What happens if an estate freeze undervalues the founder's shares?

The rule: the gift portion

Section 86(2) applies notwithstanding the ordinary freeze mechanics where the fair market value of the old shares exceeds what the founder received for them, and “it is reasonable to regard any portion of the excess (in this subsection referred to as the "gift portion") as a benefit that the taxpayer desired to have conferred on a person related to the taxpayer”. Unlike the section 85(1)(e.2) override on a rollover, section 86(2) has no wholly-owned-corporation exception — it is squarely aimed at the ordinary two-class freeze structure.

When it changes

The test turns on intent, not on arithmetic alone: a genuine, good-faith valuation error that a price adjustment clause is built to catch is a different problem from a number set low on purpose to shift value. Whether section 86(2) or the shareholder-benefit rule in section 15(1) is the better fit can depend on which family members hold shares personally on day one versus only through a wholly owned holding company.

Where this played out — Case Files

One freeze fixed the father’s redemption amount below the company’s true value and the benefit ran straight to the children. Another shows the same pricing error running through a freeze that needed no election filing at all — the defect was the number, not the paperwork.

Sources

• • Income Tax Act s.86(1) and s.86(2) — laws-lois.justice.gc.ca.
• • Income Tax Act s.15(1), shareholder benefit — cited for the structural contrast, not separately quoted here.
• • Treadstone Law — estate freeze share structure in Ontario — general background on how a freeze is structured; it does not address the gift-portion override, which is the specific rule here.