During these unique times of COVID-19 which have created uncertainty and significant stock market volatility, the famous military strategist Sun Tzu comes to mind. In The Art of War he famously stated, “In the midst of chaos, there is also opportunity”.

An Estate “Freeze” or “Refreeze” are potential tax planning strategies, which may allow you to take advantage of certain opportunities in our current low valuation market.

What is an Estate Freeze? 

An estate freeze is effectively a corporate reorganization which can be structured in various ways to achieve a particular client’s specific goals and objectives. There are many tax and non-tax reasons to implement an estate freeze. In general, the primary purpose of the strategy is to “freeze” the current wealth of an individual (the “freezor”), and to pass along the future growth to benefit the freezor’s next generation (either directly, or more commonly through a discretionary family trust).

Estate freezes are generally performed for family businesses. However, such planning may also be used for significant passive assets – although the corporate income attribution rules would need to be considered for the latter case.

By “freezing” the first generation’s wealth in a family business, for example, the associated tax liability can be “fixed”, and thus the tax liability associated with future growth can be deferred to be taxed in the next generation’s hands. Other benefits of freezing include developing a succession plan which can provide certainty to fund the freezor’s known estate tax liability, providing flexibility to determine how the future share ownership may transfer to the next generation (where a family trust is used), probate planning by transferring future growth outside of the freezor’s estate, providing control through the ability to separate Voting vs. Value through the creation of various share classes, etc.

The inherent motivation is to freeze the wealth of Generation 1 (“G1”) at the lowest value possible in order to minimize G1’s estate tax liability, and to allow for the maximum amount of future growth (and the associated future tax liability) to transfer to G1’s children and grandchildren. Accordingly, in today’s low valuation economic environment, now may be an opportune time to consider the benefits of implementing an estate freeze.

What is a Refreeze?

As the name suggests a “refreeze” effectively involves implementing a new estate freeze for one’s company at the new (lower) current Fair Market Value (“FMV”) of the business. By properly structuring the refreeze, one will have reset the estate tax liability for the freezor at the lower valuation, and thus will allow for more future growth to tax-efficiently transfer to the next generation.

Example

Mr. Smith previously implemented an estate freeze of SmithCo 5 years ago by exchanging his common shares in the business for fixed value “frozen” preference shares worth $10M. Due to the concerns of COVID-19 and the tumultuous markets, the FMV of his business is temporarily depressed and is only worth $8M.

Through a refreeze strategy, Mr. Smith can reorganize SmithCo to exchange, on a tax-deferred basis, his “old” $10M in frozen shares for newly-issued frozen shares equal to the current FMV of $8M. New “growth” common shares (which would have a nominal FMV – as all of the current value would be reflected in the “new” frozen shares) would also be given to the family trust (or to a new family trust – as noted below).

The Benefits

Why would Mr. Smith consider implementing a refreeze? The primary tax benefit is that he has lowered the value of his “frozen” shares, which accordingly has lowered his tax liability on death. In essence, as the business recovers and grows, he will have effectively limited his estate’s capital gains tax by decreasing the value of his own estate and transferring $2M of value to his intended beneficiaries.

There are other secondary benefits associated with refreezing strategies such as “resetting the clock” (when using family trusts) in respect of the “21-year rule” – which can provide more time for determining how future growth will ultimately be distributed amongst the next generation; potential Family Law protection planning benefits (e.g., for clients in Ontario who may have family members who got married before a freeze was implemented); etc.