Eight Estate Freeze Pitfalls & Tax Tips To Avoid Them – A Canadian Tax Lawyer’s Analysis

Here’s the scenario:

When a taxpayer dies, subsection 70(5) of Canada’s Income Tax Act deems that taxpayer to have sold each capital property at its fair market value immediately preceding the death. As a result of this subsection, a taxpayer will incur a taxable capital gain in the year of his or her death if appreciated capital assets were owned at the time of death.

You own capital properties, such as shares in a corporation or cottage. You want to set aside funds for the impending tax liability on your passing. But you cannot anticipate what fair market value your capital properties will have just prior to your death. And so, you cannot accurately compute the taxable gain that will result from the deemed disposition on death under subsection 70(5). Enter the estate freeze.

What Is An Estate Freeze?

An estate freeze is a transaction aimed at fixing or freezing an asset’s fair market value for tax purposes. In turn, the frozen fair market value allows the taxpayer to anticipate with reasonable certainty the tax liability from subsection 70(5). After the taxpayer implements the estate freeze, all future growth in the asset’s fair market value will accrue to other individuals or entities—usually, the taxpayer’s children or a family trust.

Even more important, the estate freeze allows the taxpayer to defer the tax on the asset’s post-freeze growth. This tax liability is deferred until realized by the next generation.

For example, simply gifting an asset constitutes an estate freeze. When a taxpayer gifts a capital property to another, subsection 69(1) of the Income Tax Act deems the transfer to occur at the asset’s fair market value: the donor is deemed to have disposed of the asset at its fair market value; the recipient is deemed to have received the asset at its fair market value. In effect, the gift “freezes” the asset’s fair market value for the donor. The donor need not worry that future growth in the asset’s fair market value will result in increased liability under subsection 70(5). She has already realized the taxable gain due to the gift. And so, she must pay the resulting tax when she files her return for that year. Still, all capital-gain liability related to the asset’s future growth in value will accrue to the gift’s recipient unless subject to the attribution rules.

But one might wish to continue owning the target asset. Moreover, gifting the target asset results in immediate tax liability should the asset have appreciated in value. This is the opposite of effective tax planning, which seeks to defer—not accelerate—tax liabilities. So, an estate freeze via gift may prove less than ideal.

For this reason, most taxpayers opt for estate freezes using a corporate vehicle. Generally, this sort of reorganization proceeds as follows: The taxpayer wishing to institute the freeze (the “freezer”) will transfer the target asset to a corporation. In return, the freezer receives fixed-value preference or special shares, which are structured to match the value of the target asset (“freeze shares”). And the corporation issues common shares (“growth shares”) to others, usually the freezer’s children. The freezer thus retains an ownership interest in the frozen asset via his or her freeze shares. In addition, the freeze shares are structured to ensure that their value remains fixed. So, if the asset’s value increases, this increase will accrue to the holders of the growth shares.

Although an estate freeze can prove invaluable to your estate plan, a freeze comes with several pitfalls if improperly executed. This article discusses eight estate-freeze pitfalls and offers tax tips to avoid them.

Estate Freeze Tax Pitfall # 1: You Trigger the Shareholder-Benefit Rule or Similar Provisions in Canada’s Income Tax Act

When the freezer initiates the freeze, the fair market value of the target asset must match the fair market value of the freeze shares. A mismatch between the two may result in a shareholder benefit under subsection 15(1) of Canada’s Income Tax Act. In effect, if a shareholder extracts value from his or her corporation—other than by way of a dividend, return of capital, or liquidation—subsection 15(1) requires the shareholder to report that value as income.

Similarly, where the estate freeze relies on the section 85 rollover, a mismatch between the fair market value of the target asset and that of the freeze shares may result in an indirect gift under paragraph 85(1)(e.2).

Tax Tip: The fair market value of the freeze shares depends on the rights attached to those shares. For instance, the presence or absence of redemption rights, retraction rights, or dividend rights can significantly affect the value of the shares.

Any of our experienced Canadian tax lawyers can help ensure that your freeze shares boast the appropriate rights.

Estate Freeze Tax Pitfall # 2: You Have No Means of Responding if the Canada Revenue Agency Challenges Valuation

The Canada Revenue Agency may dispute the valuation of the estate freeze asset. So, even if you structure your freeze shares to match the purported value of the estate freeze asset, you may still run into problems should the estate freeze asset have been erroneously valued.

Tax Tip: You can avoid these sorts of problems by obtaining a professional valuation of the asset and by inserting a price-adjustment clause in the relevant agreements. But the CRA will respect such a clause only if the parties meet certain conditions. For instance, the parties must genuinely intend to transfer the property at fair market value.

To learn more about how a valuation and a price-adjustment clause can ensure the success of your estate freeze, speak with one of our top tax lawyers Toronto today.

