It's not surprising that Canadian small business owners spend most of their time focused on growing their businesses while often ignoring perhaps the most fundamental issue of all, that of transition planning.
While many books, articles and seminars on this topic use the more common term "succession planning," this report will use the broader term "transition planning" as, the owner is very much involved both in the actual transition and, in many cases, for years afterwards.
Transition planning, when done properly and in advance, can ensure that your business is transitioned to the new owners, whether they are family members, key employees or a third party, in the most tax efficient manner possible.
This report will attempt to highlight some of the key tax and estate planning opportunities in the context of a properly structured transition plan.
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TRANSFER TO FAMILY MEMBERS
Perhaps the most obvious transition plan for a family business is to transfer it to the next generation. Whether or not this makes sense, however, will depend on whether the kids are already involved in the business and whether they have the maturity and expertise to take it over.
But what if one child is involved and the others are not? Or what if they all work in the business but you feel only one of them has the ability to successfully run it going forward? If you don't treat your kids equally with respect to equity in the business, what impact will that have on the future relationships you have with your kids and similarly, the relationships among the siblings?
All these questions can be addressed at the outset, with a documented transition plan. Perhaps the starting point, however, is to determine what is actually being transferred. That, of course, will depend on the legal structure of the business.
If the business is unincorporated, and is operating as a sole proprietorship or partnership, then you are simply selling certain assets associated with that business, which can include both tangible assets, like furniture or equipment, and intangible assets, like customer lists or goodwill.
Since most small businesses of any significant size are structured as corporations, this report will focus mainly on the transfer or sale of the corporation's shares (although an asset sale is certainly possible - see below). When transferring the shares to the next generation, you have two options: a gift or a sale.
Gift of shares
Your first inclination may be to simply gift the shares of your business in equal portions to all your children, or perhaps, only to the children involved in the business. Of course, you would only contemplate doing this if you don't need the money from the potential sale of the shares to fund your personal lifestyle and retirement.
Making a gift, however, still has income tax consequences. You are deemed to have disposed of your shares for proceeds equal to their fair market value (FMV). That's why it's generally recommended to get a third party valuation prepared so as to substantiate the FMV as the Canada Revenue Agency (CRA) or Revenue Quebec is especially 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 your adjusted cost base (ACB) or tax cost of your shares will be a capital gain, of which 50% is taxable at your marginal tax rate. Capital losses you may have realized on other property, either from the current or prior years may be available to offset part of the capital gain realized on the gift. An estate freeze (discussed below) followed by a gift of the resulting preferred shares upon death can also be an effective way of gifting the shares and deferring the tax liability. It may also be possible to shelter some or all of the gain from the deemed disposition or estate freeze using the $750,000 lifetime capital gains exemption for qualified small business corporation shares.
The 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.
Simply stated, QSBC shares are shares of a Canadian controlled private corporation in which "all or substantially all" (interpreted to mean 90% or more) of the value of the corporation's assets is used in an active business at the date of sale or transfer. In addition, either you or someone related to you 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.
One of the most important steps in the transition plan, therefore, is to be vigilant to ensure that any investments made through your small business corporation do not inadvertently disqualify you from ultimately claiming the LCGE upon sale (or ultimately, upon death.) [See Sidebar: Loss of the lifetime capital gains exemption]
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 of them are simple, while others are more complex.
Simple strategies can include: regularly distributing non-active assets, paying down debts, purchasing additional active business assets or paying a retiring allowance.
More complex strategies often involve paying tax-free inter-corporate dividends from the operating company (the active business) to a connected company, thus purifying the operating company.
The investing activities are then conducted through the connected company, which wouldn't qualify for the QSBC exemption anyway, thereby preserving the exemption for the operating company.
Owners worried about meeting the QSBC tests later on may wish to consider "crystallizing" the LCGE immediately through an estate freeze (see below).
Another important step in the transition planning process is to ensure that the corporation's shares are properly structured in advance to permit multiple family members to access their own LCGE, assuming the potential gain on the gift of the shares is over $750,000.
For example, if the business is worth $1.5 million and you wish to transfer it to the kids, ideally both you and your spouse or partner, if applicable, would each individually already own 50% of the shares enabling each of you to claim the $750,000 LCGE. If this is not currently the case, it may be worth reorganizing the share capital of your operating company to permit future access to multiple exemptions upon ultimate gift, sale or even death.
Sale of shares
In most family transition plans, rather that an outright gift of the shares, it is more likely that the business will be sold to the next generation since the proceeds from the sale represent a lifetime of wealth accumulation for the owner manager who generally needs those funds to live on after retiring from the business.
