Consider this example: Over the past 20 years, Steve, the sole shareholder of a residential construction business called ConstructCo, has grown his business into a successful enterprise that is generating profits in excess of his own personal cash flow requirements. Steve is married and has two adult children currently attending college. The spending habits of Steve’s wife and children require him to draw a significant amount of cash from ConstructCo. This puts Steve into the highest tax bracket on every dollar over $125,000 that he removes from ConstructCo each year. Knowing his wife and children are in lower tax brackets, Steve would like to issue ConstructCo shares to his wife and children so that dividends can be paid to them to cover their cash requirements. Paying dividends to Steve’s family would reduce his income subject to high rate tax, and increase his family members’ income which is subject to lower tax rates. Overall, the family could reduce their combined tax liability by over $30,000 each year assuming Steve would otherwise withdraw $35,000 for each of his family members and they had no other sources of income.
The problem is that the profitability of ConstructCo makes the value of the ConstructCo shares significant. Issuing ConstructCo shares without taking something back in return could create a significant tax liability for Steve’s wife and children. Steve might consider simply giving some of his shares to his wife and children but this too can create immediate and ongoing taxes that Steve will be subject to. A solution to this could be to implement a ‘freeze’.
A freeze is a technique whereby the current fair market value of ConstructCo is ‘frozen’ by exchanging the common shares for ConstructCo preferred shares that have a redemption amount equal to the fair market value of ConstructCo. With the value of ConstructCo ‘frozen’ in the value of the ConstructCo preferred shares, new ConstructCo common shares can be issued for just a few dollars to Steve’s wife and children.
When implemented correctly, the exchange of Steve’s common shares for preferred shares is a tax free transaction. Steve pays no tax on the transaction and will have achieved his goal of issuing ConstructCo common shares to his wife and children. Assuming the shares have the correct attributes, ConstructCo can now pay dividends to Steve’s wife and/or children to the exclusion of Steve.
This is a simple example of how a freeze can be used to split income between family members and reduce the overall tax liability of the family. This example does not address other tax issues that could result from this transaction, and implementation of this plan should not be completed without the assistance of a tax professional.
In practice, freezes are implemented for many reasons and will often involve holding companies and family trusts. In a future article I will discuss how a freeze could be used as part of a plan to save Steve an additional $490,000 on an eventual sale of ConstructCo.
This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.