An estate freeze on your business could save your children from suffering a tax shock

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Inheritance tax on your business could harm the financial fortunes of your heirs

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When a person dies in Canada, everything they own is subject to tax as if they had sold it that day.

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This can be difficult for loved ones of small business owners to sort through. The more you manage to grow your business, the more taxes your estate will have to pay, which will then eat into the amount your beneficiaries will inherit.

And in some cases, your family may face tough decisions about how to pay the bill, especially if they hope to continue what you’ve built.

This is where the estate freeze comes in. This tool helps business owners work out all of these details well in advance and gives heirs some predictability about how much tax they will have to pay.

A practical tool for estate planning

An estate freeze is pretty much what it sounds like: an option for business owners to legally “freeze” the value of their business to what it is currently worth.

The advantage is that owners will be able to anticipate and set aside the amount of money that their estate will one day have to pay in taxes.

During an estate freeze, the owner in question will exchange his common shares for frozen shares. The common shares can then be sold at a nominal price to other family members or placed in a trust.

In the event that you leave a spouse to mourn, the property freeze will be honoured. The spouse will be exempt from paying taxes due on the business until the business is sold or the spouse dies.

The next generation could also enact their own estate freeze, once they are ready to hand over the baton.

“For the business owner, the biggest benefit would be knowing exactly what your estate will be worth,” says Kriss Rossignoli, private tax director at Cardinal Wealth in Toronto.

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It is important to note that performing an estate freeze does not mean the owner has to relinquish control of their business – they will still be able to manage the business and retain voting privileges.

How it works

Suppose a company is valued at $2 million today, but is expected to grow to $8 million within the next decade. The business owner knows she will want to retire by then and would also like to have her estate plan organized.

His accountant may suggest an estate freeze, allowing him to lock in the value of his business at $2 million. Upon her death, regardless of the value of the business at that time, her estate will only have to pay tax on that $2 million, which she has already stashed in an account for her executor.

Eventually, the heirs of his business will be responsible for paying business taxes on any growth from that initial $2 million.

“Basically, you’re putting future taxes in someone else’s hands,” says Caroline Rhéaume, tax lawyer and trust and estate practitioner (TEP) and president of Fortunae International in Montreal.

When should it be used?

It is a tax planning tool that comes in handy as business owners approach retirement.

Deciding when you should freeze will take a bit of mental math: you need to make sure the business is worth enough, along with any other investments you have, to sustain you financially until retirement.

“Basically, you can plan your estate and how much tax you’ll have to pay on death, at least on those shares,” Rhéaume says. You can also purchase a life insurance policy that pays the amount that will be owed in taxes on your business.

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How to know if an estate freeze is right for you

Rissignoli says anyone wondering if an estate freeze might work for them should contact their lawyer and tax accountant first. If you’re at a point in your life when you’re starting to think about retirement and succession, it might be time to raise the question.

While it may sound like a silver bullet, performing an estate freeze can be a complex undertaking. And everyone has to be on the same page for it to work.

“When you’re looking to bring family members into your business structure or…when you’re thinking about writing your will, this could be a time to say, ‘Okay, let’s see if it would make sense to make a estate freeze today and start planning for insurance and things like that,” Rhéaume says.

Another important factor to consider is that the Canada Revenue Agency (CRA) may challenge you if they do not believe your appraisal reflects the true fair market value of your business.

“There is no need to go to a business valuator, [but] it’s always good to have something on file to ensure that, if there’s a challenge, you can show how you found value,” Rhéaume says.

And if the CRA thinks you’re deliberately trying to understate your business to shift the tax burden to someone else, they won’t allow it.

“The situation needs to be carefully considered,” Rhéaume said. “You need someone who can really review everything and make sure you avoid any mistakes.”

This article provides information only and should not be construed as advice. It is provided without warranty of any kind.

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