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      August 2010
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All in the family

By Jeff Greenberg
Illustration: Gary Clement

Strategies to maximize the value of your business and minimize tax on the succession of a family business

The old adage “shirtsleeves to shirtsleeves in three generations” too often holds true even today. While many business owners in Canada hope to see their children or family members take over the business when they are ready to retire, one of the greatest risks to a family business is succession.

Transferring a business to the next generation can be a complex process, as it involves business, ownership and family considerations. While business owners want their children or grandchildren to be successful, the desire for future success also has its roots in a business owner’s wish to validate all the work that has been put into building the business into what it is today.

The high failure rate of intergenerational business transfers can be attributed to a combination of factors, including a lack of a formal succession plan, leaving planning too late and the absence of clear communication. All these can result in business owners leaving money on the table.

Effective planning and tax strategies, particularly those put into place at least three to five years in advance, can make a significant impact on the future bottom line of Canadian family businesses.

One of the keys to success is helping your clients build the right team of advisers. In addition to a CA, other professionals should be considered part of the business succession team: a financial adviser with investment, credit and insurance expertise; a lawyer; key family members; a professional business valuator; a family business facilitator and a business mentor.

Many business owners avoid or delay implementing a business succession plan because their top priority is running and building their businesses. However, many business owners feel such a plan has helped them provide for their family’s future, helped minimize future tax liabilities and improved their businesses’ financial stability.

Factors that should be incorporated into the plan include, but are not limited to, answering the following questions:

It is important that business succession plans take into account the many family considerations that have an impact on the business owner’s overall life plan and long-term goals. It’s also important to determine the tax strategies that business owners can implement, in collaboration with their advisory team, to reduce their overall tax burden.

As in life, in business succession there is always more than one path for business owners to reach their goals. When trying to minimize taxation, often several strategies will be used in combination to create the most tax effective plan. A multistep, multifaceted plan can help get the best result for your client. A number of ideas in combination can enhance the ability of your client to transfer his or her business to family members while minimizing tax to the fullest extent possible.

Streamline the business — remove noncore assets
It is not uncommon for successful family businesses to accumulate noncore assets over time. Such assets can include real estate or an investment portfolio of marketable securities. There are a number of strategies to consider in order to purify the company, including repayments of shareholder loans and the payment of salaries or a dividend. Further, the addition of a holding company to the overall corporate structure can facilitate the movement of noncore assets out of the company on a tax-deferred basis through intercorporate dividends and/or butterfly transactions.

By removing noncore assets from the company, two key tax savings opportunities on the business succession may result. The first, purification, may allow the business to qualify for the $750,000 capital gains exemption on the disposition of the shares of the company. With succession to a family member, there is a greater likelihood of a share sale than there may be with the sale of the business to a third-party purchaser. The second, is by reducing the assets of the business to its essentials, it is very likely that the valuation for purposes of the sale will be reduced, thereby reducing any gain realized by the business owner and any associated taxes on the sale.

In addition to the potential to transfer excess funds to the holding company on a tax-free basis as an intercorporate dividend, a holding company may also provide a degree of protection from creditors of the operating business.

Individual pension plans
Individual pension plans (IPP) have grown in popularity over the past few years. Under the right circumstances they can provide a number of favourable benefits for your business owner clients planning their business succession to a family member and help secure the retirement income needs of the owner. The IPP is a creditor-protected registered pension plan that generally enables greater annual contributions than an RRSP permits and for business owners that have been incorporated as far back as 1991, the funding of a significant past service contribution may be possible. Funding of the IPP is also tax deductible to the corporation, providing another potential way to reduce noncore assets in the company. IPPs or possibly a retirement compensation arrangement can also be used as a tool to retain nonfamily key employees who are vital to the success of the business after the transfer to a family member.

