There is an abundance of articles written on the subject of estate freezes. It is one of, if not the, most utilized tax planning techniques available for shareholders of private corporations in Canada. The purpose of this article is not to discuss the implementation of an estate freeze, but rather to discuss an odd thing that is typically overlooked when implementing an estate freeze: the next generation.
Very generally, the purpose of the estate freeze is to shift any future growth in the value of a corporation to future generations. This is accomplished by issuing fixed value preferred shares to Generation 1 in exchange for common shares. These ‘frozen’ preferred shares will not increase in value even if the value of the corporation does. The increase in value will instead be attributed to the new common shares issued to Generation 2.
A Canadian resident is deemed to have disposed of property held at the time of death for fair market value. Accordingly, properties such as shares of a private corporation with accrued gains can create significant tax burdens in the year of death. The ‘freezing’ of value in Generation 1’s shares will, of course, also result in a freezing of the estate tax liability upon their death.
Because the estate tax liability of Generation 1 has been quantified as a result of the estate freeze, many advisors discuss with their clients the importance of planning to pay that tax liability. We are often asked by accountants and lawyers to address the funding of the estate tax liability by way of permanent life insurance. One of the most fundamental uses of life insurance is to provide cash to satisfy the tax burden realized in the year of death. Life insurance is the least expensive means of funding estate liabilities. It is much more cost effective than liquidating assets and has the advantage of being paid exactly when needed.
However, since the growth of the company now accrues in the common shares held by Generation 2, their corresponding estate tax liability grows as the company does. While insurance is often placed on the lives of Generation 1 to fund their impending estate tax liability, Generation 2 is often forgotten about at this juncture.
In order to illustrate the value of planning for Generation 2 simultaneously with Generation 1, it is best to use a real-life example. Last year we met with a husband (63 years old) and wife (62 years old) who own shares of a corporation worth approximately $20,000,000. Our clients have a 32-year-old daughter who is married. The corporation has an average annual growth of 5% and this growth is expected to continue. We advised they implement an estate freeze which would result in a fixed estate tax liability resulting from the deemed disposition of their shares upon death of approximately $5,000,000.
Scenario 1: No Estate Freeze
If our clients did not implement the estate freeze and the value of the corporation continued to grow at 5% annually, the fair market value of the shares at life expectancy (in 28 years) would be approximately $78,000,000. Accordingly, their estate tax liability would have grown to approximately $20,000,000. The cost of insurance to fund this growing tax liability would have been $7,2000,000 in total premiums over 10 years. While insurance was the most cost-effective means of pre-funding the future tax liability, this is still less than optimal planning – well, to be more accurate, this is the cost of no planning.
Scenario 2: With Dual Estate Freezes
However, our clients did in fact implement the estate freeze and were issued ‘frozen’ preferred shares with a fair market value of $20,000,000. The cost to fund Generation 1’s estate liability of $5,000,000 resulting from the deemed disposition of the frozen shares will be $2,200,000 in total insurance premiums, paid over 10 years. Therefore, the estate tax liability for Generation 1 will be reduced by $15,000,000 and consequently the cost of funding that tax liability will be reduced by $5,000,000. This tax-deferral and cost-efficiency is a primary reason for implementing an estate freeze. However, the planning shouldn’t stop there.
Equally, if not more important, we discussed the merits of proactive tax, estate and insurance planning for Generation 2 with our clients. Using the same assumption of 5% annual growth, and also assuming that Generation 2 will implement an estate freeze of their own around 20-years after the initial estate freeze implemented by Generation 1, the common shares issued to Generation 2 will grow in value to approximately $33,000,000. As such, their estate tax liability will be just under $9,000,000 upon the deemed disposition of their frozen shares. Since we are implementing planning for Generation 2 while they are in their 30’s and not 60’s, the cost of funding the future estate tax liability will be far more cost-effective. The total amount of insurance premiums to fund the future tax liability of $9,000,000 will be $1,400,000 paid over ten years.
It’s important to remember that an estate freeze is a tax-deferral strategy and not tax elimination. In other words, the total value of the corporation in 28 years is still $78,000,000; it has simply been spread across three-generations of the same family. Generation 1’s shares were frozen at $20,000,000; Generation 2 shares will be frozen at $33,000,000 and Generation 3 will have shares worth $25,000,000 (for a total of $78,000,000).
Conclusion: What Was Accomplished
With very basic planning, but planning with foresight, the estimated $20,000,000 estate tax liability of Generation 1 will be deferred for generations, resulting in significant tax savings. Moreover, the cost of funding Generation 1 and 2’s estate tax liability will be a total of $3,600,000 in insurance premiums rather than $7,200,000 to simply fund Generation 1’s estate tax liability with no planning.