Succession Planning Best Practice: Estate Freezes – No Panacea!

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In Expert Q&A Grant Robinson – Business Transition
Q:
Does your experience tell you that estate freezes that result in passing post-freeze value growth to next generation family members at no out-of-pocket cost to them is a good or bad thing?

 

A:

Is an estate freeze a powerful tool or a pandora’s box?

Used properly in conjunction with a comprehensive family business planning best practice strategy, the estate freeze tool is potential powerful and can do good things for a family. However, I find most entrepreneurs and family members don’t understand the implications and consequences of the tool if it is used in isolation as a tax planning tool – which in my experience it typically is.

Simply put, estate freezes driven only by income tax considerations typically do more long-run harm than they do short-term good. This where often estate freezes seem to perceived as a proxy for a comprehensive family business transition plan which they are not. While estate freezes may form part of a comprehensive family business transition plan, to talk about those two things in the same breath is equivalent to saying mice and elephants are both animals.

In my experience an estate freeze often:

  1. is used purely as a tax planning tool
  2. is used in isolation of fulsome family business transition planning and execution
  3. creates accidental business partnerships that often don’t work out in the end
  4. isn’t the panacea business owners are led to believe
  5. in the end proves to be a disaster in the contexts of both family harmony and business success or failure

Typically an estate freeze transaction that is not part of a comprehensive business transition plan results in two important things happening:

  1. the next-generation family members pay nothing by way of real consideration at the time of the freeze, and hence don’t appreciate their “something for being a family member” (read “something for nothing”) where that can lead to entitled, or more entitled, next generation attitudes
  2. the next-generation family members inherently are placed by their parents in a form of business partnership that most often is not well documented by written agreements, which in the end as things unfold often leads to acrimonious family relationships, and at extremes family litigation

Many estate freezes are contrary to succession planning best practice

The following are two critical observations I have made based on my extensive hands-on experience gained through bringing business succession best practice to my family business clients.

First, typically when I ask a room of advisors if they would like to be in business with their brothers and sisters, I rarely get any more than 5% raising their hands. And when I ask how many clients have implemented an estate freeze based on their advice for managing taxes, about 95% of the room raises a hand. In essence, these advisors have created partnerships for their client’s next generation that they would not create for themselves. This without a comprehensive family business succession planning best practice discussion that includes a review of:

  1. future business viability
  2. likely impacts of technological advances on the business, and on its prospective after-tax free cash flows
  3. prospective risks and rewards facing the business and its owners
  4. post-freeze decision making
  5. post-freeze family member employment and compensation
  6. possible strategic purchasers for the business
  7. whether an arm’s length sale is a better transition strategy in our new normal and low interest rate environment
  8. post-freeze business value growth rates under continued family ownership
  9. corporate governance implementation under continued family ownership, and
  10. multiple other important discussion points

Second, over many years I’ve seen very many parents implement an estate freeze and subsequently come to focus on facts that include, but are far from limited to:

  1. they (the parents) without thinking all the consequences through, put their children into a family partnership without any robust and meaningful conversation
  2. neither they nor their children at the time of the freeze understood all of the business and personal implications of the “income tax driven” transaction the parents had initiated and documented
  3. the next generation partners aren’t necessarily all interested in the family business other than for the lifestyle it provides them
  4. the next generation partners aren’t all necessarily equipped to participate in the family business as either executives or employees
  5. the “children business partnership” may have been (as often occurs) structured without shareholder agreements being executed, and if such an agreement was executed that may have occurred where the children were not represented by independent legal counsel
  6. there may have been inadequate consideration given to problems that might arise in the next generation pursuant to matrimonial law
  7. their children had not focused on the fact that they were indirectly entering into a business partnership with their siblings and parents
  8. it is not a good thing to be in business partnership with one or more people, in this case siblings, that you wouldn’t necessarily have yourself chosen as a business partner
  9. without a common business vision and without the next generation owners sharing a common business risk profile the business partnership is likely to end up in disagreement and disarray, or worse

Estate freezes – conclusion

An estate freeze may prove to be an effective way to manage taxes. However, often an estate freeze will be perceived to solve short-term problems only to lay the foundation for substantive long-term problems. Stated differently, an estate freeze can in the end be akin to the athlete who “snatches defeat from the jaws of victory”.

As a minimum, where an estate freeze is done to better manage taxes there should be an agreement signed by the shareholders that states how family members can monetize their interest and leave the real ownership with those who want to carry on the business.

An estate freeze used in conjunction with a well thought-out comprehensive family business succession planning best practice exercise can be a great tool if all stakeholders understand the purpose and the mechanics behind the estate freeze and how it logically fits with a comprehensive family business succession planning best practice plan and strategy.

And that’s where robust and meaningful family/multiple expert communication and family communication comes in.

Grant Robinson FCPA FCA

One of Canada’s leading family business transition planning specialists, Grant Robinson has provided business succession advice to Family Businesses and Business Families for over 30 years. He is a Fellow of the Chartered Professional Accountants of Ontario, a former board member of the Canadian Association of Family Enterprise, and a Fellow of the Family Firm Institute.

Grant is the mind behind BDO Canada LLP’s SuccessCare Program™, which program has contributed to the business transition skills of over 3,000 professional advisors.

A seasoned speaker on family business succession planning best practice, his anecdotal approach enlightens and entertains his audiences while inspiring business families to plan sensibly for the future. You can reach Grant at gcrobinson@bdo.ca, or by telephone at 800 598 6400.

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