Plan for the five stages of a business

Businesses come in all shapes and sizes, but for most owners their business represents both the cash flow engine, which supports their family’s quality of life, and their most valuable single asset.

Their equity investment in their corporation is a concentrated risk in a business they have chosen and understand, but it is susceptible to many factors beyond their control. That’s exactly why, when planning for business owners, risk management and protection strategies play a major part.

When planning for the business owners, we need to remember taxation is the largest ongoing expense, and the most predictable investment risk. Therefore any plan that does not fully contemplate the impact of taxation is deficient.

The evolution of the business generally starts with the decision of how to operate—sole proprietorship or corporation. There are a number of reasons why we would (generally) always recommend that the business be conducted through a corporation:

Limited liability for the corporation, which provides some degree of protection for personal and family assets in the event that the business fails. Considering that fewer than 30% of new businesses succeed beyond three years, this is important; Small business profits are taxed at lower rates than individuals, with the result that there are more after-tax retained earnings, which may be used to fund growth or for alternative investment.

Certain expenses such as life insurance are not deductible for tax purposes and are therefore better funded by after-tax funds in the corporation rather than personally where the funds required for premiums would mean higher taxes.

While a sole proprietor may pay salaries to family members to improve the after-tax cash flow of the family, these payments must be commensurate with services provided. If the tax department (CRA) determines these payments are excessive, it will disallow the deduction in the corporation but still tax the recipient. This is obviously an unfavourable double-tax position. However, CRA recognizes that shareholders of a corporation may receive dividends from the after-tax earnings of a corporation according to the rights of the classes of shares they hold and not based upon the work performed. By establishing proper shareholding structures it is possible to split income with spouses, adult children and other family dependants. Clearly the corporation offers greater flexibility in this regard.

Another big tax advantage is that CRA currently allows shareholders of qualifying Canadian-controlled private corporations a lifetime aggregate exemption from capital gains of $750,000 per taxpayer when they dispose of their shares. There are some complexities in establishing what qualifies and specific planning is necessary to ensure eligibility is maintained. With proper planning, a business owner and spouse may sell the shares of the business for $1,500,000 without paying tax, and apply a further $750,000 for each adult child.

There are essentially five stages that the owners of a successful business will experience:

The initial or start-up stage where the foundations of the business are conceptualized and set into motion. This is generally the most uncertain time of the business until the business concepts and entrepreneurial abilities overcome the initial barriers to business entry and customers are established.

The early growth stage is often the phase where family members work in the business part-time and eventually give up jobs to help the dream come alive. Business finance is usually secured by personal borrowings or guarantees, pledging all of the family assets to make the project succeed. Revenues are still uncertain, but overhead expenses start to grow as premises and staffing dictate.

Human capital is critical in these two stages, and death or disability of the active principal shareholders can be ruinous. So it is imperative to seek adequate insurance for life and disability.

Since cash flow is always critical, the corporation must acquire the most cost-effective convertible term insurance and where possible establish a grouped disability insurance program (with maximum future insurability options) for income replacement for the management group.

The third stage is that of stabilized growth where the business growth is more predictable, and where cash flows are positive. Debt structures are transitioning to lines of credit but are still secured by personal guarantees. Some funds are becoming available for other investment options.

It is at this stage that we recommend business owners start maximizing their retirement savings in a conservative, more income-weighted portfolio in RRSPs. The rationale is that the business is a concentrated equity risk, and will be susceptible to economic cycles. By creating a conservative RRSP portfolio we are aiming to ensure a pension of some sort will be available at retirement, independent of the business value. This is key if the business fails or if there is a desire for business succession.

This is also the stage where future consideration of estate planning goals and income-splitting strategies becomes valuable. Using a family holding company to hold passive investments and permanent insurance programs will be integrated during this stage if the structuring is not set up earlier.

The fourth stage—maturity—often coincides with the principal shareholders reaching a point where they are starting to consider retirement or succession, and are planning to maximize the cash values. There is an increasing reluctance to invest in major capital projects, a decline in growth rates, and a levelling of revenues.

This is the stage where we consider implementing enhanced retirement tools such as Individual Pension Plans, trying to make best use of the corporate cash flows, and integrating permanent insurance programs for estate planning.

Succession planning defines the fifth stage, which is generally the most complex for an owner to deal with objectively. Succession involves the transition of ownership and management control and is an emotionally charged process, often irreparably damaging family relationships and lifetime friendships. The owners also generally wish to remove their personal guarantees for business credit.

The biggest mistake advisors make is to ignore the fact that emotional attachments to the business often impact the value tag an owner puts on the business. In addition, perception of value and the sense of legacy vested in the business make passing on the reins a difficult process. Owners frequently defer these decisions until the emotional costs are greater than the perceived emotional benefits, by which stage the business may have suffered significant economic damage and it may no longer be worth investing in its sustained growth.

The advisor should help the business owners understand that succession—whether through transfer to family, key employees, or sale to third parties—is actually a continuous organic process, which should be commenced no later than the third stage. The trigger to succession planning is often taxation, but if the human and family dimensions are overlooked, even the most elegant tax structures may prove unworkable for the successors, resulting in economic destruction, and defeating the purposes of the founders.

The key is to ensure the liquidity and exit strategy of the respective shareholders and develop shareholder agreements to establish common expectations. Planning for this should start as early as possible. The role of the trusted financial advisor is not that of a historian but that of a guide who identifies points of interest, warns of possible potholes and detours, and helps map the best routes to success.

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Malcolm Ross B.Com., CFP, CLU, TEP, CAFA, Investaflex Financial Group

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Malcolm Ross