Monday, April 5, 2004

Freezing – Even In Victoria and even in August

More and more Canadians are freezing.

No, the above statement is not the latest reverse twist on global warming. Instead, it describes a common response to concerns about death taxes.

While Canada does not have a death tax per se, the Canadian income tax system has a form of death tax. On death, a person is deemed to dispose of all assets for fair market value. If the asset has an accrued capital gain – in other words, the asset has increased in value since acquisition – that capital gain is taxed. It is the opposite of passing Go in Monopoly – instead of getting $200, you have to pay out as you head off into the afterlife. And while the disposition is make-believe, the tax bill is real and has to be paid with real money.

The tax bill can be deferred by leaving assets to a surviving spouse or a qualifying spouse trust. But this only defers the tax until the death of the surviving spouse. The day of reckoning still awaits.

As assets grow in value, so does the amount of the potential tax problem.

One way of starting to deal with the death tax is to conduct an “estate freeze”. An estate freeze means capping the value of your estate at its current value – in other words, “freezing” your estate (so that it no longer grows in value). Once you have capped the value of your estate, you will have also capped the amount of your death tax bill.

Of course, you do not magically stop assets from growing in value. You just cap the value of your interest in the assets. In essence, you transfer future growth to your heirs (but without triggering any immediate income tax liability). While you give away future growth, however, you can still retain control over the asset (so as to ensure that the asset provides you with an income flow until your death). You can even remain in control about how the future growth is to be apportioned among your heirs.

One can accomplish an estate freeze in many different ways. To give a simple example, assume that you are the sole shareholder of a corporation. You paid $100 for your shares of the corporation. Those shares are now worth $1 million, having dipped somewhat in value due to recent declines in the stock market. If the market recovers, however, the shares will increase significantly in value. Since your estate can do without the extra tax liability, you decide to “do a freeze”.

In order to freeze your interest in the corporation, you trade your common shares in for a new type of share with a fixed value equal to the current value of the corporation. Voilà – your interest in the corporation is now frozen at $1 million. Since the fixed-value shares soak up all the current value of the corporation, your heirs (usually through a family trust) can acquire new common shares for a nominal purchase price. Any future growth in the value of the corporate assets will now accrue to those new common shares and not your shares. This means that any capital gains tax on that future growth can be deferred until the death of the next generation. You can (and generally should) retain voting control of the corporation. If you control the corporation, you can ensure that the corporation pays you sufficient cash to meet your needs.

Having capped the amount of your death tax bill, you and your heirs no longer have to deal with a moving target. You can take steps to deal with the (now quantified) future tax liability. These strategies may involve the purchase of life insurance, the creation of a sinking fund or the orderly redemption of your fixed-value shares over time. However, that is a subject for another article.

-- Blair P. Dwyer

The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.