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In this article, Margaret O'Sullivan, LL.B. TEP (1), argues that an estate freeze should never be treated as a technical tax exercise. Although tax minimization may be the primary motivating factor in implementing an estate freeze, the various ramifications of an estate freeze must be appreciated and evaluated from a broad-based wealth management and family dynamic perspective.
Table of Contents
Hindsight is of course always 20/20. And certainly there is more than one client who in implementing an estate freeze wants to have their cake and eat it too. The following comment on estate freezes is particularly salient (2):
"... history has shown that the strong desire of clients and their professional advisors to save taxes through the estate freeze mechanism has, on occasion, blinded those involved to the full legal implications of their actions. The 'gift' of common shares to children in the typical estate freeze is an irrevocable one. It truly makes a child a shareholder. The minority shareholder status of a child will mean that in the event of family discord in the future, corporate actions which would be fully appropriate in a 'singleman corporation' will be subject to scrutiny under a variety of statutory and common law doctrines which in at least one crucial respect do not provide recognition for the fact that the complaining shareholder's status arose out of gift. The founder of a company may, in such an event, be shocked to find the company is no longer really 'his' ...."
In order to analyze the fundamental changes which take place as a result of an estate freeze in which a holding corporation is used as the freeze vehicle, and family members become shareholders or act as directors or officers, an understanding of general corporate governance for private corporations is helpful, including the various remedies corporate law provides where rights are infringed on. Examples of cases where family members have attempted to seek recourse through the courts to invoke their legal remedies in an estate freeze context will also be reviewed.
Directors and officers of corporations are fiduciaries and as such have fiduciary obligations. These include that they must act honestly, in good faith and in the best interests of the corporation. As well, they must not act in conflict with the interests of the corporation nor may they engage in self-dealing. As a result of these obligations, the business owner, who prior to an estate freeze had total control and ownership, after he or she implements the freeze (for example by transferring growth shares to other family members, whether directly or by way of a trust) is in a significantly different position. Although he or she may think he or she still "owns" the company, this is no longer the case. There are now other owners at the table as well. The founder's corporate conduct may come under close scrutiny and be challenged, including in the legal arena, especially should family relations deteriorate. For example, if excessive salary is paid to the freezor, or if his or her expenses or allowances are too generous, or if there is an improper or unfair allocation of expenses between the freezor and the company, such allegations may be challenged.
Corporate law at both the federal and provincial level provides governance procedures which must be adhered to. It gives shareholders rights to certain information which a sole shareholder would not otherwise have to make available. For example, under the Canada Business Corporations Act ("CBCA"), there is an obligation to have audited financial statements and to provide them to shareholders unless dispensed with on consent of all shareholders. There is also a requirement for annual shareholder meetings. As well, under the Ontario Business Corporations Act ("OBCA"), if certain fundamental changes are to be made to the corporation, there is a right to a class vote. Accordingly, a majority shareholder cannot act unilaterally.
Corporate law provides a veritable arsenal of weapons available to disgruntled shareholders, directors and officers and other "proper persons." The oppression remedy under Section 247 of the OBCA (a relatively new remedy that has been termed "corporate divorce") allows a shareholder, director, officer or other proper person to complain of conducting relating to injury suffered in that capacity. A remedy under this section may arise where conduct "is oppressive or unfairly prejudicial to or that unfairly disregards the interests of any security holder, creditor, director or officer of the corporation," and applies to a wide range of conduct. "Unfairness" is determined objectively according to the standards of a reasonable commercial bystander and looks to reasonable underlying expectations of those with an interest in the corporation. The court has discretion to order a broad range of remedies, including requiring that the shares of a shareholder be purchased, compensation be awarded to an aggrieved party, the corporation be wound-up, directors be replaced or a receiver appointed.
Section 184 of the OBCA provides a remedy if a shareholder dissents to a fundamental change which a corporation proposes to make, for example, amending share rights or articles, amalgamation, or sale of all or substantially all corporate property. In such events, a shareholder may dissent and secure a court order requiring that his or her shares be purchased at fair value.
