Today's column will focus on succession strategies for business owners with children who are poised to take over the business. Now how nice is that? Dad and mom have worked their tails off for 20-30 years and have built a solid business that generates a strong cash flow. The time to retire is on the horizon, and they are looking at exit strategies. Wouldn't it be sweet to bring their children into the business so that they can eventually take the reins and build on the success that their parents have achieved?

Despite less onerous capital gains tax rates in recent years, many business owners are concerned about the impact that increasing business values will have on the tax liability their estate will ultimately face. At some point, a business owner may decide that there is sufficient equity in the business to support his or her lifestyle indefinitely, and that it is desirable to pass future growth on to a family member - typically an adult child (or children) already involved in business activities. In these circumstances, an estate freeze may be the ideal estate planning tool. There are several ways of accomplishing an estate freeze. This column will address the two most common methods - the Section 85 freeze, and the Section 86 freeze.

The Section 85 Freeze

A section 85 freeze involves the transfer of a parent's common shares of an operating company to a holding company. In exchange, the parent receives preferred shares of the holding company, in an amount representing the then-current fair market value of the business. The common shares are acquired by the child or children who are to benefit from the freeze, at a nominal amount.

Let's look at an example...

Pierre and Jacques, who are unrelated, each own 100 common shares of Brunswick Glass Inc. (Brunswick), a manufacturer specializing in windows, doors and siding for the residential market. The fair market value of the Brunswick shares is $2 million. The Adjusted Cost Base (ACB) of the shares is nominal in each case.

Pierre would like to retire in five years or so. His daughter, Nadine, is active in the business and is anxious to become a shareholder. Jacques has no children who are active in the business. He is happy to continue working indefinitely and to have Nadine as a partner.

One way for Nadine to become a partner, and for Pierre to do some tax-smart planning, is for Pierre to undergo a section 85 estate freeze. Pierre would incorporate a holding company ("Pierre Co.") and would transfer his 100 common shares of Brunswick to the new corporation. In exchange, Pierre would receive 10,000 preferred shares of Pierre Co. These shares would have the following attributes:

¨ The shares would carry a fixed redemption price equal to the fair market value of the common shares of Brunswick, i.e. they would not fluctuate in value like common shares.

¨ The shares would carry enough votes to allow Pierre to control Pierre Co. (alternatively, the preferred shares could be non-voting and Pierre could subscribe for a separate class of nominal value voting shares in order to achieve voting control).

¨ The shares would be redeemable and retractable. In other words, either Pierre or Pierre Co. could at any time require the redemption of some or all of the preferred shares for their redemption amount.

¨ Pierre's preferred shares would likely have dividend privileges in preference to the common shares, and would also have preferential treatment on any future wind-up of Pierre Co.

At the time of the freeze, Nadine would acquire new common shares, either by way of subscription or as a gift from Pierre. These would have nominal value at the time of the freeze, but would reflect all the future growth of Pierre Co. i.e. half the future growth of Brunswick. For example, if the value of Brunswick rose to $2,600,000 in five years' time, the shares owned by Pierre Co. and Jacques would each be worth $1,300,000 at that time. Assuming Pierre Co. had no other assets, its shares would have a value of $1,300,000, $1 million of which would be reflected in Pierre's preferred shares, the same value as at the time of the freeze. The remaining $300,000 would be reflected in Nadine's common shares. In this way, $300,000 of capital gains otherwise taxable to Pierre would shift to Nadine.

The Section 86 Freeze

In a section 86 freeze, the parent would exchange his or her operating company shares for preferred shares having attributes identical to the preferred shares to Pierre Co. described in the previous example. The children would at the same time acquire common shares of the operating company at a nominal price.

The section 86 freeze is somewhat more popular than the section 85 variety because it does not require another corporation nor an income tax election. As long as the reorganization meets the relatively straightforward rules contained in section 86, the tax rollover is automatic. Clients should consult their professional advisors to determine which method is better for them.

Here's an example of a Section 86 freeze...

Linda is the sole shareholder of a successful optometry business known as Clear Vision Inc. (Vision Inc.). The ACB of her shares is nil and the fair market value is $1,200,000. Linda wants to do an estate freeze, and to bring in her daughter, Hillary, as a shareholder.

Under a section 86 freeze, Linda would exchange her Vision Inc. common shares for preferred shares having a combined redemption amount of $1,200,000. Hillary would acquire new common shares that would have nominal current value, but would reflect all future increases in the fair market value of Vision Inc.

As mentioned above, the income tax rollover in these circumstances is automatic. Linda will realize no capital gain as she will be considered to have sold her common shares for their nominal ACB, and to have acquired the preferred shares for the same amount.

There are many other factors that must be weighed and considered. It is essential that your qualified tax professional be consulted to help craft the appropriate estate plan, and ensure that all proper elections are made, and filings submitted.

Oftentimes, permanent life insurance is employed as part of the succession planning process. Consider the following:

¨ Parents who acquire preferred shares under an estate freeze frequently gift them, though their will, to children active in the business. Insurance on the life of the parent/business owner can be used to pay the capital gains tax liability arising from the deemed disposition of these shares.

¨ Alternatively, rather than gifting the shares to children, the estate of the parent may sell the preferred shares to the children under the terms of a shareholders agreement. Insurance on the life of the parent(s) can be used to fund this purchase.

¨ Insurance on the parent(s) can also be used to provide funds to children who are not active in the family business, and who are therefore not receiving shares under the will. This is frequently called "estate equalization".

In most cases, the ideal client for a freeze is someone within a few years of retirement, who has a child or children active in the business and in a position to assume increasing management responsibility. In these cases, it makes both business and tax sense to pass future corporate values to the children. In cases where children are very young, or are uninvolved in the business, the tax advantages of bringing them in as shareholders may be more than overcome by other factors. In these scenarios, a Family Trust may be useful, in that it permits the parent(s) to ‘wait and see'... meaning that control has not been divested and remains in the parents hands until such time as they feel one or more of their children are ready to assume control - at which time they can divest control to those children they feel are best suited.

The information in this article is not intended to constitute legal, financial planning or investment advice, and it may not be relied upon for such. Please seek specific professional advice with respect to your particular circumstances, as each client's financial situation is unique and solutions may vary. The strategies discussed herein are general. Mutual funds are not guaranteed and their values fluctuate on a daily basis. Investments may decline in value and investors may or may not receive back the original amount invested.