Using trusts to freeze your estate and avoid income tax
Tax planning considerations come to the forefront when owners of family businesses begin to contemplate the transfer of wealth and assets to the next generation. Under the Income Tax Act of Canada (the “ITA”), the death of a taxpayer triggers a deemed disposition of the taxpayer’s assets at fair market value. If the taxpayer holds assets that have accrued gains, the capital gains realized on the deemed disposition will be subject to tax. It is understandable then that business owners who hold shares of a company will be particularly interested in estate planning strategies to minimize the amount of tax that may arise upon death.
An estate freeze is a common strategy used for the transition of a family business corporation which locks-in or “freezes” the value of a taxpayer’s existing assets. The future appreciation in these assets is directed to the next generation and will only be taxed on their demise or in the event of an actual sale.
Estate freezes of family business corporations may be implemented in a number of ways. An estate freeze involves the taxpayer (the “freezor”) exchanging common shares of the corporation for preferred shares of the same corporation on a tax-deferred basis. The value of the preferred shares is set to a fixed amount equal to the fair market value of the common shares at the time of the exchange. After this step, the taxpayer’s children will then subscribe for new common shares (i.e. growth shares) of the corporation for a nominal amount. The preferred shares do not grow in value and dividends may, but do not have to, be paid on such shares. Any appreciation in the value of the corporation will accrue to the new common shares held by the children; this will defer income taxes that would otherwise be triggered on the death of the parent.
Variations of the typical estate freeze can also be implemented through transferring common shares of an operating company to a holding corporation in return for preferred shares of the holding corporation. In this scenario, the common shares of the holding corporation are held by the children. This article provides a brief overview of the steps, considerations and advantages of implementing an estate freeze using a trust which can allow for a “reversible” estate freeze.
We set out some of the concepts and principles of estate freezing below, recognizing that some of the tax rules can make your head spin. Consulting the right tax professionals can make the implementation easy and the effort and cost should hopefully result in big savings.
Typical structure of trust estate freeze
The typical structure of a trust estate freeze involves the following steps:
Establishment of the trust
The freezor will establish a trust which will consist of the entity holding new common shares of the business corporation. The trust would be an inter vivos trust meaning that the trust is established during the taxpayer’s lifetime.
The trust is created when a settlor settles the trust with a gift. In most cases, the gift is simply a small sum of money. Note that the settlor of the trust should be a friend or family member of the freezor who will not be a beneficiary or decision maker in respect of the trust or otherwise participate in the estate freeze transaction, in order to ensure that the reversionary trust rules are not triggered (discussed further below).
The trust will be a discretionary trust, meaning that a beneficiary’s entitlement to distributions from the trust is not fixed but rather is determined by the trustees in accordance with criteria set out in the trust document. The trust deed may grant trustees the power to choose which beneficiary may receive income and/or capital distributions and choose how much of income and capital is retained in the trust. As the trust is being constituted to hold new common shares of the business corporation, a discretionary trust will allow for the “sprinkling” of dividend income and capital gains (subject to certain tax rules on split income) derived from such common shares.
The trustees may include the freezor. In many cases, the freezor will wish to be a trustee in order to maintain some control over the distribution of trust property. The freezor may also be a beneficiary, which keeps open the option of unwinding the freeze structure; however, as discussed below, this introduces some risks and requires careful planning.
Freezing the shares
Once the trust is established, the freezor exchanges his or her common shares of the company through which the family business is carried on (“Opco”) in exchange for preferred shares of Opco (the “Freeze Shares”). The redemption value of the Freeze Shares is equal to the fair market value of the existing common shares of Opco at the time of the exchange. This in effect transfers the current fair market value of Opco to the Freeze Shares, so that new common shares of Opco can be issued to the trust for a nominal amount.
Where the settlor has contributed a gift of cash to establish the trust, such funds can be used to subscribe for new common shares of Opco.
If the settlor has settled the trust with something other than cash, the trust may borrow funds from an arm’s length third party to subscribe for common shares of Opco. In order to ensure that attribution rules are not inadvertently triggered, the loan should bear interest at a rate which is equal to, or greater than, the prescribed rate of interest for tax purposes or an arm’s length commercial rate of interest on similar loans. Any interest payable in a particular year in respect of the loan must be paid within 30 days after the end of the year. The trust should repay the loan as soon as possible, which can be funded by having Opco pay dividends on the new common shares held by the trust once these common shares have accrued some value.
Making distributions from the trust
After the freezor exchanges his or her Opco common shares for the Freeze Shares, any future growth in value of Opco will be reflected in the new common shares held in the trust.
Any dividends paid on the common shares held by the trust will be income of the trust and taxed at top marginal rates, unless the dividend is paid or made payable by the trust to its beneficiaries who are not subject to the Tax on Split Income rules and are not at the top marginal rate themselves.
