As business owners age, retirement and transferring the business to the next generation becomes an important concern. An estate freeze is a classic transfer technique that allows the founder of the business to get a fair value for the business while retaining some control over the decision-making process during the transition period. For the next generation, it’s a way to acquire the business without having to incur massive debt.
How an Estate Freeze Works
The first step is to value the business. In some cases, that is a fairly simple process, in others, you may need to retain the services of a professional. For tax authorities to accept the estate freeze transactions, they must be made at fair market value. As a rule of thumb, fair market value is the price that a reasonably interested buyer would pay to a reasonably interested seller. After determining the value of the business, you convert the current common shares, owned by the founder, into preferred shares with the right to be redeemed before any other shares. In this way, any capital that comes out of the company goes to these shares. For example, if the company is valued at $1 million, the preferred shares will be entitled to the first million dollars of capital. In this way, all of the company’s value will be, at that precise moment, frozen in the preferred shares. New common shares can then be issued to the next generation of the family for a nominal consideration. In this way, they will benefit from all future growth. There are variations of this technique that use holding companies, family trusts, and multiple types of shares. You should consult a tax professional to determine what works best for your particular situation.
Freezing the value of the company is only a first step towards retirement for the founder or owner of a company. Cashing out on the value of the shares is also important for the retiring founder. As such, a plan should be put in place to gradually buy out the preferred shares. In the example above, it could be done over a period of 10 years, at $100,000 a year, with or without an interest component. Families often agree to use a set percentage of the annual profits for example 50% to make sure that the new buyers have enough cash flow to prosper,At the same time, the seller will want to retain some form of control over the decision-making process until he has been fully paid. This can be achieved through multiple voting shares, a shareholder’s agreement, or a will. Passing on a family business is always a challenge, but using an estate freeze is a great way to begin the process and ensure that it is fair for all involved.