Business succession: Time to plan

September 2011

Business succession: Time to plan

bouton-vers-francaisAs a business owner, you are no doubt reminded daily that the taxman is your principal business partner since you share with him a significant portion of your annual income equivalent sometimes to almost 50%. This reality is that much more difficult to accept when a business owner realises an additional tax can be levied upon his death. It is therefore highly recommended to turn to tax experts and financial planners whose job it is to implement tax and financial mechanisms to reduce, defer and perhaps even eliminate the tax consequences upon his death or the transfer of his business.
 
Our objective in this article is to shed some light on some the tax planning available to you. Evidently, we will not examine all the available tax strategies. A personal consultation with a tax professional remains the best means to optimize your tax situation in connection with the transfer of your business while you are still alive or upon your death.

Taxes upon death

In addition to paying taxes while you are alive, the tax authorities will come knocking at the door upon your death. Instead of requiring the payment of estate taxes, as in the United States or in France, the Canadian and Québec tax authorities proceed otherwise. Generally, upon the death of a business owner, he is presumed to have sold all his property immediately prior to his death.
 
This deemed disposition includes your company shares, your RRSPs and your investments, such as shares of listed companies and mutual funds?all at the fair market value of these assets at the time of death.
 
For example, if you own a country house which was purchased in 1980 for $25,000 and is worth $175,000 when you die, your estate will have to include a capital gain representing 50% of the $150,000 gain in your income tax return, even if you have not sold your country house.
 
There are tax provisions to defer tax payable, namely for a transfer to your spouse or to reduce any tax payable in connection with the shares of your incorporated business to the extent that the shares are qualified shares based upon various tests provided for in the tax legislation. In the latter case, the exemption is limited to a capital gain of $750,000. As for your spouse, this is only a temporary exemption, because your spouse's estate will eventually face the same problem.
 
Unfortunately, there is no total exemption for the transfer of a business to your children, subject to the possible $750,000 exemption. A parent who bequeaths shares in his manufacturing business to his children, for example, could be hit with a large tax liability. It is therefore advisable for a business owner to ask his accountant how much taxes will be payable upon his death. In this way, it is easier to plan how the taxes will be paid by the estate.

The goal of tax and estate planning

Once your advisor has told you how much the tax bill will be upon your death, in addition to realizing that you simply can't afford to die, you should ask him whether there are any ways to prevent or, at the very least, put a stop to the tax meter.
 
There are techniques allowing a business owner to determine immediately what his tax bill will be upon his death, particularly as regards his business. This technique is called an estate freeze.
 
The technique has two goals: first, it allows the business owner to determine immediately how much tax will be payable upon his death on the value of his business. Second, it fits within the business owner's plan to ensure a proper succession by immediately transferring all (total freeze) or part (partial freeze) of the future value of the business to his children or most important employees.
 
Among the techniques used to achieve this, a business owner establishes the value of his business on a given date and isolates that value in the preferred shares of the company. These shares will never increase in value, but dividends may be provided for in order to ensure a return on the capital which has been isolated or frozen.
 
Following the freeze, the business owner determines who will benefit from the future increase in the value of the business (children, trust, employees, himself in part, etc.) by issuing common shares to these persons. This tax planning technique is interesting in that the children are not required to disburse significant sums of money in order to acquire the shares, because the entire value has been isolated in the preferred shares. In this manner, the business succession is ensured without the children incurring any costs. In such a scenario, the business owner can still retain control of his business with voting shares.
 
A business owner can also set up a trust which would be the shareholder in the business instead of the children themselves. A discussion on trusts could take up an entire article, but suffice it to say that a trust allows for greater flexibility as regards the persons you want to designate as the beneficiaries of your business.
 
Thus, the children could be the beneficiaries of the trust, without having an immediate right to the shares of the family business. If a child were to decide after a few years to leave the business, he would not be required to sell the shares, but the rules governing the trust could exclude him from the earnings of the business.
 
It is even possible for a business owner to take back all the shares of the business held by the trust if some problem with the children arises. In such a case, the objective of the freeze would not have been achieved, but the business owner would keep his shares.

Among the techniques used to achieve this, a business owner establishes the value of his business on a given date and isolates that value in the preferred shares of the company. These shares will never increase in value, but dividends may be provided for in order to ensure a return on the capital which has been isolated or frozen.
 
Following the freeze, the business owner determines who will benefit from the future increase in the value of the business (children, trust, employees, himself in part, etc.) by issuing common shares to these persons. This tax planning technique is interesting in that the children are not required to disburse significant sums of money in order to acquire the shares, because the entire value has been isolated in the preferred shares. In this manner, the business succession is ensured without the children incurring any costs. In such a scenario, the business owner can still retain control of his business with voting shares.
 
A business owner can also set up a trust which would be the shareholder in the business instead of the children themselves. A discussion on trusts could take up an entire article, but suffice it to say that a trust allows for greater flexibility as regards the persons you want to designate as the beneficiaries of your business.
 
Thus, the children could be the beneficiaries of the trust, without having an immediate right to the shares of the family business. If a child were to decide after a few years to leave the business, he would not be required to sell the shares, but the rules governing the trust could exclude him from the earnings of the business.
 
It is even possible for a business owner to take back all the shares of the business held by the trust if some problem with the children arises. In such a case, the objective of the freeze would not have been achieved, but the business owner would keep his shares.

This bulletin provides general comments on recent developments in the law. It does not constitute and should not be viewed as legal advice. No legal action should be taken on the basis of the information contained herein.

 

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