With the world in flux and an unprecedented shutdown of the world’s economy, those who were planning to transfer businesses to the next generation have been given what is (hopefully) a once-in-a-lifetime opportunity to defer additional taxes for many years. As valuations of investments and businesses — both public and private — have reduced sharply, unless you are in the hand sanitizer business, right now is arguably the best time ever to freeze one’s estate.
ESTATE FREEZE
Since capital gains tax is imposed at the time of death, owners of closely held corporations are assessed a capital gains tax on the growth of their shares on their terminal return. The idea behind an estate freeze is to limit the tax payable upon death by limiting the growth of the taxpayer’s interest in the company. It is not that we want to freeze the taxpayer’s business itself. Rather we want to stop the growth of the taxpayer’s shares while allowing the business (and somebody else’s shares) to keep growing.
In a nutshell, an estate freeze converts a taxpayer’s shares in their business into preferred shares with value equal to the value of the shares they traded in. After the freeze the taxpayer is left with preferred shares that will never increase in value. The corporation then issues a few new common shares worth $1 to family members or a family trust. And as the business and its assets increase in value over time, that increase is attributed to the common shares, owned by the next generation, which at the time of the freeze were only worth, say, $1, but which could turn out to be worth millions of dollars down the road. And voilà, tax on any further increase in value of the business is paid by the next generation many years in the future when they sell the $1 shares that were given to them — not by the taxpayer who had frozen their estate.
WHY FREEZE NOW?
While the crisis is still its infancy, it is important to take advantage of the fact that business valuators have still not figured out how to go about performing a meaningful valuation. Until more is known about the duration and the severity of the recession/depression, valuators are likely going to be approaching valuations very conservatively. So while it is going to be a good time to perform an estate freeze at any point during the crisis, it may be best to act sooner than later to take advantage of the uncertainty.
AUDITS AND VALUATIONS
There is always a possibility that the Canada Revenue Agency will audit a freeze transaction. And there may be an increased likelihood of attracting CRA attention and scrutiny for freeze transactions with very low valuations. So if the CRA comes calling, it is always best to be prepared. And being prepared means being ready to either a) support the valuation or b) in the case where one cannot successfully oppose the CRA’s challenge of the valuation, one needs to be able to avail themselves of a price adjustment clause, which will allow them to retroactively adjust the valuation of the preferred shares.
But one of the requirements in order to be able to invoke the price adjustment clause is that the original valuation was arrived at using a methodology that was fair and reasonable. So one can’t just be cheeky and value a $1 million business at $100,000, then do an estate freeze on that basis and expect to be able to use the price adjustment clause if the CRA audits. If it is determined by the Canada Revenue Agency that the valuation that the taxpayer is relying upon was not performed in a fair and reasonable manner, the CRA won’t allow the price adjustment clause to be invoked and there will be tax consequences, plus penalties could be applied.
In either case — whether one wants to challenge the Canada Revenue Agency by supporting their valuation or whether they want to accept the CRA’s valuation and invoke the price adjustment clause and revalue the preferred shares — a taxpayer will require a proper valuation upon which they can rely. And the gold standard is to get a valuation performed by a certified business valuator (CBV). As long as one has a CBV valuation they stand a far greater chance of either supporting their valuation or of invoking a price adjustment clause and ultimately having a successful estate freeze.
Moral of the story: Freeze your estate now and get a proper valuation performed by a CBV.
Dale Barrett is a Canadian tax lawyer, managing partner of Barrett Tax Law, founder of Lawyers & Lattes Legal Cafe, author of Tax Survival for Canadians, editor of Lexis Nexis’ Family Law and Tax Handbook, tax columnist at The Lawyer’s Daily and frequent tax lecturer, primarily for accountants and other financial professionals.
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