Upon death, a taxpayer is deemed to have sold of all of their property at fair market value thus resulting in a tax liability. This is known as a deemed disposition. Estate freeze is an estate planning tool where the growth of appreciating assets are frozen in such a way that a deemed disposition does not occur and any future growth of assets accrues to the next generation of family members. The most common method of an estate freeze is a Section 85 freeze.
Deemed Disposition
According to Canadian tax law, a taxpayer is deemed to have disposed of all of their property at the fair market value, immediately before death, even though a sale of assets did not take place. This could include non registered assets, RRSPs/RRIFs, real estate, cars, investments, shares in a private company, etc. This triggers capital gains and burdens the estate with a potential tax liability that they’d have to be responsible for.
A terminal tax return must be filed by the executor in order to account for this deemed disposition and the tax payable that’s triggered. However, you may defer the tax through:
- Rollover Provisions – Registering your assets in joint a, naming a qualifying beneficiary on your registered investments, transferring assets into a spousal trust
- Exemptions – Taking advantage of tax planning tools such as Lifetime Capital Gains Exemption
- Tax Elections – Contributing into a spousal RRSP, splitting income, filing additional tax returns, using capital losses, etc.
An estate freeze would allow you to freeze any capital gains so that any future gains would accrue in the hands of the beneficiaries.
Section 85 Freeze
Section 85 is a provision of the Income Tax Act that that involves transferring assets of value into a corporation and receives shares in return. It allows for a tax-free rollover meaning that no deemed disposition or realized gains occur. Through this provision, you’re able to achieve estate freeze as discussed below.
The transferor would be transferring assets to the operating company and in return would receive preferred shares. In order for the transfer to be valid, the preferred shares must be of equal value of the assets transferred in. The value of these assets would be considered frozen in these preferred shares.
Subsequently, common shares would be issued to a trust which could include family members of the transferor as beneficiaries. Any future growth of the assets in the corporation will be reflected in the common shares which would be attributed to the beneficiaries
Advantages of an Estate Freeze
- Freezing the Gains – Through an estate freeze, you’re able to freeze the value of an appreciating asset in order to save on taxes. In addition, you would be aware of the tax liability that would be triggered in the future which can be managed through purchase of an insurance or savings over time.
- Maintaining Control – Parents would receive equal consideration of value for assets transferred in. The consideration would often be preferred shares in which allow the parents to maintain control.
- Income Splitting – Growth of an appreciating asset is attributed to beneficiaries. There may be an opportunity of income splitting without attribution of income through usage of a trust.
- Capital Gains Exemption – By taking advantage of the Lifetime Capital Gains Exemption (LCGE), there could be significant tax savings on the disposition of private shares for a qualifying small business corporation.
- Reducing Probate Fees – By freezing the assets, any future growth of the shares will not be attributed to the shareholders’ estate and not subject to probate fees.
