Once retirement is on the horizon, an estate freeze can allow a business owner to gradually transfer ownership to the next generation while also dealing with tax concerns proactively. Kim Parlee speaks with Georgia Swan, Tax and Estate planner with TD Wealth, about this common strategy.
Originally recorded March 2020.
- OK. You're a small businessperson who has built up your business from the ground up over the years. Now you're successful, and you've reached all your personal financial goals. Congratulations. But you don't want to expose your company or yourself to more tax than you need to. With retirement on the horizon, what do you do?
One option is something called an estate freeze, and here to tell us all about it is Georgia Swan. She's a Tax Estate Planner with TD Wealth. This sounds complicated, so go slowly for me. Let's just start with the basics. What is an estate freeze?
- Well, an estate freeze is basically a way of transferring usually a family-owned business from one generation to the next generation. And what's good about it is that it helps to defer taxes. It helps in the retirement plan of the parent owner, and it also helps in that transition getting the kids to now have an ownership interest in the family business.
- Now, you and I have talked about this before. And in terms of the way this happens, you're transferring some ownership to the children, which is great because then they're bought in, and hopefully they're excited and moving it forward. But I know that it also allows for the parents, let's say, in this situation who built it to retain control.
- That's correct. The way it works is basically, as you know, a company is owned through its shares. And at a simplistic level, there are two types of shares. There's common shares and preference or preferred shares. You can call them either way.
Now, the common shares are the ones that are tied to the value of the company. They increase in value as the company becomes more successful and grows. But the preferred shares, usually in private corporations, are basically only worth whatever you first acquired them for. So their value doesn't change, so there's no capital gains if you dispose of them.
But the reason they're preferred is that they have other things that are good about them. So one of them can be retaining control. The other one could be that they get dividends before the common shares get dividends. So the way an estate freeze works is that the parent who wants to transfer the business to the kids transfers their common shares to the children so that they now have the growth, they now have a vested interest in the success of the company on a go-forward basis, but the parent retains those preferred shares.
They don't change in value, so therefore, when the parent passes away, the tax liability is known. And they can retain the control and the votes. The only issue is that private companies and family businesses are not always run as formally as public corporations with the board meetings and so forth.
- And the governance and all that stuff.
- Exactly. So sometimes that vote is more around the kitchen table as to what the family is doing with the business at any one time.
- And I'm sure that the parents retaining control for an extended period of time might be an issue too in terms of when the children want to actually get full control over things and do things as well. How early do you need to start thinking about this? I'm assuming the issuance of shares and share structures-- that's something you do on a Friday and put in place on a Monday.
- No. Early. I would say maybe even 10 to definitely 5 years before you're planning on retiring, because there is a lot of things you should think about. First of all, look at your children and look at them honestly and say, are they ready to take over the business?
- Or do they want to?
- Exactly. And what do you need to do to help them succeed once they do take over? Then you have to be realistic about your retirement goals. So do you still need an income from the business, or are you going to have enough saved outside of the business in order to be able to retire and have an income?
Then these are complicated. You need to have competent legal, tax, accounting advice. And as a matter of fact, the children should have their own people, and you should have your own people.
- One of the benefits you also talked about, I think, is that if the owner-- or sorry-- the people who built it-- say the parents, in this case, who built the business, and they have the preferred shares, and they need-- their business value is part of their retirement. This protects this event.
- Exactly, because those preferred shares can have a guaranteed dividend per year, for example. So that way that, the parent owner or previous owner can continue to receive an income into their retirement. And that's the issue. A lot of times with family businesses, that's the biggest family asset. And where it's not sold, where it's transferred to the children instead, the parent needs some income to retire on.
- What are the red flags?
- The red flags are really somewhat of a lack of planning-- so basically, people not really understanding what this means. Another red flag could be the idea that once the parent is no longer really the owner of the business, and the kids have ideas about what they want to do and how they want to grow the business, disagreements can happen. And if the children are not managing the business properly and effectively, and the business just basically goes offside, the whole thing can crumble. And at one time where you might have had a viable, vibrant business that could have had value to be sold, you now actually have a business that is ailing and may not have the same value.
- What-- I mean, you do this. You work with people all the time. They're trying to figure this out. You've got some-- you've got a story of one that didn't go particularly well.
- Mm-hm. So we had a situation with a business owner who-- it was actually a multigenerational business that had been transferred to him from his father, and then he ran it for quite some time. And it came time for him to retire, and he decided to transfer it to the son. And the son was not equipped to really run the business well. And within a fairly short period of time, the business started losing money significantly.
And as a result, the parent whose retirement was tied to the business-- there was an expectation of income-- was not getting that income. And they tried to speak to their child, and it just did not work out. It ended up with the parents actually suing their own child. So of course, there were the legal fees. There was the loss of that family bond.
And these-- while they can be undone-- there's something called an estate thaw, as a matter of fact-- they're not easily undone. And in this particular case, because it had gone to court, there was an order that the parents' shares be redeemed-- in other words, bought back by the company. But because of the way this was structured in the first place and the fact that it wasn't intended to be undone during the parents' lives, the parents ended up having a huge tax liability when this happened. So not only was there a loss of the family relationship, but because of a lack of understanding of how this was really going to work, there was a loss of financial well-being for the parents as well.
- If someone's thinking about this, and they hear that cautionary tale, what do they need to think about to make sure that it's a success and doesn't end up like that?
- First of all, start early. As I said, 5 to 10 years, definitely. Then take a good, long look at your family and the people to whom you want to transfer this business. Are they equipped? Do you have to do something to help them be successful? Because sometimes, that's not the answer. Sometimes the answer is to actually sell the company.
Make sure you have excellent, experienced professionals not only on your side, but on the children's side as well, good lawyers, tax accountants, and regular accountants. And as I said, be realistic about what everyone's expectations and goals are with respect to this whole transaction. If it's tied to your retirement plan, then it has to be structured in such a way to protect that.
- Georgia, thank you.
- Thank you.