By Maurie Cashman
An estate freeze is an ownership transition planning strategy used to defer taxes payable by limiting the taxable capital gain that has to be realized on death. Once the freeze is in place any future growth in the capital property is transferred to your heirs.
For example, if your business is incorporated, then the value of the shares you own in your company will hopefully increase over time. On death, for purposes of income tax, you are deemed to have sold the shares and your estate must pay taxes on the unrealized capital gain. To cover the tax liability, the estate may be forced to sell the business under adverse terms.
Avoiding these taxes sounds too good to be true doesnâ€™t it? To quote Meatloafâ€™s lyrics from Paradise by the Dashboard Light (hope Momâ€™s not reading this): â€œStop right thereâ€¦I gotta know right nowâ€¦ before we go any further do you love me? Will you love me forever will you need me? Will you never leave me will you make me so happy for the rest of my lifeâ€¦?â€ Weâ€™ll talk about those issues next week but for now, on with the show.
An estate freeze is an asset management strategy to transfer assets from an estate owner to his beneficiaries while deferring tax consequence. Usually the estate owner transfers common stock in exchange for preferred shares. The company will give the beneficiaries new common shares at market value, so that no capital gain exists for the receiving parties on the exchange. Because preferred shares are non-growth securities, the original owner will not incur future capital gains taxes on the preferred shares or on the original common shares.
Asset Appreciation for Heirs
The advantage of an estate freeze is that the current value of stock can be locked in for one person, while attributing the value of future growth of that stock to another person. It is generally used in transferring a business from one generation to the next. Appreciating assets may be transferred from parents to their children on a tax-deferred basis. This provides taxation and estate planning advantages by ensuring the current owners (the parents) of the shares can minimize capital gains and estate taxes while allowing their heirs to benefit from the increase in value of the asset after the estate freeze.
From the time of the estate freeze, any increase in value in the business accrues to the heirs. The property held by the parent, who puts the estate freeze in place, does not grow in value. This can make an estate freeze very effective if your company will continue to grow in value. It also solves the problem of how to pay the estate taxes without having to sell the golden goose, the company, which you would like to keep at the top of your familyâ€™s beanstalk.
The main value of an estate freeze is the tax deferral. The longer that payment of the taxes can be deferred, the higher the value. By deferring payment of taxes, you have more cash available to use in your business. This allows you to put that cash to work to further increase the value of the business and to pay those preferred dividends that the parent will now be reliant on. This re-investment can also make the company more valuable to an outside buyer should the children want to sell out and move to Margaritaville.
An estate freeze can help you minimize the taxes arising from your death and can also buy time to prepare your heirs to take over the business. It can be part of the process to carry out an ownership transition plan under which the children will eventually take over the business and be ready to run it when you want to retire. Even if in the end you decide not to do the estate freeze, going through the process may be of value for this purpose alone.
However, as Meatloaf came to lamentâ€¦â€So now Iâ€™m waiting for the end of time so I can end my time with you.â€ Next week weâ€™ll expand on why those lyrics may become frozen in your head along with your estate freeze.