Estate planning is a complex process that looks into various aspects, from tax planning to the seamless transfer of assets to protecting assets from claims by creditors and other persons. The primary reason for estate planning is to prepare for the tax liability that triggers after the estate owner’s death.
The Canada Revenue Agency (CRA) deems that the deceased sold its assets to the beneficiary at the fair market value (FMV) at the time of the death. This triggers a capital gain added to the beneficiary’s taxable income in that year. For instance, Mary inherited a stake in their company from her spouse, Robert. The value of the shares appreciated by $500,000. As per the capital gain tax (CGT) rule, 50% of the gain up to $250,000 is added to Mary’s taxable income. She cannot pay a heavy tax bill arising suddenly in a year and may be forced to sell the shares. This is a scenario for most people.
What is an Estate Freeze?
An estate freeze can help Robert freeze the asset’s value to determine his estate’s tax liability. Once he knows the amount, he can accumulate money for the tax liability that will trigger his demise. In such a scenario, Mary can defer the CGT from when she inherits the shares to when she sells the assets.
How can one freeze their estate? The most common form is to transfer your voting equity shares to your corporation and take fixed-value preference shares worth the same FMV as the equity. Note that the key ingredient in an estate freeze is the FMV of your assets and getting the equivalent value of preference shares. This process is complex and prone to mistakes.
In this article, we will cover the common errors in estate freeze and how you can address them with careful consideration.
5 Things That Can Go Wrong with Estate Freeze and How to Prevent Them
An estate freeze is a complex process that needs several considerations to avoid surprise taxes.
Supporting the Valuation of Estate
At the core of an estate, freeze is converting the value of growth shares with voting rights into fixed-value preference shares, which can give you returns through dividends, return on capital, and selling of these shares. You may value your shares using a specific method, which the Canada Revenue Agency (CRA) might not agree to.
The CRA could challenge the valuation of the frozen asset and impose tax liability on the difference. Since you did the valuation as you understand, you may not be able to respond to the CRA’s challenge, which will make you pay more tax.
Tip: You could consider hiring a professional to value the asset as they can respond to the CRA in the event of scrutiny. Also, consider adding a price adjustment clause to the relevant agreements that could give you some flexibility around asset pricing. However, this clause has specific requirements, which a professional estate planner can help you with.
Shareholder-Benefit Rule
Getting a professional valuation of your estate can reduce valuation errors. However, a mismatch in the value of growth and preference shares could trigger a taxable shareholder benefit. For instance, your preference share might give a special dividend or a specific voting right, which could trigger a shareholder benefit.
Tip: Determine the value of your shares based on the rights it gives you, such as redemption rights and dividend rights.
Potential Claims by Family Members
When you freeze the value of your shares and transfer the growth shares to the beneficiary as a gift, he/she does not incur any immediate tax liability. However, one often fails to consider the potential claim of the beneficiary’s spouse on the asset. Suppose Robert transfers his growth shares worth $500,000 to his son James. James’ ex-spouse, Maya can claim her right to the growth shares inherited by James.
Tip: When gifting shares, you could look for legislation that protects the transferred assets from a claim by the beneficiary’s family members.
Failing to Update the Estate Freeze in Will
When you freeze your estate, it comprises preference shares and not growth shares. Any major life event or change in your asset should be updated in your will. Often, estate owners fail to update their frozen assets in their will, which leads to intestacy – meaning the frozen assets are treated as assets with no will. Assets without valid will are distributed as per the state laws after the estate owner dies.
Tip: If your estate has a will, make sure to revise it after an estate freeze.
Miss Out on Strategies to Reduce Tax Liability On Death
The tax liability on death arises as the CRA deems that you have sold all your assets to the beneficiaries at the fair market value upon death. Estate owners freeze their assets to ensure certainty regarding the tax liability on death and arrange for the funds. However, there is a strategy called wasting freeze, under which the estate owner gradually sells their frozen shares over a period of time and reduces the estate value. This could help them reduce their tax liability on death.
However, one should consider one’s financial situation before selling the assets as one could lose income from them.
While an estate freeze is an effective way to defer tax liability, it can get complicated as multiple facets must be considered. Such complex strategies are better implemented with the help of a professional tax consultant.
Contact Black and Gill LLP in Toronto to Help You with Estate Planning
A professional tax consultant can help you chart out a holistic estate strategy that preserves the value of your estate, reduces your tax liability, and ensures a smooth transition of the assets while considering your financial situation. At Black and Gill LLP, our tax and estate consultants can provide services such as estate and tax planning. To learn more about how Black and Gill LLP can provide you with the best estate planning expertise, contact us online or call us at 416-477-7681 to learn more about how we can help you and your business.