Jun 11, 2019
Family business succession planning: A primer
Tuesday, June 11, 2019 | Published in The Lawyer's Daily
We are in the midst of the largest transfer of intergenerational wealth in our history. Nearly 60 per cent of owners of Canada’s small- and mid-sized businesses are now 50 or older. Further, four out of 10 entrepreneurs will exit their businesses in the coming years.
Of these, 25 per cent expect to transfer the business to a family member. More than 50 per cent intend to sell or transfer the business to someone outside the family. About 20 per cent expect to wind down the business and sell its assets.
According to RBC's Wealth Transfer Report 2017, 39 per cent of business owners have a comprehensive plan in place for the future of their business or their family wealth, while 22 per cent of business owners have yet to start even minimal transition planning.
When considering how they will be transferring their businesses, here are some of the things business owners need to consider.
Start planning early
While every business is different, a successful plan for a family-owned business will typically require a number of years to properly implement.
If the intention is for their families to become or remain involved, then the role of the various family members going forward will have to be considered. If the intention is to ultimately sell to an outside party, then the business owner will likely have to ensure that the business is set up to be as attractive as possible to a potential buyer and that the structure of the business makes sense for that future sale.
If one of the primary goals is to leave the business to the next generation, then the business owner should consider whether their financial stability is a continuing concern, or whether they are comfortable and the ongoing financial success of the business for the next generation is more critical. These goals are not mutually exclusive, but in certain circumstances may conflict.
Regardless of how the business owners end up transferring their businesses, if they don’t start early, they may not be able to take advantage of efficient tax planning.
In order to maximize the sale of the business, it is important to ensure that the proper legal structure is in place.
If a business owner sells an active business, then they may be able to take advantage of the lifetime capital gains exemption. Every individual who is resident in Canada is entitled to the use of the exemption during their lifetime upon the sale of shares of a private corporation, which for 2019 is slightly under $867,000 (it is indexed to inflation). That results in the first $867,000 on a sale of shares effectively being tax-free, resulting in a net tax savings of approximately $230,000, based on today’s tax rates for an Ontario resident.
There are certain requirements that need to be met to make use of the exemption, but the first, most basic requirement is that it is a sale of shares. As such, only a business owned by the individual through a corporation would be eligible for this exemption
Cash flow considerations
The tax consequences of not planning ahead can be quite significant. For example, in a situation where a business has grown in value and the business owner dies, the business owner will be treated as having sold the business for income tax purposes, resulting in a capital gain and tax payable to Canada Revenue Agency at a rate of approximately 26.75 per cent. On a company valued at $20 million, that’s about a $5 million tax bill!
Life insurance is certainly one way to deal with this issue, but assuming there is no life insurance in place, or not enough, the business owner’s estate will have to come up with the funds necessary to pay the taxes. If no cash is available, then some or all of the assets of the business may have to be sold, which could result in the end of the business.
The business owner should be thinking about these issues during their lifetime, and again, plan ahead. The capital gains exemption is available when someone passes away, but only if the shares qualify at that time — planning is needed to make sure that option is possible.
Holistic tax planning
If the intention of the business owner is to pass the business to the next generation, then there likely won’t be a sale (unless they wish to sell to their kids, but that option won’t be considered here). Even in those circumstances, having a corporation still could have many benefits for the business owner (putting aside commercial reasons for doing so).
One possible strategy for a business owner to consider is known as an “estate freeze.” This type of plan is typically undertaken when the business is owned through a corporation.
An estate freeze is an asset management plan where business owners essentially transfer future value to the next generation without immediate tax consequences — the business owner “freezes” the value of his or her shares in the corporation at their current value and shares representing the future growth (but with no immediate value) will be issued to the next generation. This allows the next generation to enjoy the growth in the business, including any growth that may result from their own efforts, while giving the business owner shares representing the value that they have built up to date. This planning can also allow the business owner to maintain control of their business.
Assuming the business owner will continue to draw income from the business, one common strategy is for these “frozen” shares to slowly be redeemed (i.e. purchased back) by the corporation over time, allowing the business owner to continue to draw an income, while reducing the value of the shares they hold in the corporation. This also reduces the ultimate tax bill that will be payable upon their death.
The shares which will be given to the next generation can either be issued to them directly or through a family trust for their benefit. The use of a trust can afford families with more flexibility and potentially more planning opportunities.
While having the proper structure and succession plan in place is extremely important, all of the planning can potentially collapse without having a full estate plan in place, including ensuring that the business owner’s wills are structured properly. Proper will planning can allow for additional tax saving opportunities, but more fundamentally, it ensures that their business succession plan is implemented in the way they wish.
There can be serious bumps on the succession planning road that will need to be addressed, and it is crucial to the long-term success of the business that everyone be on the same page. By starting early, business owners have the best chance of preserving their business and maintaining family harmony.