Section 206 of the OBCA provides for winding-up of a corporation where conduct is oppressive or unfairly prejudicial. This provision has been used in deadlock situations where there has been complete frustration of the underlying purpose of the corporation, or a fundamental breach of underlying understandings.
How corporate legal concepts and remedies have actually been applied in a family situation is very helpful in understanding their power. John Chapman (3) put it well in his comment on the uniqueness of each family situation in the context of an estate freeze:
"Tolstoy said it best: All happy families resemble one another, each unhappy family is unhappy in its own way (4). So it is in the litigation which has arisen out of estate freezes. Although common threads can be seen, in each instance there is a unique combination of personal relationships, ego, vanity, selfishness, greed, jealousy, disappointment, slights (real or imagined), foolishness (of young or of old age) and of a yearning to be loved, appreciated and respected which compels the characters to act as they do."
Naneff vs. Con-Crete Holdings (5) is a particularly good demonstration of use of the oppression remedy in an estate freeze situation.
In this case, Naneff Sr. ("N"), the founder of the business, froze his estate, and gave each of his two sons one-half of the common shares in the business, while retaining control through his voting preference shares.
Initially, there was family harmony, and father and sons worked well together in the business. However, the younger son, ("A"), began a relationship with a divorced woman which the family disapproved of. This led to a breakdown of family relations. Ultimately, A was fired from the company, removed as a director and refused repayment of his shareholder loans.
At trial, the court found that the actions of the father, ("N"), to have been "oppressive" and ordered that the business be put up for auction, at which each of N and his two sons could bid. On appeal, the court held that the remedy given by the trial judge did more than "rectify" oppression, and that it gave A, the younger son, more than what his "reasonable expectations" were, since these would not have included the possibility that he would control the company during his father's lifetime. Instead, the appeal court substituted the remedy that A's shares be bought out at fair value with no minority discount.
Another example of application of the oppression remedy in the context of an estate freeze is 820099 Ontario Inc. v. Harold Ballard Ltd.(6) Harold Ballard ("HB") froze his estate in 1966, and gave his three children non-voting common shares of his holding company, while retaining voting control. At the time of the freeze, his shareholding was worth about $3M. By the late 1980's, the value of the children's' shares had increased dramatically to about $60M.
A deterioration in family relations occurred, and HB wished to reacquire his children's shares. In 1989, he purchased his daughter's shares for about $15.5 M and one son's shares also in 1989 for about $21M. However, his third child, William Ballard ("WB") refused his father's offers to purchase his shares.
The corporation was re-organized and a share issue occurred to finance the purchase of the children's shares, and to ensure HB's control over the operating company, Maple Leaf Gardens. As a result, WB was "frozen out". WB brought an action to nullify the re-organization on the basis that it was oppressive conduct. The court held that in effecting the re-organization, the directors had acted for an improper purpose, that they acted only in the interests of the majority shareholder, and that they did not consider the interests of the minority shareholder. As a result, it set aside the re-organization.
Another factor to be borne in mind in deciding whether to implement an estate freeze is the potential impact of matrimonial property law in the event of a matrimonial breakdown or death of a family member who is a shareholder.
The Family Law Act (FLA), as well as the matrimonial property legislation of many other Canadian provinces, gives certain rights to division or sharing of matrimonial property or its value. In
Where a child is the owner of private company shares or is a beneficiary of a family trust which holds such shares further to an estate freeze, how these interests are treated should the child marry owning such interests, or receive shares or become a beneficiary of a trust which holds shares, post-marriage, must also be considered in terms of inclusion in the child's matrimonial or family property, and appropriately planned for.
In order to avoid potential attacks on a founder arising out of his or her conduct, it is critical that there be a clear understanding by the founder of what an estate freeze entails, combined with the commitment by the founder to carry out his or her corporate and fiduciary obligations which arise as a result. Without this understanding and acceptance by the founder, and his or her recognition of the change of his or her ownership rights, and that new legal relations and rights have been created in favour of others, the founder puts himself or herself on a collision course leading to potential problems down the way. However, there are various tools and mechanisms whereby the founder can strive to maximize his or her control, and protect and bolster the estate plan of which the estate freeze is a component.
