Refreezing your preferred shares by Kevin Keith, KPMG Lethbridge
December, 2009
If you own a company, as time has slipped by, chances are that some value has been built up. You may have considered some succession planning and done an estate freeze to lock in that value that has built up and have your children take on new common shares so that any future value would build up with them. There are many valid reasons why a scenario like this would have been done, including capping estate tax liability as well as transitioning the company to future generations.
This all works great in times when the economy is strong and business values are continually rising. So, what happens when the bubble bursts and the economy goes into a downturn as it has recently? The value of the business may now have become lower than the value of the frozen shares due to operating losses or declining asset values in the past couple of years and the initial goal of transferring business growth to future generations has not occurred.
The good news is that there is a solution. It is possible to refreeze or exchange old shares frozen at a higher value for new shares at the lower current market value. This will ensure that any increase in the value of the company will benefit the next generation of common shareholders. There are some advantages of this, including saving tax that would be required to be paid by the owner of the preferred shareholder on their death. There may be exceptions to this tax on death for qualifying farm company situations. Another area of concern with overvalued preferred shares, is if they end up in the hands of family members who are not involved in the ongoing farming business.
For example, let's assume that Jim had retired a few years ago, after farming through a company his whole career. He implemented an estate freeze to fix the value of his preferred shares at $2 million (fair market value at the time). His son, John, who was interested in taking over the farm business, bought common shares in the company so that any future profits from his work would accrue to him. Due to the downturn in the economy, the value of the farm is only worth $1 million today. Without a refreeze, any recovery will accrue to Jim, due to the fixed redemption value of his shares. But if the $2 million shares are exchanged for new preferred shares with a value of $1 million, then the estate value on Jim's death would be reduced to $1 million. If the shares create tax on Jim's death, this provides a net tax savings to Jim's estate of almost $200,000. Also, any future profits earned will then be attributed to John.
However, perhaps of equal concern to John is let's assume that Jim left preferred shares to his sisters, who do not farm. This could put John in a situation of working to pay his sisters value for shares which is not supported by the business operations.
In practice, if the value of the company preferred shares remains below the original value of the preferred shares the deemed disposition amount would be the lower of the two amounts. However, there may be some dispute with CRA over this matter. A refreeze will reset the value of the preferred shares so that there should be no dispute over the value those shares. It is important to note that refreeze will also lower the preferred share owner's assets and as such will need to be aware of the reduction in value.
There are many other advantages of a refreeze. Sometimes there are clauses that prevent paying out dividends to common shareholders if it will negatively affect the ability to redeem the preferred shares. In this situation, the planning options are more complex, therefore good legal and tax advice will be mandatory.
There are matters to consider in order to be able to implement a refreeze. If the company has a written shareholders agreement in place, it will need to be reviewed. A shareholder agreement may have restrictions on share ownership that requires all the shareholders to agree with the refreeze, otherwise it may not work. It is advisable to keep your banker informed throughout the whole process to ensure that there are no violations of any covenants tied to borrowings and make sure that they are on board with what you are trying to accomplish. Also, it is always a good idea to check with your lawyer to ensure that this will not put any business assets at risk.
Estate planning matters can be quite complex. We recommend that you speak with your professional advisors to discuss if a refreeze is right for your company.
kkeith@kpmg.ca
Kevin Keith would like to thank Dan Bosters of KPMG for his assistance with writing this article |
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