Estate Freezes Belong in the Tax Planning Garden

August 23, 2019 | Wendi P. Crowe

The Financial Post recently published an article claiming that “[r]ich Canadians are getting out of paying taxes with ‘estate freezes’” and calling for the elimination of this “garden-variety” tax planning. Whether or not one agrees that wealthy Canadians should pay more taxes, the elimination of estate freeze planning will not make our tax system fairer or more efficient.  Canada generally taxes income when it is received, and capital gains when they are realized.  Unrealized gains are also taxed on a deemed disposition on death, so wealth cannot be passed down to future generations without payment of tax.  The estate freeze does not offend these broad tax policy objectives.

Estate freezes serve an important purpose by allowing a business owner to conduct an orderly transition of an ongoing business to the next generation or to its employees. The founder of the business “freezes” the current value of the business in preferred shares. The successors can then purchase new shares that entitle them to future growth for a nominal but fair market value consideration, because all of the existing value of the business is attached to the founder’s preferred shares.  None of this value escapes taxation; on the contrary, it is taxed in the hands of the individuals who benefit from it, when it is realized or deemed to be realized.

In the Financial Post article’s example, John owns Canco, which is currently valued at $10 million.  John wants to transition the business to his three adult children, and he does not need any more wealth for his own retirement.

John could, nonetheless, retain ownership of the business while he tries to train his successors to “think like owners.”  The flaw in that strategy should be obvious.  Moreover, the article notes that if the business value grows to $100 million during John’s lifetime, his children will be left with a $25 million tax bill. (Actually, this would be John’s tax bill because John would still own the shares.) But the reality is that the business would have to fund the tax, caused by a deemed disposition on John’s death, as opposed to a real liquidity event, such as a sale to a third party. It is nearly impossible to come up with that kind of cash without selling off all or part of the business, or borrowing heavily against it.  Both of those strategies would run counter to John’s plan for the future of the business and may threaten the very survival of the business itself.

Alternatively, John could sell his shares to his children now.  He would be taxed on a $10 million gain at the time of sale. If the business grows in value, the children would pay tax on that growth when they sell the business, or upon their deaths – the same time as under an estate freeze. But where will John’s children get $10 million to buy John’s shares?  Even if John agrees that the children can pay him later, John still needs $2.5 million to pay his capital gains tax right away – before he actually gets paid for his shares. He faces the same conundrum of liquidating or leveraging a $10 million business to pay 25% of that value in tax.

The estate freeze helps to address these liquidity problems without any leakage in the total taxes due. In fact, tax rates may actually be higher because John will pay dividend tax of up to 47.4% as he redeems his preferred shares from Canco to fund his retirement.

The Financial Post article suggests that the U.S. would do a better job of taxing John’s wealth. But the U.S. currently allows each of its citizens an exemption from estate and gift tax of US $11.4 million – that’s about $15 million Canadian dollars.  The U.S. exemption amount has been increasing by leaps and bounds over the past twenty years, such that only the very wealthiest Americans now pay any estate or gift tax at all.  Under the U.S. system, John would pay zero estate or gift tax on the entire $10 million of value he keeps for himself.

There is no legitimate policy reason for taxing future growth of the business in John’s hands, when John is prepared to give away the possibility of that growth to his children today.  Rather, the children who will ultimately benefit from the growth should pay tax on it when they dispose, or are deemed to dispose, of the business. It is most certainly not good tax policy to force business owners to liquidate their businesses at every generation, nor to put aside cash and “save up” to pay a large tax bill. But how else would John (or worse, his children after his death, in a “fire-sale” scenario) come up with the cash to pay tax on the value of the business?  Successful businesses don’t have cash sitting in the bank earning next to nothing – they have inventory on shelves, employees driving trucks, and goodwill in the name on the sign out front.  Business owners re-invest their cash in growth by buying new equipment, hiring more employees, expanding their premises, and more.

It’s in everyone’s interest for our tax policy to encourage the orderly and successful transition of business ownership. If the estate freeze is “garden-variety” tax planning, let’s allow it to nourish businesses for seasons to come.

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