A corporation is no more than a legal fiction, but a powerful one. Without its organizational contributions, the growth in industrialization and living standards of the last few centuries would scarcely have been possible. Along with the invention of fire and the wheel, it has been one of the great devices that have vaulted humanity beyond the achievements of their fellow apes.
Corporations range all the way from global mega-corporations with millions of shareholders to small private corporations with only a few. For family businesses, the corporate form is an important vehicle for wealth preservation and the transfer of a business as a going concern from one generation to another.
An Estate Freeze with Corporate Shares Can Provide Valuable Tax Deferral
Where a small or medium-sized family business has increased in value, capital gains taxes could be a serious impediment to passing it on from one generation to another. The government, aware of the economic importance of the continuity of small businesses, has provided some leniencies in the tax code to reduce this burden.
The “estate freeze” permitted under section 86 of Canada’s Income Tax Act is one of the most important measures for this purpose. Ordinarily, if a parent makes a gift of shares in a family corporation (or passes them on by his or her will at death), capital gains tax must be paid based on the fair market value of those shares. For a business with good prospects and a growing value, an estate freeze can defer a substantial portion of this tax for a whole generation. In monetary terms, a tax deferral has huge value, as it means that the business retains a larger amount of capital on which growth will compound over many years.
A corporation is legally permitted to have an unlimited number of different “classes of shares,” designated as Class A through Class Z and onward to Class ZZZ… if necessary. Each of these classes can have different rights as designated in the articles of incorporation. An estate freeze involves the issuance of new classes of shares by the corporation, which are purchased by the next generation for a nominal price. Through an appropriate designation of rights, it can be arranged that all further growth in the value of the corporation accrues to the new classes of shares owned by the younger generation. As a result, at the time of the eventual death of the parents who founded the corporation, there will be no capital gains tax payable on this increase in value.
Risks of Unfortunate Outcomes when the Next Generation Gets Married
The parents who do an estate freeze are potentially giving away a great deal of wealth to the next generation. Nobody lives forever, and for most entrepreneurs, part of the incentive for accumulating wealth is the pleasure of being able to pass it on for the benefit of their children and grandchildren or even great-grandchildren.
Unfortunate pitfalls can arise, because real life doesn’t always have happy endings. It is often overlooked when a narrow approach is taken to estate freezing that ignores broader issues of estate planning. It is all well and good to give shares with growing value to your children, in the hope that it will benefit them and stay in your family for generations. However, bad things can happen to good people, and a prudent plan will attempt to guard against them. The adult children who receive the new shares from an estate freeze can enter into bad marriages that end in divorce. Even worse, the children may get married and then die childless.
People who have accumulated wealth through years of hard work and struggled to build up a business will have a sense of satisfaction from transferring their wealth to children and grandchildren that they love. Even if they are friendly with their childless son-in-law or daughter-in-law, they would rather have their wealth go to their own grandchildren. In the situation where they dislike the in-law, having the money go to them only makes it more aggravating. In such an unfortunate event, they would prefer the money to stay in the family, and come back to benefit their remaining children.
Protection against these risks could be assisted by a properly drafted will or pre-nuptial agreement when the second-generation shareholder gets married. In practice, many young adults are reluctant to deal with those issues. A will is a particularly unreliable method for dealing with it. Even if a will is executed by the young adult at the time of the initial share distribution, a will is automatically revoked when he or she gets married. Subsequently, if the shareholder dies intestate without children, all the shares will become the property of the spouse of the deceased.
An Unwanted Minority Shareholder Can Use the Oppression Remedy
An estate freeze will often create multiple classes of shares, with each child of the founders receiving a different class of shares. The directors of the corporation in theory have complete discretion over the dividends. Each class of shares can pay a different dividend rate, or no dividend at all. Under such an arrangement, the parents who founded the business, while they remain in control, can use their discretion to distribute income to different beneficiaries according to their needs. There will also typically be a restriction on share transfer.
Unfortunately, none of these safeguards is foolproof. Suppose that a person inherits shares, contrary to the share transfer provision. The Ontario Court of Appeal has ruled that such an event constitutes a breach of contract by the person responsible for the inheritance, but the transfer of shares is nevertheless effective.
Where shares have gone by inheritance in a way that was not desired by the founder, the founder can attempt to limit the damage where the dividends are discretionary. The founder, still in charge of the corporation, may pay little or no dividends on this particular class of shares. However, in such a case, a minority share owner may make a claim for oppression against the corporation, pursuant to section 248 of the Ontario Business Corporations Act, or an identical provision in the Canada Business Corporations Act for federally incorporated companies.
Under the oppression remedy, minority shareholders can apply to force the corporation to buy their shares at fair value, or if necessary to even require the corporation to be dissolved so that their share of the assets is paid out. The outcome will be uncertain, depending on the facts of each case. The courts developed the principle that in oppression claims, the reasonable expectations of the minority shareholders are to be given effect. Sometimes they have been successful in having the corporation dissolved, while in other fact situations they have not.
A Unanimous Shareholder Agreement Can Provide Additional Protection
This is where a well-designed Unanimous Shareholder Agreement (“USA”) can possibly save the day. Among the many clever contrivances within corporate law, the USA is one of the most powerful and most flexible. The Business Corporations Act allows the shareholders to make a contract among themselves to govern any aspect of the corporation. Moreover, the legislation specifies that a USA, once established by the previous owners, is binding on all subsequent owners of the shares. If the recipients of the shares did not purchase the shares at market value, “the person who acquired the share shall be deemed to be a party to the agreement whether or not that person had actual knowledge of it when he or she acquired the shares.”
One of the provisions that can be included in a USA is a mandatory buy/sell provision. This can specify that a triggering event, such as the death, divorce or disability of an existing shareholder, makes it mandatory for that person’s share to be sold back either to the corporation or to other shareholders. Through this, a family corporation or other closely-held entity can prevent undesired persons from becoming shareholders. The buy/sell provision sometimes states that the purchase of shares will be based on a calculation of fair value, but that is not a requirement for it to be enforceable. It can be at an arbitrarily set fixed price, and it will still be enforceable if this was made clear to the owners in advance. It has been observed by the courts that, when the provision is triggered by death, it can make the USA a testamentary instrument.
These matters can become complicated, and the appropriate approach will depend on the circumstances of each ownership group. Careful design is also needed to ensure that the tax code is complied with, to avoid defeating the intentions of the estate freeze. This brief review can only provide the most salient issues to be considered. If this is a matter of concern to you, it is important to seek focussed advice.