Estate Freeze Tax Pitfall # 3: You Attach Inappropriate Rights to the Freeze Shares

Attaching inappropriate rights to the freeze shares can also cause a mismatch in value between the shares and the target asset. For instance, if the freeze shares pay an unreasonable dividend or provide the holder with voting control, the Canada Revenue Agency may insist that those shares are worth more than the target asset.

Tax Tip: A share right may be inappropriate in one context but not another. For instance, freeze shares providing the holder with control of the corporation may be harmless where shareholder interests are aligned but cause a valuation mismatch where those interests conflict.

Meet with one of our seasoned tax lawyers to discuss when a certain share right might cause problems.

Estate Freeze Tax Pitfall # 4: The Estate-Freeze Transaction Causes an Unintentional Capital Gain

Generally, when an individual transfers an asset to a corporation, the Income Tax Act deems that transfer to have taken place at fair market value. So, depending on the asset’s cost to him or her, the transferor may realize a taxable capital gain.

Tax Tip: You may be able to defer the taxable gain. Various sections under the Income Tax Act allow an individual to transfer an asset to his or her corporation without triggering a taxable gain. For instance, section 85 permits an asset transfer to a corporation on a rollover basis, and section 86 allows for a tax-deferred share-for-share exchange. These rules are complex, and they require you to meet stringent formal requirements—section 85, for example, requires the transferor and transferee corporation to jointly file a form T2057 with the earliest due tax return between them.

But, in some cases, you may wish to trigger a capital gain—when, say, crystallizing your lifetime capital gains exemption (LCGE).

Speak with one of our Canadian tax lawyers about the strategy that makes the most sense for you.

Estate Freeze Tax Pitfall # 5: You Fail to Consider Potential Claims by Family Members

When gifting the growth shares to your beneficiaries, you should consider whether you want or need to safeguard these assets from a beneficiary’s spouse.

Tax Tip: Some family-law legislation provides the means of protecting assets from a claim by your beneficiary’s spouse. For example, Ontario’s Family Law Act allows a donor to exclude a gift from the recipient’s net-family property if certain conditions are met. This will prevent the recipient’s ex-spouse from staking a claim against that gift. But, if this is done improperly, the donor’s ex-spouse may raise a claim on the basis of anti-fraud legislation, like Ontario’s Fraudulent Conveyance Act.

Estate Freeze Tax Pitfall # 6: You Fail to Account for the Estate Freeze in Your Will

After you complete the estate freeze, you now own a new asset: you no longer own the target asset; you own the freeze shares.

So, if you fail to revise your will accordingly, your freeze shares may fall into intestacy and end up in the hands of an unanticipated beneficiary.

Tax Tip: Don’t forget to revise your will to account for the freeze shares.

Consult one of our experienced Canadian tax lawyers about revising your will and pursuing other tax-saving strategies for your estate.

Estate Freeze Tax Pitfall # 7: You Ignore Strategies that Might Have Reduced Tax Liability On Death

As mentioned, when an individual dies, he or she is deemed to dispose of all capital property at its fair market value. This is one of the strategies that the tax system uses to prevent indefinite capital-gains deferral.

Generally, one uses an estate freeze to both defer tax on an asset’s post-freeze appreciation and provide more certainty regarding the tax liability resulting from the deemed-disposition-on-death rule.

But the estate freeze can also provide a means of reducing this tax liability. A strategy known as a wasting freeze allows one to gradually realize and thus grind down the freeze shares’ taxable gains. As a result, the freeze shares ideally produce no taxable gain on death.

Tax Tip: A wasting freeze is a complex strategy demanding legal consultation. And it may not be appropriate in all cases. If done improperly or without considering your personal financial needs, you might incur greater overall tax.

Estate Freeze Tax Pitfall # 8: You Fail to Consider the Attribution Rules

Canada’s Income Tax Act contains various attribution rules, which aim to deter one from splitting income with a spouse or related minor. For instance, a high-income taxpayer may transfer an investment property to his or her low-income spouse. Absent the attribution rules, the income from that property, which now belongs to the low-income spouse, would be taxed at that spouse’s lower marginal tax rate. The attribution rules combat this arrangement by deeming the income to still be that of the transferor.

The corporate attribution rule found in subsection 74.4(2) proves particularly concerning for taxpayers considering an estate freeze. Generally speaking, this rule applies where an individual transfers or loans property to a corporation for the purpose of reducing his or her income and benefitting a spouse or related minor. When it applies, subsection 74.4(2) deems the transferor to receive a prescribed rate of interest income.

Tax Tip: Subsection 74.4(2) provides for various exceptions—for example, the deemed interest is reduced to the extent that the transferor received dividends on the shares that the transferor received as consideration from the corporation. Careful tax planning by one of our top Canadian tax lawyers can help you avoid the tax pitfall of attribution rules like subsection 74.4(2).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.