If you work with high net worth clients, chances are a high percentage of them are business owners.
The tax needs of this group, which makes up a large percentage of the higher net worth clients being served by Canadian advisors, are unique; especially when it comes to passing the business to new hands.
Succession planning is a critical part of any business owner’s long-term strategy, especially when the value of the business accounts for a significant portion of the owner-manager’s personal wealth.
And advisors can play a key role in helping ensure a client’s business transfers successfully to new owners – whether they’re family members, key employees or a third party – in the most tax efficient manner possible.Here are some key tax and estate planning opportunities to consider in the context of a properly structured succession plan.
Transfer to family members
Perhaps the most obvious succession plan for a family business is to transfer it to the next generation. Whether this move makes sense, however, will depend on if the kids are already involved in the business and if they have the maturity and expertise to take over.But what if one child is involved and the others are not? Or what if they all work in the business but only one of them has the ability to successfully run it? Not treating the kids equally with respect to equity in the business will impact the owners’ relationships with their kids, and similarly, the relationships among the siblings.
To address these questions ahead of time, advisors must work with the owners at the outset to develop a documented succession plan. The starting point is usually to determine what’s actually being transferred. And that, of course, will depend on the legal structure of the business.
If the business is unincorporated, and operating as a sole proprietorship or partnership, then what’s being sold is simply certain assets associated with that business. This can include both tangible assets, such as furniture or equipment, and intangible assets, such as customer lists or goodwill.
Since most small businesses of any significant size are structured as corporations, let’s focus mainly on the transfer or sale of the corporation’s shares (although an asset sale is certainly possible). When transferring the shares to the next generation, there are two options: gift or sale.
Gift of shares
An owner’s first inclination may be to simply gift the shares of the business in equal portions to all the children, or perhaps only to the children involved in the business. Of course, this option would only be contemplated if the owner doesn’t need the money from the potential sale of the shares to fund his or her own retirement.
Making a gift, however, still has income tax consequences. The giftor is deemed to have disposed of the shares for proceeds equal to their fair market value (FMV). That’s why it’s generally recommended that a third-party valuation be prepared. It substantiates the FMV – important since the CRA is likely to review the valuation, given there was no arm’s length party on the other side of the share transfer to validate the FMV used.
The difference between the FMV and the adjusted cost base (ACB) or tax cost of the shares will be a capital gain, of which 50% is taxable at the giftor’s marginal tax rate. It may be possible to shelter some, or all, of the gain from the deemed disposition using the $750,000 lifetime capital gains exemption for qualified small business corporation shares.
Lifetime capital gains exemption
The lifetime capital gains exemption (LCGE) may be available to shelter up to $750,000 of capital gains on the sale of qualified small business corporation shares (QSBC), a qualifying farm or fishing property.
QSBC shares are shares of a Canadian controlled private corporation (CCPC) in which “all or substantially all” (interpreted to mean 90% or more) of the value of the corporation’s assets are used in an active business at the date of sale or transfer. Further, either the owner or someone related must have owned the shares for at least two years prior to their disposition; and during that entire two-year period, more than 50% of the corporation’s assets must have been used in an active business.
So, one of the most important steps in the succession plan is to ensure any investments made through the small business corporation do not inadvertently disqualify the owner from ultimately claiming the LCGE upon sale (or, ultimately, upon death.) That’s why it’s important for business owners to keep the operating company pure. There are a number of ways to do this. Some are simple, and others more complex.
Simple purifying strategies include:
Another step in the succession planning process includes properly structuring the corporation’s shares in advance to let multiple family members access their own LCGEs, assuming potential gain on the gift of the shares is more than $750,000.
Sale of shares
Rather than an outright gift of shares, most succession plans sell the business to the next generation as the proceeds represent a lifetime of wealth accumulation for the owner.
However, structuring a sale to a family member will be deemed to receive proceeds equal to the FMV of the shares sold, no matter what price is assigned to the shares. While a parent might be tempted to give the kids a good deal on the shares, he or she may find such a gift could actually result in double taxation. How?
The Income Tax Act states that when property, and that includes shares, is sold to a non-arm’s length party, the vendor is deemed to receive proceeds equal to the FMV. But the purchaser’s new ACB for the purpose of computing his or her own capital gain on ultimate disposition or death, is only deemed to be the amount paid.
