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Wednesday, January 6, 2010

What is an estate freeze?

An estate freeze is a way of transferring ownership of a privately held corporation, often between family members, by reorganizing the company. The freeze has two purposes. One is to transfer ownership of the company from one owner to another. The second is to limit the capital gains tax for the business owner who is transferring his or her shares to someone else. Both of these things happen at the same time.

Before the freeze, the business owner usually holds common shares of his or her business. Common shares give the share owner a stake in the profits and direction of a company. Usually a common share does not give the owner a right to receive a dividend but instead represents a share of the overall value of the company itself. As the value of the corporation grows, the value of the common share also grows. Another important feature of a common share is that it almost always gives its owner a vote in the running of the corporation.

On th day agreed on for the estate freeze, the business owner exchanges those common shares for preferred shares that have a fixed monetary value. At this point, the old owner is owed a specified sum of money for the ownership of the business. That sum of money is reprsented by the new preferred shares. The sum of money might also be secured by putting a promissory note into place in addition to the preferred shares.

The new preferred shares can either be shares of the operating business itself or can be shares of a holding company. They will never increase in value even if the common shares increase in value. The new preferred shares can be voting shares or non-voting shares, depending on what the business owner and the successor have agreed, although it would be more common for the old owner to receive non-voting shares.

The outgoing business owner is liable for capital gains tax on the increase in value of the business from the day he acquired it to the day of the freeze. The new owner is liable for the tax from the day of the freeze onward.

Business owners might discuss the possibility of an estate freeze with their estate planning lawyers, corporate lawyers and accountants. For a detailed background discussion of estate freezes, see my book "Succession Planning Kit for Canadian Business."

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