Business Valuation for Tax & Estate Planning

This blog post will discuss the concept of an estate freeze, which is a commonly used tax and estate planning tool. We will also discuss how an independent business valuation is an important part of that process.

What's an estate freeze?

Section 86 of the Income Tax Act allows for the tax-free exchange of shares in specific instances. It is commonly used for estate planning purposes. Section 86 generally allows for the transfer of one's shares to be done at fair market value, tax free. Generally, the owner of an operating company can exchange their common shares for preferred shares at fair market value and then issue new common shares to a person (such as a child) and then the child's common share value would be based on the growth in value of the company. At a high level, this is what is referred to as an estate freeze.

A simple example –

Suppose a single mother (Mrs. Smith) is the sole shareholder of her company that she started up from scratch over 20 years ago using her hard work and sweat (BusinessCo Inc.).  BusinessCo Inc. is now a highly successful service company and Mrs. Smith's shares are worth $1 million today, according to a recent business valuation she had. Based on the company's
current growth prospects her Business Valuator tells her that it is quite possible her shares will be worth $3 million in 15 years from now. Mrs. Smith is 65 years old today and her only child is her son Larry, who is 30 years old and is active in the business. Larry is poised to take over the company leadership role soon. Mrs. Smith is concerned about the taxes her estate will face upon her death and heard that an estate freeze is a good estate planning tool to implement.

2 Scenarios:

Scenario 1 - flash forward 15 years: Mrs Smith dies at age 80 but she DID NOT have the estate freeze done when she was 65

Assume that Mrs. Smith's Business Valuator was right and that her shares are now worth $3 million. Income tax legislation states that her shares are deemed to be disposed of at fair market value immediately before her death and therefore this triggers a capital gain for Mrs. Smith's estate of almost $3 million. This puts a significant tax burden on the estate, which may or may not have the liquidity to cover this big tax hit resulting from the full capital gain.

Scenario 2 - flash forward 15 years: Mrs Smith dies at age 80 and she DID have the estate freeze done when she was 65

If Mrs. Smith did the estate freeze when she was 65 she would have exchanged her common shares for new preferred shares with the redemption/retraction price of those preferred shares being the fair market value of the company at that time (which was $1 million). Her son Larry would have received common shares that would have been issued to him and therefore the future growth value of the company would accrue only to Larry's common shares. In other words, the value of Mrs. Smith's preferred shares would be “frozen” at $1 million and any growth in the value of the company over and above that would go to Larry’s common shares.

When Mrs. Smith dies at age 80 the value of her preferred shares would be the frozen $1 million amount of the preferred shares, since the future growth of company value of $2 million would have accrued to Larry's common shares. Therefore the capital gains impact on Mrs. Smith's estate would only be about $1 million and NOT the full $3 million, which would drastically reduce the capital gains tax impact triggered on Mrs. Smith's death.

Some other advantages of doing an estate freeze to Mrs. Smith is that she would know with certainty what the tax impact on her estate would be at the time of her death and could plan for it by using some tactics (such as using insurance) to address it. With the estate freeze in place Mrs. Smith can still retain voting control of the company, receive regular dividends but the growth in company value would go to Larry's shares.

So how does an independent business valuation from a Chartered Business Valuator (CBV) fit in?

An independent business valuation is important in a Section 86 capital reorganization estate freeze for a number of reasons:
 

• When doing an estate freeze, CRA says that the shares must be transferred at fair market value. In other words, when Mrs. Smith is 65 and exchanges her common shares for preferred shares it must be done at fair market value. If not there could be consequences from CRA due to what is known as a conferral of benefit issue. In the event that CRA determines that the transfer took place at an amount that is not at fair market value, then provisions in section 69 of the Income Tax Act might apply to the transaction and the consequences may be where one side of the transaction is adjusted by CRA but the other side is not, essentially resulting in double taxation hit. Chartered Business Valuators are well-positioned to provide an independent report on the fair market value of the shares.
• CRA requires that a bona fide reasonable attempt at value determination in a Section 86 capital reorganization be made. CRA does not formally define what is meant by a “reasonable attempt.” A valuation report from a Chartered Business Valuator is usually viewed by CRA to be a bona fide attempt.
• In the event of a possible dispute with CRA, tax practitioners may use a Price Adjustment Clause (PAC) in a Section 86 capital reorganization. Basically, a PAC retroactively changes the value that was transferred in the share exchange to the amount that CRA adjusts it to, in order to get around the conferral of benefit issue. However, an important point to keep in mind is that a PAC may NOT help if a bona fide attempt at valuation was not done in the first place. There are precedents where a court has rejected a PAC because the parties did not make a good faith effort to do a bona fide valuation.  Therefore, having a independent valuation report prepared by an Chartered Business Valuator would be a prudent step.

If you use an estate freeze as an estate planning tool it is important to have the valuation set independently by a Chartered Business Valuator to help minimize risk from CRA for future disputes on value, which could be quite significant.

Please contact Steve Skrlac, MBA, CFA, CBV to discuss business valuations for section 86 capital reorganizations or other corporate reorganizations.  steve@keystonebv.ca

Keystone Business Valuations
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This blog post is for informational purposes only and is not professional advise. Please talk to an independent professional.