TAX ALERT

Estate Planning During an Economic Downturn

April 27, 2020

Freezing or Refreezing Your Estate

The impact of the COVID-19 pandemic has many of us feeling like we no longer have control over anything. The enormity of the global effects on most industries and businesses is difficult to comprehend. Dealing with the here and now has taken priority over planning for the future, but lower company values may provide a timely opportunity for succession planning. Typically, succession plans for family-owned businesses include a strategy for the next generation to take over the business in a tax-effective manner that avoids cash flow concerns for either party. For example, parents could sell shares of their business to their children at fair market value (FMV), or have the children acquire new shares from treasury at FMV. This can be costly – the children may not have access to financing and vendor financing can also cause cash flow issues for the parents.

Estate Freezes

One solution is an estate freeze, whereby common shares of the business held by the parent are exchanged for preferred shares on a tax-deferred basis. This essentially transfers all of the company’s current value to the preferred shares. If a company is worth $1 million, the preferred shares are then issued with a value of $1 million; the value is fixed, or ‘frozen’, at this amount and new common shares can be subscribed from treasury at a nominal amount. The value of the preferred shares is retained by the original shareholders and all future growth belongs to the new common shareholders, which is typically the next generation. The new common shares can be subscribed by individuals, or instead by a family trust in order to maintain control and provide flexibility.

In Canada, you are deemed to dispose of your capital assets immediately before death. Another benefit of an estate freeze is that the maximum estimated estate tax on the freeze preferred shares is a known value that can be managed.

Refreezing Your Estate

Given the current landscape, the value of a company may have declined such that it is below the value of existing preferred shares issued on a previous freeze. In these situations, it is possible, and may be appropriate, to refreeze at the lower current value; this prevents paying estate tax on a value that has already decreased.

Valuation

In any estate freeze or refreeze transaction, it is vital to determine and document the FMV of the company, including the value of the associated underlying assets. In some cases, this may seem straight forward, such as an investment company holding a portfolio of investments. While a brokerage report will provide a current investment value, relying on it will ignore issues such as investment liquidity, premiums due to shareholding influence, terms of a shareholders’ agreement, any trading restrictions or contingencies embedded in the company. Of note is the effect on value of a COVID-19 influenced market downturn – shareholders of the company may perceive it to be temporary in nature or potential buyers of the company may be sitting on the sidelines until the markets settle down.

Let’s consider a real estate holding company. While an appraisal is relatively simple to obtain, it relies on comparable historical transactions less relevant during a COVID-19 period, and it may not account for temporary market illiquidity conditions. It is also noteworthy that an appraisal simply values the real estate, it does not consider any company specific issues.

When determining the FMV of an operating company, particularly one expected to include goodwill value, additional complexities arise. As the FMV of a company is based on future expectations of cash flow, one must consider the impact of COVID-19 on near-term and long-term cash flow. Timing for the company to return to ‘normal’ operations and changes in the risk profile of the company also need to be considered. One must also evaluate overall market conditions during the COVID-19 period. While a company may have theoretical value, the marketplace for acquisitions may have dried up resulting in decreased FMV.

current marketplace conditions as a result of COVID-19 and the possible increased Canada Revenue Agency of COVID-19 period estate freezes, it is important to seek the advice of a valuation expert.

Implementation

Estate freezes and refreezes are complex transactions which could attract various adverse income tax consequences such as attribution rules, shareholder benefits and anti-avoidance rules. In addition, the FMV used for assets and/or shares should be supportable using accepted valuation techniques. Professional advice is a must when considering implementing these strategies. If you have questions or concerns about these types of transactions, or about how a decline in value has affected your business or estate plan, please contact your MNP Advisor.