Estate Freeze Shares – Tax Planning

Introduction

In planning for corporate restructurings, we often advise our clients on the need to ensure that they receive the full current value of their shareholdings before issuing new shares to family members. A transfer of future growth is easily accomplished in a tax-effective manner, but a transfer of current value carries immediate adverse tax consequences.

Comments

Comments by the Tax Court (for example, in the Sommerer case) suggest that a failure to take back the full fair market value may havelong-term repercussions, particularly where shares are issued to a Trust. These comments suggest, for example, that when an estate freeze takes back less than the fair value of the corporation, and shares are then issued to a Trust in which the freezer is involved as a Trustee or a beneficiary, all income and gains on those shares may be attributed to the freezer in perpetuity, eliminating all benefits of the freeze.

An effective price adjustment clause is an important step to provide the ability to adjust the redemption value of preferred shares in the event of a later valuation dispute, although the Canada Revenue Agency will accept such an adjustment only where a bona fide effortwas made to take back the correct fair market value.

While considerable uncertainty can exist in valuing shares of corporations, the Canada Revenue Agency has a longstanding administrative policy of accepting fair market value of preferred shares with certain rights and restrictions being equal to theirredemption price . The Canada Revenue Agency has indicated that these rights should include the following:

  • Redeemable at the option of the holder
  • Entitled to dividends not in excess of a reasonable amount
  • Carry rights to vote on any matter involving a change to the rights, conditions or limitations attaching to the shares (they need not have full voting rights)
  • Receive a priority on distribution of assets on a winding-up, dissolution or other form of distribution of the assets
  • Unrestricted as to transferability (except for any restrictions required by provincial law to maintain private company status)
  • Other shares classes must be precluded from receiving dividends which would result in the corporation being unable to redeem the preferred shares for their full redemption price.

The Canada Revenue Agency also notes that outside factors which reduce the value of the shares would also be considered. The Canada Revenue Agency commented on clauses in a shareholder’s agreement recently which could reduce the value of the preferred shares, such as:

  • Agreement not to require all shares be redeemed at the same time
  • Agreement not to require redemption without consent of all shareholders
  • Agreement to accept a term note bearing interest at less than a reasonable rate as payment on redemption

Practically, of course, demanding immediate redemption of all preferred shares would typically bankrupt the corporation, and the holder of the preferred shares will commonly refrain from requiring a redemption which would impede the corporation’s financial stability. In fact, it is common for freezors to refrain from demanding fair compensation for their services to, and investment in, the company, to the benefit of the freeze beneficiaries.

It appears that the Canada Revenue Agency requires the shareholders take the continued benevolence of the freezors on faith, and may challenge whether they have received fair market value for their interests if they contractually limit their rights in this regard. Unfortunately, in some cases, this leaves the company vulnerable to a change of heart by the freezer, or to a less sympathetic approach taken by the heirs when the freezer dies. If such concerns exist, the parties may wish to put a plan in place to enable the preferred shares to be redeemed should the need arise. One approach implemented by some organizations is insurance to fund the redemption should the holder die, at least avoiding reliance on the beneficiaries being as friendly to the business as the freezer was.

Conclusion

Joe Truscott has been advising his clients for over 30 years in the valuation of their shares and in assisting his clients with various estate freezes to minimize the growth of their shares and therefore minimize the income taxes payable when a shareholder has deceased.

If you wish to engage Joe Truscott’s services in this area, or in any related personal or corporate income tax area, you can reach Joe at 905-528-0234 ext: 224, or email Joe at joetruscott@josephtruscott.com.

October 2012