Advantages of estate freeze using trust
As discussed above, an estate freeze provides significant benefits by facilitating the transition of a business to a successor and allowing for a tax deferral on capital gains that result from the deemed disposition of assets upon death. In addition to these benefits, the use of a trust to implement an estate freeze offers the following advantages:
- Flexibility and control: The trustees will be able to determine which beneficiaries can benefit from the trust, make decisions as to the amount and timing of distributions from the trust, and ultimately decide who will inherit the business. For business owners whose successors are still too young to take the reins, being able to have the trustees (which often includes the freezor and his or her spouse) retain control over the distributions of capital or income to successors is extremely important.
The freezor can ensure that the business of Opco continues to run smoothly and any necessary organizational restructurings are properly completed; the freezor can retain voting shares of Opco, which will allow operations and restructurings to be carried out without seeking approval from the beneficiaries. Certain reorganizations will require the approval of the trustees but not the beneficiaries. Alternatively, the voting shares can be held by the trust which will also not require seeking approval from the beneficiaries.
If the freezor is also a beneficiary, the trustees can choose to distribute the new common shares of Opco to the freezor in whole or in part thereby undoing the estate freeze totally or partially, as the case may be. This can generally be done on a tax deferred basis.
- Avoiding probate fees: Probate is the legal process that occurs when a person dies, including reviewing the assets of the deceased, determining inheritance of estate assets, paying remaining liabilities of the estate, and other general administration matters of the deceased’s will. To go through the probate process, an estate is often required to pay an estate administration tax (or probate fee), which is based on the value of assets in the estate. Estates with assets of significant value can attract a hefty probate fee. Since assets held in a trust do not form part of a deceased person’s estate, implementing an estate freeze through a trust has the added benefit of reducing probate fees.
- Multiplication of capital gains exemption: If Opco is a “qualified small business corporation” (“QSBC”), the freezor’s capital gains realized on the sale of Opco shares may be sheltered by the freezor’s lifetime capital gains exemption (the “LCGE”). The LCGE has a cumulative lifetime limit ($971,190 in 2023), meaning that it can be used to offset capital gains of the freezor during their lifetime arising from the disposition of QSBC shares until the limit has been reached provided certain conditions are met. This represents significant tax savings.
The benefit of the LCGE can be multiplied through a trust estate freeze. Provided the attribution rules do not apply (discussed below), taxable capital gains from the disposition of Opco shares held by the trust can be distributed to individual beneficiaries and taxed in their hands. Each beneficiary can then claim their own LCGE in respect of the taxable capital gains.
In order to qualify as a QSBC, often it is necessary for the trust holding the common shares to have a holding corporation as one of its beneficiaries so that profits of the Opco not reinvested in the business (i.e. excess cash) can be paid to the holding corporation. Excess assets having a value greater than ten percent of the fair market value of all assets of Opco at time of disposition of the common shares will disqualify the Opco as a QSBC.
- Addressing the corporate attribution rule: The ITA contains a corporate attribution rule which deems phantom interest income to be received by an individual who “transfers” property directly or indirectly to a corporation for income splitting purposes; this attribution rule would apply where one of the main purposes of the transfer is to reduce that individual’s income and to benefit a “designated person” of the individual. The term “designated person” means, generally, the spouse, common-law partner, and minor children or nieces and nephews of the individual.
Various types of estate freezes risk triggering the corporate attribution rule, as the CRA takes a broad view of the types of transactions that would fall within the scope of a “transfer” including an exchange of shares. An estate freeze using a designated beneficiary trust is an effective way to get around the corporate attribution issue (as discussed further below).
- Protection of family assets in divorce: When a married couple gets divorced, there is often a division of matrimonial assets so that parties can equally share in the increased value of assets during the marriage. If the freezor’s child goes through a divorce, the child’s former spouse may be entitled to receive some of the value in the growth of Opco shares issued to the child. However, if an estate freeze is implemented using a trust, the new growth shares of Opco are not issued to the child directly but to the trust, of which the child is a beneficiary (possibly along with other beneficiaries). This can serve as a basis to keep the common shares out of the child’s family assets. It should be noted that division of property upon marriage breakdown is a provincial matter and not federal jurisdiction. Therefore the rules of each province may vary and should be considered in light of the general comments made herein.
Tax issues to keep in mind
Reversionary trusts and trust rollout rules
In drafting the terms of the trust, it is critical to ensure that the following conditions are met in respect of any property contributed to the trust:
- The property held by the trust may not revert to the settlor or other contributor that contributed such property;
- The settlor or contributor cannot determine who will receive the property of the trust; and
- The settlor or contributor cannot veto the disposition of the property by the trust during the settlor or contributor’s existence.
If any of the above conditions are not met, the trust will be considered as a “reversionary trust”. In this case, any income and losses of the trust from the property, as well as capital gains and capital losses of the trust from the disposition of the property, will be attributed back to the person who transferred such property to the trust (while such person exists or is alive and is a resident of Canada).
