One may not want to think about tax planning with all that is going on.
However, unless you believe that things won’t eventually bounce back, this is the perfect time to consider some longer term tax planning.
Many of you have read my client newsletters for many years, and will have read about a planning technique referred to as an “Estate Freeze”.
Estate Freezing
An Estate Freeze is an important tool in planning your estate. An estate freeze is not a technique - it is the result of applying any one, or more of a number of different techniques to your assets, to literally "freeze" the value of those assets in your hands. The result is that any future growth in the value of those assets will accrue to other taxpayers - spouses, children, grandchildren, etc.
By freezing the values today, you can accomplish a number of objectives. You can quantify the tax liability which will be triggered upon death or other disposition of your assets, in order to finance those liabilities. You can also take steps, in many circumstances, to actually work at reducing those liabilities over a period of time. By limiting values, you can also reduce your exposure to probate and other estate settlement costs. For those with Qualified Small Business Corporations, you can multiply the availability of the Lifetime Capital Gains Exemption (LCGE) by increasing the number of taxpayers who are shareholders. And most importantly, you can effect an orderly transition between generations, ensuring that your assets go where you want them to go, with the least fuss and bother.
An estate freeze will also, in the proper circumstances, give you the ability to split income with your spouses and/or children on an ongoing basis, lowering the overall family tax bite and building an asset base for the beneficiaries of the freeze. This is subject to the, relatively, new TOSI (Tax on Split Income) rules introduced by the Liberal Government, which are beyond the scope of this Memo.
Typical Freeze Transaction
There are many ways that an estate freeze can be undertaken. To illustrate a typical freeze transaction, let’s assume that Mrs. Jones set up JonesCo (a qualified small business corporation) in 2000. The business has grown to the point that its value is now $2,000,000. If Mrs. Jones were to sell the business, gift it to family members, or die, she would recognize a capital gain of $2,000,000. This gain may qualify for the LCGE, discussed below.
Subject to the availability of the LCGE, the top tax rate in Ontario for a capital gain is approximately 26.76% of the gain, or in this example, approximately $535,200.
If Mrs. Jones does nothing, and the business grows to $5,000,000, then upon sale, gift or death, the gain would be $5,000,000 and the tax would be $1,338,000.
In a typical freeze transaction, Mrs. Jones would, today, exchange her shares of JonesCo for a separate class of fixed value shares having a total value of $2,000,000. She would, through these shares, still have voting control of JonesCo.
However, If Mrs. Jones had done an estate freeze when the business was worth $2,000,000, any gain in excess of that amount would not be taxable in her hands.
Obviously an estate freeze can be more complex than that, but that would depend upon the specific circumstances.
Lifetime Capital Gains Exemption (LCGE)
A Lifetime Capital Gains Exemption exists for “qualified small business corporation shares”. The exemption is currently $800,000.00, indexed for years after 2014, and will continue to be indexed until it reaches $1,000,000. For farming and fishing businesses, the LCGE is already $1,000,000.
The effect of the LCGE is that upon a sale of the shares of the corporation, either an arm’s length sale, or a transfer to the next generation, or death, the first $800,000.00 (now $883,348 with indexation) of capital gain per shareholder will be free of tax.
If shares of a qualified corporation, are owned by a family trust, the gain on the sale of the shares can be allocated among all of the capital beneficiaries of the trust and each beneficiary can claim their individual LCGE.
At 2020 Ontario and Federal tax rates, the tax saving in respect of $883,348 of capital gains would be as much as $245,227.40 per individual shareholder.
Qualification of Shares for the LCGE
There are many technical rules to determine whether shares of any particular corporation qualify for the LCGE, the most significant one being the percentage of assets of the corporation that must qualify as active business assets. At the time of a sale, or other disposition, 90% of the assets must qualify as active business assets. Furthermore, for the 24 month period prior to the disposition of the shares 50% of the assets must qualify as active business assets.
A detailed discussion of the qualification requirements is beyond the scope of this Memo. However, I have written about the LCGE previously and you can find a discussion on my Blog Page.
Shareholder Entitlement to LCGE
Assuming that the shares of a company qualify for the LCGE there is still a requirement that each shareholder is entitled to claim the capital gains exemption.
The first requirement is that the shareholder must be an individual. This will include a family trust, but not another corporation such as a holding company.
