How to Lock In Your Business Value for the Next Generation With Section 86 Estate Freezes
An estate freeze is one of the most effective succession planning tools available to Canadian business owners. It allows a founder to fix or “freeze” the current value of their equity interest in a business and transfer all future growth to the next generation without triggering capital gains tax on that future appreciation in the founder’s hands. When carried out through a reorganization of a corporation’s existing share capital, the authority for this is section 86 of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (the “ITA”).
This article explains what a section 86 estate freeze is, how the share exchange mechanics work, who receives the growth shares and in what structure, how the freeze interacts with the lifetime capital gains exemption, and what can go wrong when the freeze is not properly planned. For a broader view of the corporate reorganization tools that sit alongside the estate freeze, see Kalfa Law Firm’s guide to corporate reorganizations in Canada.
What Is an Estate Freeze?
An estate freeze is a restructuring of a business owner’s shareholding that locks in the current value of their equity interest while transferring all future appreciation in the business to the next generation. After the freeze, the founder holds shares with a fixed dollar value that will not increase regardless of how the business grows. Every dollar of growth above the frozen value accrues to new shares held by the successor’s children, a family trust, or key employees.
The name refers to the effect on the founder’s estate. A capital gains tax liability arises on the death of a Canadian taxpayer by virtue of the deemed disposition rule in subsection 70(5) of the ITA. If the founder’s shares in a growing business are worth $10,000,000 at death, a large capital gain is triggered at that moment. An estate freeze implemented today, when the business is worth $2,000,000, limits that eventual liability to the gain on $2,000,000, regardless of whether the business is worth $10,000,000, $20,000,000, or more when the founder eventually passes away or sells. The earlier in a business’s growth trajectory the freeze is implemented, the greater the difference between the frozen value and the ultimate sale price, and the more value that is transferred to the successors tax-free from the founder’s perspective.
What Is Section 86 of the ITA?
Section 86 of the ITA governs the tax treatment of a reorganization of capital specifically, the situation in which a shareholder disposes of all of the shares of one class held in a Canadian corporation and receives, in exchange, shares of one or more other classes of the same corporation as part of a reorganization of the corporation’s capital.
The key feature of section 86 is that the exchange is treated as a tax-deferred event when the statutory conditions are satisfied. The shareholder does not recognize a capital gain on the exchange of old shares for new shares. Instead, the adjusted cost base of the surrendered shares is carried over and allocated among the new shares received, with adjustments prescribed by subsection 86(3) of the ITA. The deferred gain is preserved in the new shares and will be recognized when those shares are eventually sold or redeemed.
Section 86 differs from a section 85 rollover in an important way. A section 85 rollover involves transferring property, which can include shares from a person to a corporation in exchange for shares of that transferee corporation. A section 86 reorganization happens entirely within a single existing corporation. The shareholder exchanges their shares of one class for new shares of a different class in the same corporation. No T2057 election form is required for a section 86 reorganization because the tax-deferred treatment is automatic when the conditions of the section are met.
The Share Exchange of How a Section 86 Estate Freeze Works
The mechanics of a section 86 estate freeze follow a consistent pattern, though the specific implementation depends on the corporation’s existing share structure and articles.
At the outset, the business founder typically holds all of the common shares of the corporation. Those common shares carry all of the current value of the business and all of its future growth potential. The freeze converts those common shares into two separate components through a reorganization of the corporation’s capital.
First, the corporation’s articles are amended to create a new class of preferred shares. The founder then exchanges all of their existing common shares for these new preferred shares. The preferred shares are given a fixed redemption and retraction value, meaning the founder can require the corporation to redeem them for a set dollar amount, and the corporation can retract (repurchase) them for the same amount equal to the fair market value of the surrendered common shares on the date of the exchange. This redemption value is the frozen amount, the maximum equity value the founder will ever extract from the corporation under this structure.
Second, after the exchange is complete, new common shares are issued. Because all existing equity value has been allocated to the founder’s preferred shares, these new common shares have a nominal paid-up capital typically $1 or $100 in aggregate. All future growth in the corporation’s value, above the frozen amount, accrues entirely to these new common shares. Those shares are issued to the intended successors.
