An estate freeze is often recommended as an effective strategy for transitioning your business to the next generation. It offers tax efficiency and allows the business owner to maintain control. Let us walk through how an estate freeze works and what to consider before moving forward.
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What Is an Estate Freeze?
An estate freeze is a tax-efficient way to begin transferring ownership of your business to your children while still maintaining control and securing retirement income.
Here is a basic example of how it works:
- You currently own a business worth $5 million. This value is represented by your common shares.
- In an estate freeze, you exchange your common shares for preferred shares worth the same amount, $5 million. This exchange is done on a tax-free basis.
- Your children then subscribe to new common shares, which have an initial value of zero.
At this point, you hold preferred shares worth $5 million, and your children hold new common shares.
Benefits of an Estate Freeze
There are several advantages to using this strategy:
1. No Debt for the Next Generation
Your children become owners of the business without taking on debt. They do not have to borrow $5 million to buy your shares. Instead, they simply acquire new common shares with no initial value.
2. Incentivizes Business Growth
Since your preferred shares are frozen at $5 million, any future growth in the business increases the value of your children’s common shares. This structure motivates them to grow the business.
3. Tax Advantages on Sale
If the business is sold in the future, your children will be able to use their capital gains exemption to shelter tax on the sale of their common shares.
4. Retain Control
Preferred shares can be structured to give you voting control as long as you own them. If needed, you can step back in to take control if the business is not being run properly.
5. Retirement Income
Preferred shares can be gradually redeemed to provide retirement income. For example, redeeming $200,000 per year over 25 years would provide income while reducing your taxable estate.
6. Estate Tax Reduction
As preferred shares are redeemed, the size of your taxable estate shrinks. For instance, if you redeem half of your shares, your estate tax liability is reduced accordingly.
Additional Options
You can also have a family trust subscribe for new common shares instead of your children directly. This can add flexibility in terms of future ownership and estate planning.
Key Considerations
While an estate freeze offers many advantages, it is important to carefully weigh a few potential downsides:
- Control Dynamics
Will your children be comfortable with you maintaining control until you pass away? - Motivation
Will your children remain motivated to grow the business if they do not have personal financial investment at stake? - Retirement Risk
If you are relying on the business to fund your retirement, are you confident your successors will manage it profitably enough to provide your required income? - Family Risks
Divorce or separation of your children could introduce risks to business ownership.
Final Thoughts
An estate freeze can be an excellent tool for transitioning your business to the next generation in a tax-efficient way. It allows you to maintain control, protect your retirement income, and reduce future estate taxes. However, like any strategy, it is not without its challenges.
Before implementing an estate freeze, be sure to work closely with your team of professionals, including your accountant, lawyer, and financial planner, to ensure it fits your family and business goals.
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