Estate Freeze via a Trust (Strategy and Tax Concerns)
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An estate freeze utilizing a family trust is a sophisticated strategy designed primarily to lock-in the current value of a taxpayer's assets (typically shares in a private corporation) and transfer all future growth to the next generation. This process involves the original owner (the freezor) exchanging their common shares for fixed-value preferred shares, which represent the company's current fair market value. Simultaneously, a discretionary family trust is established to subscribe for new common shares at a nominal price. By doing so, any subsequent appreciation in the company's value accrues within the trust for the benefit of the beneficiaries, effectively freezing the tax liability on the freezor's death to the value of the preferred shares held at the time of the reorganization.
The primary objective of this strategy is the significant deferral of capital gains tax that would otherwise be triggered upon the death of the freezor under the deemed disposition rules. By directing growth to a trust, the freezor ensures that the tax on that future appreciation is postponed until the assets are eventually sold or until the beneficiaries themselves pass away. Additionally, the use of a trust provides unparalleled flexibility and control; the freezor can often act as a trustee, maintaining authority over the business and deciding the timing and amount of distributions to beneficiaries. This prevents young or inexperienced heirs from gaining direct control over corporate assets prematurely while still allowing them to benefit from the equity growth.
Beyond tax deferral, a trust-based freeze is frequently used to multiply the Lifetime Capital Gains Exemption (LCGE). In Canada, individuals may be eligible for a significant tax-exempt limit on gains from qualified small business corporation shares. When these shares are held by a family trust, the trust can potentially allocate the capital gains from a future sale among multiple beneficiaries, allowing each to utilize their own LCGE. This can result in millions of dollars in tax savings for a family unit (more on multiplying LCGE). Furthermore, the trust structure offers a layer of asset protection, as the assets are legally held by the trust rather than the individuals, potentially shielding the growth from the personal creditors or matrimonial claims of the beneficiaries.
However, implementing this strategy requires navigating a minefield of complex tax provisions, most notably the attribution rules found in the Income Tax Act (Canada). If a trust is not structured or funded correctly (for instance, if the freezor contributes property but retains too much power over its reversion) Section 75(2) of the Income Tax Act can apply, causing all income and capital gains to be taxed back in the hands of the freezor. Similarly, the corporate attribution rules can deem the freezor to have received interest income if the freeze is seen as a means to benefit a spouse or minor children. Careful legal drafting and adherence to prescribed interest rates on any loans to the trust are essential to ensure the tax benefits are not inadvertently nullified by the Canada Revenue Agency (CRA) (more on attribution rules).
Another critical tax concern is the 21-year deemed disposition rule, which prevents trusts from deferring taxes indefinitely. Under Section 104(4), most personal trusts are treated as having sold and immediately repurchased their capital property at fair market value every 21 years. This reset triggers any accrued capital gains within the trust, potentially creating a massive tax bill without an actual sale to provide the necessary cash. To avoid this, many families must roll out the trust’s assets to beneficiaries on a tax-deferred basis before the 21st anniversary, which requires careful timing and may conflict with the original goal of maintaining centralized control over the family business (more on trust roll-out strategy).
Moreover, the Tax on Split Income (TOSI) rules represent a significant hurdle for families attempting to use a trust for income splitting. Historically, trusts allowed for the distribution of dividends to family members in lower tax brackets to reduce the overall family tax burden; however, the recent expansion of TOSI largely restricts this for private company dividends unless the beneficiary is actively engaged in the business or meets specific age and ownership criteria. Consequently, while a trust remains an elite tool for managing capital gains and succession, its utility for annual income splitting has been greatly diminished (more on tax on split income). Prospective users must balance these restrictive rules against the high setup and maintenance costs of a trust to determine if the strategy remains viable for their specific financial landscape.
Contact our law firm today to learn how our legal team can help you plan for the future, including wills, trusts, powers of attorney, personal directives and other estate planning documents, or deal with the legal demands associated with the passing of a loved one. Contact our law firm at 403-400-4092 or via email at Chris@NeufeldLegal.com to schedule a confidential initial consultation.
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