This new Advisor to Client series helps clients learn about the elements of financial planning through the examples of their favourite fictional characters.
Subject: Claire Dunphy, Modern Family
- Succession and contingency plans
- Tax strategies to protect family businesses (this article)
Watch: Wednesdays at 9 p.m. on City
Scenario: Claire Dunphy took over the family custom closet-making business when her father Jay retired. The transition was far from smooth.
At first, Claire struggles to gain legitimacy in the eyes of other workers, who see her as the boss’s daughter. When it’s clear she’s good at her job, Jay feels like his position at the company is being squeezed out. After less than a year in retirement, Jay returns to the company as an employee while Claire keeps running the business.
Claire has three children: Haley, Alex and Luke. None of them have expressed interest in going into the family business. Jay’s grown son Mitchell is a lawyer by training who is trying to figure out his next career move. Jay’s stepson Manny and his third son, Joe (a toddler, to be fair), also haven’t shown any interest in the business.
Claire is in her 40s, so she has time to start looking for her successor and shaping her legacy and exit strategy.
Assumption: In this case, though Claire is president of Pritchett’s Closets and Blinds, we assume Jay still controls the shares. We also use Canadian laws and tax planning strategies.
Protect the business from tax
Once Jay and Claire sort out their succession plans for Pritchett’s Closets and Blinds, Jay can turn to minimizing how much tax he’ll have to pay when he passes down the company.
If Jay pegs the company’s value in an estate freeze and then creates a family trust to pass on his interest in the company (as Vancouver financial planner Marco Faccone suggested in Part One) it would have the added benefit of stabilizing the capital gains tax owed when he dies.
“He’s setting the maximum tax liability at today’s value, not the value down the road when he passes away,” explains Sarah Netley, a tax manager at Collins Barrow’s Durham Region office.
An estate freeze for Pritchett’s Closets and Blinds would work by creating two classes of shares in the company: common shares, which can change in value, and preferred shares, which have a stable value. If Jay takes back the preferred shares and then puts the common shares into the trust, the value of his stake in the company would be frozen. The company’s future appreciation would be attributed to the children’s shares, held by the trust.
Netley says the freeze and trust are useful whether Jay dies while owning the company, or he decides to sell. “If the family trust is made today and the company is worth $10 million, that goes to Jay. But if you make the trust and when you sell later it’s worth $10.5 million, $10 million goes to Jay and $500,000 goes to the family trust.”
Another drawback to keeping Jay as the sole owner is he would be the only person entitled to capital gains tax exemption upon sale or his death. CRA exempts business owners from $824,000 (in 2016, the amount is tied to inflation) of capital gains tax, but if Pritchett’s Closets and Blinds is valued at more than the exemption, he or his estate face a heavy tax burden.
“The more shareholders you have in a company, the more tax savings,” explains Netley. If the trust allocates a capital gain from the sale of the shares to the individual beneficiaries they could use their own capital gains exemptions.
“An $824,000 tax exemption translates to tax savings of about $200,000” per person, Netley says.