Freeze and Redeem Strategy Can Help Offset Increased Capital Gains Rate

SEPTEMBER 27, 2024

Increased capital gains rates mean that individuals with holding companies will have a higher tax bill when transferring shares to the next generation. The freeze and redeem strategy is a great way to reduce the tax burden. It may be possible to reduce the tax cost on transfer from 35 to 45% of the value of the company to close to zero.

On death, the deceased is deemed to have disposed of shares in their holding company, and under the expected tax rate increase, this tax hit will rise from 26.5% to 35%.  In addition, in many circumstances the planning will involve additional planning to remove assets from the holding company causing additional tax but eliminating future tax that would occur without this planning.

To minimize the tax bill at the time of transfer, a common technique is to freeze the value of the company and issue common shares to a trust or directly to heirs, effectively locking in the current value and allowing future appreciation to occur outside the estate. 

To further benefit from the planning the preferred shares are purchased back by the company in a tax efficient manner.  Provided the freeze is done early enough and investment returns are in the range of 6% it may be possible to eliminate all of the preferred shares prior to the transfer to the next generation and avoid any tax bill!

How the Freeze and Redeem Strategy Works

1. Valuation and Freezing: The initial step in an estate freeze involves determining the fair market value of the holding company shares. This valuation is crucial, as it establishes the baseline for future gains. The owner then "freezes" this value by converting their shares into fixed-value preferred shares. These preferred shares will not appreciate in value, while new common shares, which can appreciate, are issued.

2. Transfer of Common Shares: The newly created common shares can be issued directly to heirs or placed into a trust for their benefit. This allows future growth and appreciation of the company’s value to occur in the hands of the heirs, effectively removing it from the estate of the original owner.

3. Redemption of preferred shares: As investment income is earned the company taxes will pay taxes at rates similar to those paid by an individual.  The income will generate refundable tax and capital dividend account balances.  These tax balances are used to help redeem the preferred shares in a manner that generates no additional tax but allows the investment income to be removed from the company as the preferred shares are redeemed.  In a nutshell, dividends are replaced by redemptions of preferred shares resulting in the same tax that would normally be incurred by earning investment income.  However, with the added benefit that the preferred share balance and therefore the tax payable on the eventual estate transfer shrinks with each year.

The Benefits of Utilizing the Freeze and Redeem Strategy 

  • Tax Savings: By freezing the value of the holding company, the original owner can lower their exposure to capital gains tax that would have been incurred upon death. This is particularly beneficial in an environment of rising capital gains taxes.

  • Business Continuity: An estate freeze can facilitate smoother transitions in family businesses, allowing heirs to take over operations without the immediate financial burden of significant tax liabilities. 

  • Flexibility with Trusts: By involving a trust, the original owner can set terms regarding the management and distribution of assets, ensuring that future generations are not only financially secure but also prepared for the responsibilities that come with significant wealth.  A trust can also allow flexibility in how the assets are eventually transferred among beneficiaries.

Pitfalls

-       Having your children own shares in your company can cause complications from a family law perspective

-       If your children leave Canada then having a non-resident beneficiary of a trust or a non-resident shareholder in a passive company can cause significant issues

-       A trust must distribute the shares within 21 years – so often it is best not to freeze too early.

-       The strategy is best when the recipients of the estate are happy to leave the capital invested and use the investment income.  If they want the capital immediately then a freeze and redeem strategy may not provide much benefit.

-       Negative tax consequences can occur if the planning is not done carefully. In particular care must be taken not to benefit a spouse or minor.

As capital gains rates increase, the necessity for effective estate planning becomes more critical. An estate freeze, particularly when combined with the redemption strategy, can provide a powerful tool for minimizing tax liabilities. It is important to start planning early to ensure that you can transfer any excess growth to your intended beneficiaries. Further, if you have implemented a freeze, it is important to monitor your circumstances to ensure that the freeze continues to meet your needs.

Please reach out if you have any questions.