These include use of a family trust, matrimonial and domestic contracts, shareholder agreements and appropriate will planning. With the proper use of these tools and vehicles, perhaps some of the potential problems which have arisen as witnessed through the case law could have been avoided. The use of a family trust to hold shares offers many advantages in the context of an estate freeze, as described in the following sections a) through f):
The use of a family trust can maintain control of voting shares at the level of the trustees of the family trust, which may in certain cases include the freezor, as opposed to at the children's level.By use of a family trust and an appropriate share structure, it is possible to separate equity from control. Although equity may eventually pass down to the children and other family members, it may be possible to maintain control through a separate class of voting shares held at the trust level by the trustees.
The use of a family trust can offer flexibility to determine future owners of the shares, as opposed to giving children or other family members a direct interest in the shares, which also gives them minority shareholder rights.A trust can be used to control the time and ages at which share ownership passes. As well, if it has discretionary terms, the trustees can be given the authority to determine to which family members they should pass. This flexibility is important in ensuring that ownership does not pass too early to children and others who do not have sufficient financial maturity. As will be illustrated in the case of Edell v. Sitzer described below, it is also important in allowing flexibility to make key succession decisions as to who should have share ownership, and who should not, in particular where it is considered problematic to have certain family members as shareholders in the family business.
Use of a family trust may also offer better protection in the event of a child's or other family member's matrimonial breakdown than if shares are directly owned. The possibility of share ownership passing outside the family, or a forced sale of shares to satisfy claims further to a matrimonial breakdown, is minimized because a beneficiary of a discretionary trust has no direct ownership of the shares or control over them.As well, a family trust may minimize the exposure of a child or other family member to a larger equalization claim or division of property on marriage breakdown where growth shares increase significantly in value during a marriage. An interest in a discretionary trust is generally considered to have a nominal value, which may result in a lower equalization claim on marriage breakdown. If shares are directly owned, and have increased in value during a marriage, and their value cannot be excluded from family property (note that under the
Use of a family trust may offer better protection against a family member's creditor problems, including on bankruptcy. An interest in a discretionary trust is generally considered an asset which does not form part of the family member's estate in bankruptcy.
A family trust provides a vehicle by which to control succession of property to future generations. If shares are given to children and family members on an absolute basis, it is the child's or family member's will that will control where the shares devolve in the event of death. Failing a will, the laws of intestacy will dictate distribution. This may result in shares passing to spouses or others, which may not be desired by the freezor or be appropriate in a family business setting. However, the freezor is forced to rely on the child's decision-making and planning in this regard (or lack thereof). In contrast, a family trust can provide for a flexible plan of distribution which the freezor will have achieved by the terms he or she has provided in the family trust agreement. He or she can ensure, if desired, that only his or her lineal descendants benefit under the terms of the family trust.
The recent case of Edell v. Sitzer (7) is an interesting example of the advantages a family trust may offer in the context of an estate freeze. As well, it is an insightful illustration of the judicial treatment of the family trust, and the respect afforded to the family trust and its underlying legal principles under the law of trusts.In this case, Paul Sitzer ("P") and his brother had built a successful real estate development business. P's son Michael ("M") and his brother's son Howard ("H") were both involved in the business. P's daughter Jodi ("J") was not active in the business. P and his brother along with H and M became involved in complex succession planning for the business. A freeze of their operating company ("Opco") was implemented in which M and H and their issue would have growth shares by way of family trusts. Future growth in other non-business assets was to accrue to J and her issue and P's brother's other issue by way of family trusts. P and his brother retained voting control of Opco by their voting preferred shares.P and his spouse were the trustees of M's trust and J's trust. Both trusts provided discretion to the trustees to distribute income and capital among P's issue prior to the distribution date as they determined. The capital of the companies was later re-organized because P and his brother became concerned that the larger potential for growth of Opco's shares than for the non-business assets would result in inequality between their respective active and non-active children. P's participating shares were divided equally between each of M's and J's trusts. Shareholder agreements were implemented giving M and H extensive powers to manage Opco after the death of their fathers.