Pay a retiring allowance
If the business owner is planning on retiring from his or her business, it is possible to pay a retiring allowance in recognition of his or her long-term service, reducing noncore assets in the company. While the amount paid by the company would be taxable to the business owner, under paragraph 60(j.1) in the Income Tax Act, it may be possible to roll the amount into an RRSP and take an offsetting deduction against income. The amount that qualifies as an eligible amount is limited to the sum of $2,000 for each year of employment with the company up to and including the year 1995, plus an additional $1,500 for each year of employment up to and including the year 1988, for which there were no employer contributions to a registered pension plan or deferred profit-sharing plan that have vested for the employee.

The advantage of using a retiring allowance is that it allows for an extra RRSP contribution over and above the regular RRSP contribution limit, which will give the opportunity for more funds to grow on a tax deferred basis. If the business owner will be in a lower tax bracket in the future, the withdrawal may also be at a lower tax rate than would have occurred had these funds been paid directly to the business owner.

Implement an estate freeze
For many business owners, the structure of their business has remained constant since the day it was set up. In many cases the business is owned through a single corporation entirely by the business owner. On occasion this ownership of the company may be shared with a spouse. In most cases the ownership shares have a nominal adjusted cost base and paid-up capital.

The implementation of an estate freeze is often an essential step in minimizing tax as part of the business succession plan. Through an estate freeze, the value of the business owner’s shares subject to tax can be frozen, thus limiting the potential future tax liability on a transfer to family or deemed disposition tax at death.

Further, when well structured, successors can be brought into the ownership of the business, either directly through share ownership or indirectly through a family trust. A family trust can also be used for income splitting purposes.

Implement a family trust for income splitting purposes
Inter vivos trusts (family trusts) are often set up by business owners as a way to facilitate income splitting with their spouses and minor children or grandchildren have the option of facilitating income splitting among family members. Another advantage in setting up a family trust, especially within the framework of an estate freeze, is that when properly structured, the family trust can help minimize the business owner’s future taxes on a business succession.

By freezing the value of the business owner’s shares, future growth in the business accrues to the next generation. The estate freeze also enables the $750,000 capital gains exemption to be multiplied many times over the beneficiaries of the trust when that future growth has increased. As well, the use of a family trust as part of an estate freeze allows for dividends from the after-tax profits of the business to be paid to adult beneficiaries of the family trust and be taxed in their own names at a potentially lower tax rate than the business owner would have.

Consider vendor take-back financing
In many family business succession situations, the successors do not have adequate funding to purchase the business at the time of the transition. Provided the business has the potential to continue to produce sufficient profitability to support the successors’ additional debt load, supplying some of the debt financing in the form of vendor take-back financing for the business succession may be a tax advantageous strategy to consider for your business owner client.

The capital gains reserve found in Sec. 40(1) of ITA allows for the deferral of the recognition of capital gains on the sale of the shares of the business to the extent that payment is not received for those shares, subject to certain limitations. The reserve typically allows for a maximum deferral of capital gains equal to 80% of the total unpaid amount in year one, 60% of the un-paid amount in year two, and so on until the deferral is exhausted in year five. With the transition of a family business to a child or grandchild, the maximum deferral time period under Sec. 40(1.1) ITA is doubled to 10 years, effectively allowing for a 90% deferral in year one, 80% deferral in year two, and so on.

Corporate-owned life insurance
Insurance is another idea that should be considered to help your client minimize the cost of taxes through the business succession. That is, allocating surplus assets in the corporation to a tax-exempt life insurance policy can achieve the following benefits:

Disability insurance for children taking over the business and key-person insurance for management should also not be forgotten as important components of developing a succession and contingency plan.

Conclusion
Business succession can be complex, but well-thought out planning can help maximize the value of the business, minimize tax and preserve family wealth — and harmony. The strategies utilized will depend on the business owner’s specific circumstances and should be implemented in collaboration with a team of professional advisers.

The need to be able to adapt as circumstances and legislation change is key. It is also important that you and your clients’ other advisers keep your clients’ overall goals in mind — to provide the means to fund the next stage in their lives, have the resources available to take care of their loved ones, and to ensure that their business survives and prospers into the next generation and beyond.

Jeff Greenberg, CA, is vice-president, financial advisory support, RBC wealth management services in Toronto

Technical editor: Brigitte Alepin, M.Fisc., MPA, CA, president of AGORA