Preferred Share Design in an Estate Freeze
The design of the preferred shares issued to the founder is critical and must satisfy both corporate law and the requirements of the ITA.
For tax purposes, the adjusted cost base of the founder’s new preferred shares is determined under subsection 86(3) of the ITA. That provision sets the ACB of the new preferred shares equal to the ACB of the surrendered common shares, adjusted downward for any non-share consideration (boot) received. The deferred capital gain from the original shares is therefore carried forward into the preferred shares and will be recognized when the preferred shares are redeemed or sold.
The paid-up capital of the new preferred shares is governed by the ITA’s PUC rules. Under subsection 86(2.1) of the ITA, the aggregate PUC of the new shares is limited to the PUC of the surrendered shares. An inadvertent excess PUC, for example, if the preferred shares are issued with a stated capital equal to their redemption value rather than to the lower PUC limit, results in a deemed dividend under subsection 84(1) of the ITA that is immediately taxable in the founder’s hands. This is one of the most consequential errors in estate freeze planning and requires close attention from both the corporate lawyer and the tax advisor.
On the corporate law side, the preferred shares must be authorized in the corporation’s articles. If the existing articles do not include the required class, an article amendment by special resolution of the shareholders is required before the exchange can occur either under the Ontario Business Corporations Act or the Canada Business Corporations Act, depending on the jurisdiction of incorporation.
Who Receives the Growth Shares?
After the founder’s common shares have been exchanged for preferred shares, new common shares capturing all future growth are issued to the intended successors. There are three standard structures.
The first is direct issuance to the founder’s children. Each child receives new common shares directly and personally owns the growth in the business from the freeze date forward. When the business is eventually sold, each child who sells their shares may be eligible to claim the lifetime capital gains exemption of $1,250,000 under section 110.6 of the ITA, enhanced effective June 25, 2024, provided the shares qualify as shares of a qualified small business corporation and the 24-month holding period is satisfied. This structure is simple but inflexible once issued directly to a child, the shares and their income belong to that child.
The second is issuance to a discretionary family trust. A family trust established for the benefit of the founder’s family holds the new common shares as trustee. The trustee retains the flexibility to allocate income and capital gains among multiple beneficiaries each year and to adjust those allocations as family circumstances change. This is the most common structure in Canadian estate freeze planning because of its flexibility and the ability to multiply the LCGE among several family members.
The third option, less common but relevant in management succession contexts, is issuance to key employees, either directly or through a holding company or employee share ownership plan. This structure is used where the succession plan involves a transition to a management team rather than to family members.
Using a Discretionary Family Trust in an Estate Freeze
A discretionary family trust is often the preferred vehicle for holding the growth shares in an estate freeze. The trust is established by the founder (as settlor) for the benefit of family members named as discretionary beneficiaries, typically the founder’s spouse, children, and grandchildren. The trustee holds the new common shares and has the discretion to allocate income and capital gains to any of the beneficiaries in any proportion each year.
The most powerful advantage of the trust structure is the ability to multiply the lifetime capital gains exemption. When the business is sold and the trust realizes a capital gain on its common shares, the trustee can allocate that gain among the beneficiaries each of whom may be able to shelter up to $1,275,000 of their allocated gain from tax under section 110.6 of the ITA. A family with four adult beneficiaries could potentially shelter more than $5,000,000 of capital gain on a sale, a result not available if the shares were held by the founder personally.
There is one constraint every trust-based estate freeze must address. Under subsection 104(4) of the ITA, a discretionary trust is deemed to dispose of all of its capital property at fair market value every 21 years from the date the trust was created; the “21-year rule.” This means that any capital gain accrued in the growth shares held by the trust will be triggered as a taxable gain at the 21-year anniversary if no action is taken. The standard approach is to distribute the shares out of the trust to the beneficiaries on a tax-deferred basis under subsection 107(2) of the ITA before the anniversary date, allowing each beneficiary to hold the shares personally and eventually benefit from the LCGE on a subsequent sale.