Let’s say a business is worth $3 million and the owner decides to sell it to his son for $1 million. For tax purposes, assuming a negligible ACB, the owner will be deemed to have sold the shares for the FMV of $3 million and thus be taxable on the resulting $2 million capital gain.
The owner’s son, however, would only have a tax cost or ACB of $1 million, equal to the amount he actually paid. If he sells the shares to a third party even a day later, and realizes $3 million of proceeds (the shares’ true FMV), he will also end up paying tax on a $2 million capital gain.
Alas, double taxation!
As with a gift, the CRA may examine a sale transaction between related parties to ensure it’s done at FMV. That makes it important to include a “price adjustment clause” in the contract of purchase and sale. Should the CRA (or Revenue Quebec) challenge the sale price of the shares, and value them at a higher amount than was used in the purchase/sale agreement, then, upon unanimous consent, the price of the sale can be adjusted upwards, retroactively.Finally, the LCGE is also available to shelter all, or a portion, of the capital gains realized upon sale from tax.
If the owner still wishes to be involved in the business, and participate in or even control major decisions going forward, in addition to receiving some annual cash flow from the business, an estate freeze may be in order.
An estate freeze is a corporate transaction that allows a business owner to freeze the value of his or her ownership in the corporation, and have the future growth in the value of the company accrue to someone else, like the kids, who will ultimately control the business. The result: Tax liability of the owner can be fixed at today’s fair market value, and the tax liability on any future growth can be transferred to the new owners (e.g. family members).
A freeze, which can be done on a tax-deferred basis, is often accomplished by exchanging the common shares of the corporation for new fixed-value preferred shares, redeemable at the current fair market value of the corporation. New common shares are then issued to whoever may one day take over the company. In the case of continuing family involvement in the business, new common shares can be issued to the kids either directly or, preferably, through an inter-vivos family trust.
The new fixed-value preferred shares – referred to as the freeze shares – can have voting rights. This allows the owner to maintain control of the company, without being involved in daily business operations. Running the company can be left to the kids, who now own the new common shares to which any future increase in value of the business will accrue.
The shares can also have a preferential stated dividend rate, allowing the owner to receive an annual income from the company while the shares are outstanding.
Sale to key employees
While many of these tax-planning concepts are also relevant when the succession plan involves non-family members, such as key employees, there are a few additional opportunities that should be examined when dealing with employee succession plans.
In fact, businesses transferred through a management buyout (MBO) are generally more successful going forward than businesses where family members or even an arm’s-length third party become the successors. That’s because the existing management team is intimately familiar with the business, the industry and its suppliers and customers, allowing it to run with minimal interruptions.
It’s critical, however, to involve management early in the succession process to ensure they truly want an equity stake. In some cases, they may be content to simply manage and run the business, as opposed to having the risk associated with entrepreneurial ownership.
Financing the MBO
Perhaps the biggest impediment to the MBO is financing. In other words, how are the employees interested in taking over the business going to pay for it? Chances are, they don’t have the financial wherewithal to finance it upfront.
Debt financing, also known as a leveraged buy out (LBO), is often used by employees in such scenarios,. In an LBO, the employees buying the operating company from the original owner(s) form a new corporation used to purchase the shares.
This new employee-owned company would obtain third-party financing and use the proceeds to purchase shares in the operating company. Then, both companies would be amalgamated, allowing interest paid on the debt to be tax deductible against future earnings. This is essentially a self-funding structure, since the future profitability of the operations will both service the debt (pay the interest) and pay it down over time (pay the principal.)
Provided the employees aren’t related to the owner, the $750,000 LCGE can be used to exempt part or all of the resultant capital gain from tax.
Sale to a third party
The final option for succession – and perhaps the most common – is to sell to a third party, assuming family members won’t take over and no key employees are interested or capable of acquiring the business.
A third-party sale can involve selling to a supplier, competitor, customer, an entirely unrelated third party or even going public. Often competitors are extremely attractive suitors as it not only allows them to grow their own business but also eliminates an obvious competitor.
The search for the right purchaser, however, can be a challenge, and it’s best to bring in experienced professionals to assist in the process. For example, an investment banker that specializes in buying and selling small- and-medium-sized private companies can not only get the highest possible selling price but also structure the deal to maximize tax efficiency, while maintaining confidentiality and ensuring minimal disruption to the ongoing business.
The tax issues associated with sale of shares to a third party are similar to those in connection with a sale to a family member.