Estate Freezes and Succession Planning: When Might An Estate Freeze Make Sense?

If you own a successful private company, there’s a good chance a significant portion of your wealth is tied up in the business.

As that business grows, so does the value of your shares. That can be great while you’re building the company, but it can also create a larger tax bill down the road, particularly when those shares are eventually deemed to be disposed of at death.

For business owners thinking about succession and estate planning, one strategy that may be worth exploring is an estate freeze. An estate freeze can help fix the current value of your interest in the company while allowing future growth to accrue to the next generation or other future owners. It can be a useful planning tool, but it needs to fit your broader succession, tax, and estate goals.

What is an estate freeze?

Broadly speaking, an estate freeze “locks the current value of your ownership interest in a company into a special class of shares.

A common transaction involves exchanging your existing common shares for preferred shares with a fixed value. New common shares can then be issued to another person, such as a child, other family member, key employee, or even a family trust. From that point forward, future growth in the value of the company accrues to the new common shareholders rather than increasing the value of your frozen shares.

For example, if your shares are worth $5 million when the freeze is completed, your new preferred shares might be fixed at that $5 million value. If the business later grows to $8 million, the additional $3 million of growth would accrue to the holders of the new common shares rather than increasing the value of your frozen interest.

The tax and legal mechanics behind that process can vary considerably, which is why the transaction needs to be carefully planned.

Why would a business owner consider one?

One of the main reasons is estate planning.

When you die, you are generally deemed to have disposed of your capital property at fair market value immediately before death. For an owner whose private-company shares have appreciated significantly, that can create a sizeable capital gain and tax liability for the estate that could be a burden for your survivors and even destabilize the company.

An estate freeze doesn’t make the accrued gain disappear. Instead, it limits future growth in the value of the shares you continue to own. That gives you a clearer picture of the value that may ultimately be subject to tax and can make it easier to plan for how the resulting liability will be managed and funded.

It can also be an important succession-planning tool. If a child, family member, key employee, or other successor is expected to take a larger role in the company, an estate freeze can allow them to participate in the business’s future growth while the current owner is still involved.

If you’re still working through the broader question of who might eventually take over, our article on succession planning for a successful retirement looks at some of the other decisions worth considering.

Why does valuation matter?

A successful estate freeze depends on knowing what the business is worth at the time of the transaction. The value assigned to your existing shares generally determines the value being “frozen,” so the transaction needs to be supported by an appropriate valuation based on accepted valuation methods.

That valuation matters not only for tax purposes but also for fairness between the current owner and whoever will participate in the company’s future growth. If the business is worth more or less than assumed, serious tax and operation issue might arise. . That’s why valuation should be considered an integral part of the planning process rather than something added at the end.

For more background, we’ve previously looked at why business valuations can be particularly important in succession and estate planning.

Does an estate freeze mean giving up control?

Not necessarily.

A freeze changes how future economic growth is allocated, but the current owner may still be able to retain voting control of the company depending on how the share structure is designed. That can make an estate freeze attractive to owners who are ready to begin a transition but aren’t ready to step away from the business entirely.

The key distinction is between ownership value and control. An estate freeze can help shift future growth without necessarily requiring the owner to immediately surrender decision-making authority and enable the continued success of the business.

When might an estate freeze make sense?

An estate freeze may be worth discussing if:

Your business has appreciated significantly and you expect it to continue growing;

• You have identified children, family members, or other successors who may participate in the business’s future;
• You’re comfortable with the current value of your interest in the company;
• You want greater certainty around the value that may eventually be subject to tax in your estate; and/or,
• You want to begin transferring future growth while remaining involved in the business.

It’s also important to consider whether the value you retain will be sufficient to support your own financial needs. Once future growth has been shifted elsewhere, you generally won’t participate in that growth in the same way you did before.

Depending on your objectives, different freeze structures may be available, including arrangements where only part of your interest is frozen. Those choices can have different tax, ownership, and control implications, so the details matter.

An estate freeze is one part of the bigger plan

An estate freeze can be a useful tool, but it shouldn’t be considered in isolation.

The right structure depends on the value of the business, your own financial needs, who will participate in future growth, how much control you want to retain, and how the transaction fits with your broader succession and estate plans.

It may also require coordination between your accountant, business valuator, and lawyer to make sure the tax, corporate, and legal pieces work together.

If you’re starting to think about stepping back from your business, an estate freeze may be one option worth exploring. Contact your DMCL advisor to discuss whether it could fit into your succession and estate planning.