Income allocations from the trust to beneficiaries who are not actively involved in the business must also be reviewed against the tax on split income (TOSI) rules in section 120.4 of the ITA, which apply to certain dividend and capital gain allocations from private corporations to family members. The TOSI analysis has become an essential step in estate freeze planning since the rules were substantially tightened in 2018.
How an Estate Freeze Interacts With the Lifetime Capital Gains Exemption
The interaction between an estate freeze and the lifetime capital gains exemption is one of the primary reasons founders implement a freeze. The LCGE of $1,275,000 per individual under section 110.6 of the ITA allows each eligible shareholder to shelter a large capital gain on the sale of qualifying shares from tax entirely.
By issuing growth shares to multiple family members either directly or through a family trust an estate freeze positions each family member to claim the exemption individually on a future sale. The shares must be shares of a qualified small business corporation, which requires, among other conditions, that the corporation be a Canadian-controlled private corporation with at least 90% of its assets used in an active business at the time of sale. The shares must also have been owned by the particular shareholder for at least 24 months before the sale.
Beginning the freeze at least two to three years before any anticipated sale is strongly advisable. Successors who receive growth shares fewer than 24 months before a sale may not be able to claim the LCGE on their portion of the gain. Careful planning of the timing of the freeze relative to any contemplated sale is part of the pre-sale reorganization analysis covered in Kalfa Law Firm’s complete guide to corporate reorganizations in Canada.
Thawing and Re-Freezing
An estate freeze sets the founder’s preferred share redemption value based on the fair market value of the business at the time of the freeze. If that valuation turns out to have been too high because the business has not grown as anticipated the founder’s preferred shares will be worth more than the corporation’s actual equity, leaving the growth shares with no real economic value. In this situation, a “thaw and re-freeze” may be appropriate.
A thaw involves redeeming the existing preferred shares (or exchanging them for common shares in a second reorganization) and re-doing the freeze at a lower, current value. This is a second reorganization under section 86 of the ITA and carries the same planning requirements as the original freeze including a new fair market value determination, new articles amendments, and new share issuance documentation.
More commonly, a re-freeze is used when the business has grown substantially and the founder wants to lock in a higher frozen amount, or when new family members need to be incorporated into the plan, or when the family trust is approaching its 21-year anniversary and the structure needs to be reconsidered.
Working With a Corporate Lawyer on an Estate Freeze
An estate freeze is a multi-step transaction requiring coordinated corporate law and tax planning. The corporate lawyer’s work includes amending the corporation’s articles to authorize the necessary classes of shares, drafting the share exchange documentation, issuing the growth shares to the appropriate recipient or establishing the family trust, and updating the corporate minute book to reflect every structural change.
The tax advisor’s work includes determining or confirming the fair market value of the business on the freeze date, a valuation that is critical because it sets the redemption value of the preferred shares, and analyzing the application of the PUC rules, section 84.1 of the ITA, the TOSI rules, and the LCGE qualification requirements for each family member.
Setting up or verifying a holding company structure before implementing the estate freeze is often advisable, because the holding company can serve as the freeze company while the operating company continues its business without structural disruption. Kalfa Law Firm’s article on holding companies in Canada covers how the holdco structure fits into succession and estate planning.
Speak With a Corporate Lawyer About an Estate Freeze
An estate freeze implemented at the right time and with the right structure is one of the most powerful succession and tax planning tools available to a Canadian business owner. Implemented incorrectly with a PUC error, an inflated frozen value, or TOSI-exposed income allocations, it can produce the opposite of its intended result. The lawyers at Kalfa Law Firm work with business owners across Canada to design and implement estate freezes that achieve lasting results for the family. Contact Kalfa Law Firm to book a consultation.
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Shira Kalfa, BA, JD, Partner and Founder
Shira Kalfa is the founding partner of Kalfa Law Firm. Shira’s practice is focused in corporate-commercial and private M&A law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law.
© Kalfa Law Firm | November 10, 2026
The above provides information of a general nature only. This does not constitute legal or accounting advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.