The LCGE is not $883,348 per company, but $883,348, in aggregate, for each shareholder. Accordingly, if a shareholder claimed $400,000 on the disposition of shares of a company in the past, he or she would only have $483,348 available to be claimed. If there is any question as to a shareholder’s entitlement, the Canada Revenue Agency will, upon request, confirm the amount of capital gains exemption previously claimed by any individual.
In addition to determining whether a shareholder has previously claimed any amount of the capital gains exemption, it is important to determine if he or she has any accumulated investment losses (referred to as a Cumulative Net Investment Loss or CNIL account). To the extent that a shareholder has a balance in his or her CNIL account, that balance will reduce the amount of the capital gains exemption that he or she can claim. In planning for the sale of a QSBC, it is important to plan for the reduction of any CNIL account balances for any of the shareholders.
Use of Family Trusts
A family trust for children and other family members can be used, and is often used, as part of the estate freeze process. Income paid out of the trust, for the benefit of the beneficiaries, is taxed in their hands. See my Memo entitled "Trust Basics"
Kiddie Tax / Tax on Split Income (TOSI)
In the February 1999 Budget, Finance Minister Martin introduced a new tax, payable only by those under age 18. It is a tax at the highest marginal tax rate, and the parents will be jointly and severally liable to pay the tax. The tax is on dividends, whether received directly or through a trust, and on business income earned in a trust or partnership if a person related to the minor was providing goods or services related to the earning of that income.
In 2017, the Liberal Government introduced rules to extend the “kiddie tax” rules to include spouses and children over the age of 18 who own shares, or are beneficiaries of a family trust that owns shares in a family company and who are not actively involved in the business.
If TOSI applies to an individual’s income, that income is subject to tax at the highest marginal income tax rate. In order avoid the application of TOSI, the income must meet one of the exclusions contained in ITA 120.4. The TOSI rules are beyond the scope of this Memo.
To illustrate, Moodys Gartner LLP is one of the pre-eminent tax firms in the country, and has been in the forefront of the tax profession’s fight for fair tax provisions. Kenneth Keung, Director of their Canadian Tax Advisory Services, has prepared a flow chart to show how the new TOSI rules will operate. With their kind permission, I am including a link to that “simple” flow chart.
Initially, Morneau intended to include capital gains in respect of qualified small business corporation shares under the new TOSI rules, but he backed away from this position.
The allocation of an exempt capital gain will not be caught even for minor children. If the gain is in respect of shares that qualify for the LCGE, this gain will continue to qualify for the exemption when it is allocated to trust beneficiaries.
It is vitally important to ensure that the shares of an operating business ALWAYS qualify for the LCGE, as discussed above. If the shares qualify, each beneficiary can claim the LCGE. If the shares do not qualify, the capital gain on any non-active family member will be caught by the TOSI rules.
Re-Freezes
Some individuals have done estate freezes in past years, only to see the value of the business drop. In this situation, the gain accrued in the shares taken back on the freeze would be higher than if the freeze had never been done in the first place.
In this situation, it may be appropriate to “refreeze” at the lower current value, to reduce the accrued gain, and the tax cost resulting from that value.
Care needs to be taken to determine the cause of the decline in value. If the decline in value is not the result of stripping out corporate assets, but is legitimately as a result of a decline in the value of the business, the CRA has accepted that this is a valid exercise and can be accomplished without tax cost.
WHY NOW?
You may be asking yourself why I am bothering you with this now rather than waiting for things to settle down.
The simple answer is that, whether your company is an active business company that might qualify for the LCGE, or an investment company holding a portfolio, the midst of this crisis is likely (and hopefully) the lowest value you will see. As things improve around us, the markets will go back up, businesses will get back to business and the value of your companies will grow.
Accordingly, the tax benefit of an estate freeze, or re-freeze, will never be as high as it is right now.
The most successful estate freeze I was ever involved with was a freeze of an Anglophone company in Québec, whose primary customer was the Québec Government. The freeze was done in 1976, just after the Parti Québécois came to power. Although the company went on to thrive and grow, there was little doubt that, based on any valuation, the company’s value was at a low point.
I would be pleased to work with your advisors to consider a freeze, or re-freeze of your companies to take advantage of these trying times.
I hope everyone stays safe.
— Chuck
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