In determining whether the reversionary trust rule is triggered, it should be noted that the term “property” includes property that is substituted for the property originally contributed to the trust. On the other hand, the reversionary trust rules do not apply to bona fide loans made to the trust or fair market sales to a trust.
In addition to the attribution of income and capital gains back to the transferor, there is an additional downside pertaining to reversionary trusts. Normally, a personal trust can distribute property to its capital beneficiaries on a tax deferred roll-out basis with no immediate taxation, provided that such beneficiaries are residents of Canada. However, if the reversionary trust rules apply to any property held by the trust at any time, the trust is tainted and the roll-out feature is denied in respect of all property of the trust (not just the property which triggered the reversionary trust rule). The one exception to this rule is if the property is rolled out to the person who contributed the property or his or her spouse or former spouse or common law partner. Any other distribution of trust property to capital beneficiaries (not qualifying for roll-out) would be deemed to have been disposed of at fair market value, and therefore subject to tax on any capital gains realized on the disposition.
21-year deemed disposition rule
Trusts established for the purpose of implementing an estate freeze are generally deemed to have disposed of its assets every 21 years at fair market value. Any capital gain resulting from the deemed disposition is taxed in the trust at the highest marginal tax rate. Following the deemed disposition, the trust continues to hold the trust property but with a cost base equal to the proceeds of disposition (i.e. the fair market value at the time of the deemed disposition). These gains cannot be allocated to a beneficiary to be taxed in their hands instead of in the trust.
Because of the 21-year deemed disposition rule, a freezor should consider the timing of the freeze. For example, if the children of the freezor are currently too young, it may be better to wait and undertake the freeze at a later time. For example, if the freezor is 60 years old, he or she will be 81 years old when they have to make a decision as to how much to distribute to the children and how much to retain; hopefully they should know what is optimal at that age. A freezor who is 50 years old may or not know how much of the equity should be transferred to his or her children at the age of 71 given today’s long life spans. Someone who is 40 will probably be too young at age 61 to give away much of the common share equity. This must be understood in the context of the dollars in play as well.
Under the ITA, corporations which are associated are required to share entitlement to certain tax benefits. One example of such a benefit is the small business deduction which reduces the corporate income tax of a Canadian-controlled private corporation (“CCPC”). The maximum amount of small business deduction available is determined by the CCPC’s business limit for the year, being generally $500,000. If other corporations are associated with the CCPC, the $500,000 business limit must be shared between all of them, instead of each corporation being able to benefit from a separate $500,000 business limit.
For this reason, consideration should be given to ensure that the use of a trust in an estate freeze will not inadvertently cause two family corporations to be associated. Generally, two corporations can become associated when both of the corporations are controlled, directly or indirectly, by the same person or group of persons, or when the persons controlling each corporation are related. There are two additional rules which complicate this issue:
- Where shares of a corporation are owned by a discretionary trust, each discretionary beneficiary of such trust is deemed to own all of those shares held by the trust; and
- Where shares of a corporation are owned by a discretionary trust and the trust has beneficiaries that are minors, any shares owned by the trust are deemed to be owned by both parents of the children (each parent being deemed to own 100 percent of the shares at the same time) even if the parents have no connection to the trust. This deeming rule does not apply if it can be demonstrated that the child manages the business and affairs of the corporation without a significant degree of influence by the parent.
These rules should be considered when deciding which persons should be named as beneficiaries of the trust.
Designated persons provisions in the trust (to address corporate attribution rule)
As noted above, the corporate attribution rule deems interest income to be received by an individual who transfers property directly or indirectly to a corporation to reduce the individual’s income and to benefit a “designated person” of the individual. A trust can be used to ensure that the corporate attribution rule is not triggered when planning for business succession. In fact, a specific relieving provision pertaining to trusts is provided, which deems the benefit requirement of the corporate attribution rule not to be met when the following three conditions are met:
- The only interest that any "designated person" has in Opco is a beneficial interest in shares of Opco held by a trust;
- The terms of the trust provide that no designated person may receive or otherwise obtain the use of any income or capital of the trust while being a designated person of the freezor; and
- No designated person has received or otherwise obtained the use of any income or capital of the trust, and the trust has not made deductions for any amounts paid or payable to, or included in the income of a designated person.
Due to this relieving provision, estate freeze trusts are often implemented to reflect the conditions described above. However, it should be noted that if the trust terms contain these “designated person” provisions, it will not be possible to split income with the freezor’s spouse (since unlike children who lose the designated person status when they are no longer minors, the freezor’s spouse will not cease being a designated person of the freezor unless they legally separate or divorce or the freezor passes away).
The implementation of estate freezes using trusts can offer a number of advantages, but should be done with care so as to not inadvertently trigger undesirable consequences. If you require more information or assistance with estate freeze planning, please do not hesitate to contact any member of our Tax and Estate practice.
This article provides only general information about legal issues and developments, and is not intended to provide specific legal advice. Please see our disclaimer for more details.