From a tax perspective, you have to be careful when structuring a sale to a family member, such as your son or daughter, since you will be deemed to receive proceeds equal to the FMV of the shares sold, no matter what price you assign to the shares. In other words, while you may be tempted to give your kids a "good deal" on the shares, you may find that such a gift can actually result in double taxation. How?
The Income Tax Act states that when property, such as 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.
For example, let's say your business was worth $3 million and you decide to "sell" it to your son for only $1 million. For tax purposes, assuming you had a negligible ACB, you will be deemed to have sold the shares for the FMV of $3 million and thus be taxable on the resultant $3 million capital gain.
Your son, however, would only have a tax cost or ACB of $1 million, equal to the amount he actually paid. If he should sell the shares even a day later to a third party, and realize $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 very likely may take a look at a sale transaction between related parties to ensure that it was done at FMV. That's why it's important to include a "price adjustment clause" in the contract of purchase and sale. This clause basically states that should the CRA (or Revenue Quebec) challenge the sale price of the shares and value them at a higher amount than what was used in the purchase/sale agreement, then, upon unanimous consent, the price of the sale can be adjusted upwards retroactively.
Finally, the LCGE discussed above is also available to shelter all or a portion of the capital gain realized upon sale from tax.
Proceeds in cash or debt
Once the FMV price of the shares has been established, the next question is how you will be paid: cash or debt.
Naturally, if the successor has the cash to pay, this is ideal as not only will it allow you to invest that cash to fund your retirement, but it can also allow you to distribute, either now or later, some of the cash to children or other family members who may not be participating in the business transition.
But debt can also be a handy tax deferral mechanism. If you take back debt, perhaps in the form of a promissory note, you have the ability to defer paying tax on the capital gain realized upon the sale of the shares immediately and recognize it over up to five years. If the sale is made to your child or grandchild (or their spouse or partner), then you can recognize the gain over ten years. This is known as the "capital gains reserve."
For example, let's say you realized a $1 million capital gain on the sale of your shares to your daughter and you structured a promissory note payable to you, with 10% (the maximum allowable under the Income Tax Act) due each year. That would allow you to report only $100,000 of the capital gain in the year of sale and another $100,000 each year for the next nine years.
Another factor to consider, however, is whether you want to still be involved in the business and participate or even control major decisions going forward. In addition, perhaps you would still like to receive some annual cash flow from the business. Both of these goals can be accomplished through a shareholder's agreement (discussed below) or an "estate freeze."
Estate freeze
An estate freeze is a corporate transaction that allows you to essentially "freeze" the value of your ownership in the corporation, and have the future growth in the value of the company accrue to someone else, like your kids, who will ultimately control the business. The result is that the 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, which are 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, which provides tremendous flexibility for future planning.
The new fixed-value preferred shares, referred to as the "freeze shares", that have been issued to you can have voting rights. This allows you to maintain control of the company, while not necessarily continuing to be involved in the daily operations of the business. Running the company can be left to the kids, who now own the new common shares to which the future increase in value of the business will accrue.
The shares can also have a preferential stated dividend rate, allowing you to receive an annual income from the company while the shares are outstanding.
Given the current economic conditions, doing a freeze when your company's value is depressed can permit you to significantly reduce your estate's tax exposure at death, assuming the value of the shares ultimately appreciates again. You must, however, ensure that the value associated with your freeze shares today will be sufficient to support your future needs.
But what if you've already implemented an estate freeze? In that case, you may wish to consider a "refreeze." For example, if you froze the company in 2005 when the value was worth $5 million, and today the company is worth only $3 million, you would refreeze by exchanging your old $5-million redeemable preferred shares for new preferred shares redeemable at $3 million (assuming you are comfortable with this reduced entitlement). Should market conditions recover and the business go back up in value, any future gain can be taxed in the common shareholders' hands instead of yours (or your estate's).
Disclaimer:
As with all planning strategies, you should seek the advice of a qualified tax advisor.
This report is published by CIBC with information that is believed to be accurate at the time of publishing. CIBC and its subsidiaries and affiliates are not liable for any errors or omissions. This report is intended to provide general information and should not be construed as specific legal, lending, or tax advice. Individual circumstances and current events are critical to sound planning; anyone wishing to act on the information in this report should consult with his or her financial advisor and tax specialist.
Copyright® 2009 Canadian Imperial Bank of Commerce. All rights reserved.