In order to explain the family succession plan to all family members, a meeting was held at which time the arrangements that had been implemented were discussed. Unfortunately, the relationship between M and J subsequently deteriorated as well as that between between J and P because J was unhappy with the estate plan and proposed control by her brother M.As a trustee, P exercised his power to encroach on J's trust and appointed the Opco common shares solely to M. At the same time, he offered to settle with J in exchange for a full release by her. J rejected the settlement offer, and challenged the validity of the encroachment in a court application on the basis it was not made bona fide. The court held that the primary purpose of dispositive powers in estate planning is to provide flexibility. The court looked at the motive and purpose for the encroachment. It determined that P had decided it would be detrimental to all of his descendants if J or her children had beneficiary rights to receive Opco shares on termination of the trust, which would lead to dissension, discord and litigation between J and M and their family, and likely break-up of the business and dissipation of their assets. P believed that in view of the statutory rights of minority shareholders, the fact that the Opco shares were not voting was not sufficient to obviate his concerns. The court held that P as trustee had acted for a proper purpose and that the court should not intervene in the trustee's decision in making the encroachment of the shares in favour only of M.
Domestic contracts -- including pre-nuptial agreements made before marriage, marriage contracts made after marriage, and cohabitation agreements -- can also play an important role in the context of an estate freeze and general family succession planning. They can be used to provide protection on marriage breakdown or death against claims made in respect of shares which have already been transferred to a child pre-marriage or acquired post-marriage. As well, post-marriage, they can be used to bolster the freezor's estate plan to ensure his or her spouse agrees to the plan for succession of corporate interests on death and the terms of the freezor's will in this regard, which may provide for example, for the use of various trusts as opposed to an outright distribution of property.
Shareholder agreements also play a key role in succession planning in the context of an estate freeze. In an attempt to avoid future family dissension, the freezor can stipulate for a shareholder arrangement which will govern shares that children and family members may own now or acquire in future. The agreement can provide for various events, including marriage breakdown of a shareholder, and provide for the right to purchase out a shareholder, including if a court order is made in respect of the shares. It can also require each shareholder to enter into a marriage contract to protect corporate interests from marital property claims, deal with issues of corporate confidentiality, corporate governance, and buy-and-sell arrangements in certain events, including on disability or death, as well as placing restrictions on transfer of shares to others to ensure succession within a family group.
A fundamental cornerstone of any good estate plan is a well-drawn and well-considered will plan. Where corporate interests are involved, sophisticated will planning is often critical. For example, it may be appropriate to appoint special executors and trustees to control and administer family wealth, including oversight of any operating businesses and to provide for specific trust terms. Of particular importance will be how best to structure succession to any corporate interests, as well as deal with the issue of control and who should exercise it. In certain situations, use of conditional bequests of corporate interests may be appropriate, such as a condition that a beneficiary enter into a shareholder agreement and/or domestic contract in order to be entitled to receive the bequest.
This article was originally published as a CALU Report in October of 2003 and is based on Margaret O'Sullivan's presentation to the CALU Associate Members' meeting of November 2002. CALU thanks the author for her contribution of this article which serves to reinforce the fact that, with well-considered planning and use of some of the techniques and vehicles that have been described, some of the obvious pitfalls associated with an estate freeze can be eliminated, or at least their potential negative impact minimized.
(1) The author, Margaret O'Sullivan, LL.B, TEP, of Margaret O'Sullivan & Associates, can be reached at firstname.lastname@example.org.
(2) John Chapman, "Sharper Than a Serpent's Tooth - Estate Freezes Thirty Years Later", Estates & Trusts Journal, Vol. 16 (1997), p. 48-49.
(3) Supra, at p. 52
(4) Anna Karenina, opening line.
(5) (1993), 11 B.L.R. (2d) 218 (Ont Ct. (Gen. Div)), affd 19 O.R. (3d) 691 (Div. Ct.), revd in part 23 O.R. (3d) 481, (
(6) (1991) 3 B.L.R. (2d) 113 (Ont. Ct. (Gen. Div.)).
(7) (2001) 55 O.R. (3d) 198 (Ont. S.C.J.)