shares are issued to Michelle and any future growth in the value of the business will accrue to her.

When Tony and Michelle sell the business for $1,500,000, Tony will not pay taxes on the redemption of his preferred shares. Furthermore, Michelle’s common shares will be worth $650,000 (i.e., $1,500,000 less $850,000) and assuming she qualifies for the lifetime capital gains exemption, the sale of her common shares can also be performed on a tax-free basis. If Tony did not have the foresight to effectively plan for the future, he could have been subject to capital gains tax of over $339,000 upon the sale of his company for $1,500,000. With guidance and planning from his valuations advisors, Tony saved his family $339,000.

When performing an estate freeze, the Canada Revenue Agency requires that fair market value be supportable and determined based on an examination of all the relevant facts and following the application of appropriate valuation methodologies. Therefore, to avoid adverse tax consequences and penalties, it is best practice to engage an expert for independent valuation advice.

Crowe MacKay’s Chartered Business Valuator’s and Chartered Professional Accountants are here to help clients navigate through periods of uncertainty and plan for the future.

Chad Rutquist
Chad Rutquist
Partner, Business Valuations and Litigation Support
Daniel Sturgess
Daniel Sturgess
Partner, Incorporated, Corporate Finance Lead and Valuations and Litigation Support Lead
Jess Jiang
Jess Jiang
Senior Manager, Business Valuations & Litigation Support
Garrett Louie Tax Expert
Garrett Louie
Partner, Incorporated, Tax Lead