Business Value and Transition 2.0

Is an Estate Freeze a Powerful Transition Tool?

by Ian R. Campbell | April 16, 2019 | Generational Transition

Note: The term Estate Freeze is broadly used in Canada by business advisors and owners. Other jurisdictions may be subject to different laws, terms and practices. Readers should discuss the contents of this post with their professional advisors.

Why an Iceberg image?

Question:  Why an iceberg as a lead-in to an estate freeze discussion?

Answer: Approximately 90% of an iceberg is a submerged, hidden danger. An estate freeze is a related series of transactions in issued private company shares that likewise often is not all it seems to be.

An Estate Freeze – Be Surprised – Ask Professional Advisors Two Questions

Question: Would professional advisors themselves act on their estate freeze advice?

Commentary: Discussion over many years suggests that if one ask a room full of professional advisors:

1. if they would like to be in business with their brothers and sisters. Less than 10% are likely to answer in the affirmative.
2. how many of them have advised their family business clients to complete an estate freeze principally to defer income tax. More than 90% are likely to answer in the affirmative.

It follows that many of those advisors have:

1. effectively created partnerships for their client’s next generation that they may not have created for themselves.
2. typically done that without concurrently working with their client to develop a comprehensive family business transition plan – or as a minimum recommending that be done.

 Estate Freeze Defined

Question: What is meant in Canada by the term estate freeze?

Answer and Commentary: In a family business context, estate freeze is a term to describe a transaction that results in one generation of family business shareholders ‘freezing’ the value of their respective share interests at an amount equal to a notionally determined fair market value at a specific point in time.

The principal objectives of an estate freeze are to:

1. pass growth in capital (i.e., family company share) value, typically at nominal cost, on to one or more subsequent generations.
2. minimize what otherwise would be a larger income tax on a disposition or deemed disposition at the time of the death of shareholder-members of the current generation.

Typically, this is done in income tax jurisdictions that allow it by:

1. having the current owners:

• exchange their common shares for fixed value preferred shares in the family business.
• file prescribed income tax forms necessary to complete the estate freeze

2. issuing treasury (new) common shares to subsequent family generation members at a nominal cost.

Estate Freeze Discussed

The Important Question: Is an estate freeze implemented in isolation a comprehensive generational business transition?

Answer and commentary: The simple answer is no. A more complete answer follows.

In some jurisdictions an estate freeze can:

1. potentially result in significant income tax deferral.
2. result in family members thinking they have completed a comprehensive family business transition plan, which they have not.
3. result in the pre-freeze common shareholders imposing a family partnership on subsequent generation family members without the latter individually or collectively:

• understanding the possible business and personal potential consequences of that – both good and bad.
• seeking independent legal advice.
• paying only a nominal amount for capital assets (i.e., company shares) that are expected to increase in value, where this may contribute to next generation:
  • business partners who aren’t interested in the family business other than for the lifestyle it provides them.
  • business partners not equipped to effectively participate in the family business as directors, executives or employees.
  • entitled attitudes, unrealistic value systems, and unrealistic monetary expectations.

Further, estate freezes:

1. frequently are completed without concurrent execution of a well-documented shareholder agreement.
2. may lead to acrimonious family relationships and at extremes litigation.

An Estate Freeze – Conclusions

An estate freeze:

1. can prove to be an effective way for business owners to manage income taxes.
2. may solve short-term problems while concurrently laying the foundation for substantive long-term issues.

can be a useful monetary tool if all stakeholders understand its principal purpose and use it as a catalyst in the development of a comprehensive family business transition plan.

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Ian R. Campbell has provided business valuation and transition advice to business owners and advisers for 50 years. See Profile.

In his retirement from active practice he:

• Advises a limited number of business owners with respect to valuation and their business transitions.
• Works to provide business owners and their advisors with thought-proviking business value and transition commentary.

Disclaimer: Blog content ('Content') does not constitute individualized business valuation, transition, economic, technology or investment advice. The ideas, views and opinions expressed in the Content are solely those of the author. Provided 'as is', Content is general in nature and may not be relevant to individual business facts and circumstances, may change without prior notice, may be incomplete, inexact, or incorrect for jurisdiction-specific or other reasons. Content is used at the reader's own risk.

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