Beyond the horizon

If you own a family business and you’re in the younger baby boomer cohort, one or all of these statements is probably true:

• You’re thinking about how you’ll transfer ownership of the business to the next generation, or how to get the business ready for a possible sale.
• You’re nearing retirement and contemplating the famous Benjamin Franklin idiom about death and taxes.
• You’ve asked your advisor about doing an estate freeze to bring some certainty around point number two—namely, your tax bill upon death.

Estate freezes are a common succession planning tool and they’re where I spend a lot of my time with clients these days—not surprising given 22 per cent of the working-age population in Canada is now approaching retirement, the entire baby boomer cohort will reach retirement age (65) by 2031, according to Statistics Canada, and the much-heralded “great wealth transfer” is well underway.

The mechanics of an estate freeze are pretty simple: You lock in or “freeze” the current value of your company by exchanging common shares of your business that have growth potential for fixed-value preferred shares. When structured properly, an estate freeze allows you to defer the taxes payable on any accrued gains on the shares and cap your tax liability on death, while transferring future growth in the value of your business to the next generation.

In terms of how economic conditions might affect timing, there’s generally never a bad time to do an estate freeze. Even as inflation and interest rates have gone up and markets and business valuations have gone down, now could be an ideal time to freeze your estate, so the value of your company is frozen at a lower level, resulting in a lower final tax bill.

Also, while an estate freeze can allow you to tap into cost savings, it’s important to think beyond the numbers. Successfully setting your family up to manage future wealth requires a much broader discussion about estate and succession planning, and a bigger-picture look at the family itself.

One part of a larger plan
The mechanics of an estate freeze may be simple, but properly executing one involves a few different parts. To start, you will need to review your will to make sure it’s up to date and reflects the assets you currently own. If you have a spouse, you will need to do the same with them.

Secondly, look at how an estate freeze will fit into your larger estate plan. For example, you may have strategies to minimize probate fees, which is generally based on the fair market value of assets on death. According to CPA Canada, Ontario has the highest probate fees in the country, at 1.5 per cent for assets over $50,000.

If you are in a province with higher probate fees, you may want to consider a dual-will strategy. Typically, a single will covers the value of shares and debt of the private enterprise, and would not be subject to probate fees. The second will covers all other assets, so when the estate goes through probate, only the non-family business assets are subject to the fees. Given that most of your family’s wealth is likely tied up in the business, this planning can help significantly reduce provincial probate fees.

Estate freezes and family dynamics: It’s complicated
Tax is often the driver of an estate freeze, but for many families, there’s more to it than saving money. An estate freeze is part of your overall succession plan and is often the first step in transitioning ownership and control of the business to the next generation. It’s a natural way to help your children be involved in day-to-day operations, while enabling them to participate in the future growth and equity of the business.

However, bringing the next generation into the business as owners through an estate freeze can bring complicated family dynamics to the forefront. For instance, when future growth in the business is determined by the issuance of new common shares, a number of questions arise. What family members get those common shares? What happens when not all of your children or other family members are involved in the business? Do you give everyone shares, or only those who are active, participating members?

Giving shares directly to family members is one scenario. A more popular one is setting up a family trust, which would own the common shares. You would then identify the various beneficiaries, including your active and non-active children. As a trustee, however, you would still maintain some control over making decisions in the business and how the dividends paid to the family trust are distributed to family members that are beneficiaries of the trust. The rules on paying dividends to non-active shareholders could pose some challenges, so careful planning may be required in order to avoid any unintended tax consequences.

But this, too, raises more questions for families: How does each family member get involved in decision-making? Who gets a say in how the money is distributed to the beneficiaries? How do you compensate children who are active in the business versus those who are not? What happens when the children aren’t aligned with the family’s wealth goals?

To answer these questions and try to achieve harmony, developing a governance model is vital. Governance, which centres on how the family and the business make decisions, operate and communicate, allows for broader discussions about how the wealth is going to be transitioned to the next generation, and how to balance the different needs and interests of family members.

Think of it like a business. As an owner, you have structure and processes in place to ensure your business runs smoothly. Your wealth is the same: you’re still running a business; it’s just a different asset in the form of cash and investments. So, you need formalized processes in place to make decisions, align family members and steward your wealth for future generations.

And, just as your business didn’t grow overnight, your estate and succession planning won’t happen overnight. There’s no magic number for when to start planning, but a rule of thumb is five to seven years ahead of your exit from the business. Wherever you’re at, though, think about putting a plan in place that you can execute in a series of steps down the road. These small steps can help you achieve big things for your family and your business.