"You have to do it by yourself and you cannot do it alone."
- Martin Rutte (Author, speaker)
There are various options available to the owners of privately held businesses. In crafting a business succession option, goals must be clearly defined. The business owner must take many factors into account when considering the options including, among others, the business strength and savvy of the intended successors and the psychological and emotional effects of any decision on employees and family members. Finally, all parties must be fully aware of the plan, and they must embrace it. These include: Transfer of ownership to the next generation Public offering Recapitalization of the business (estate freeze) Sale of the business to a third party Liquidation of the business Transfer ownership to next generation Only one in three transfers of businesses to the next generation result in success. To avoid becoming a statistic, create a plan that involves the next generation, and be sure to get the early buy-in of all parties to help lay the foundation for a smoother transition. Children who are active in the business present both unique opportunities and potential pitfalls. You may choose to take advantage of a number of restructuring techniques to transfer the ownership at the time of your choosing, and to possibly retain some control of the business after that transfer. However, there is always the risk of family disagreement and the challenge of balancing the estate for those who are not active in the business. There are several creative ways to transfer the business to the next generation including, for example, an employee stock ownership plan. You should consult with your advisors on the options that are available to you. Public offering Another alternative is to “go public”. Using this method, corporate shares are offered to the general public and traded on the stock market. This is usually a very expensive option that requires a sufficient revenue base and a strong business plan. Also, it is not optimal as an exit strategy if you are near retirement. The public offering strategy is best employed early in the succession planning process while you are still very active in the business. This option is most useful for providing growth capital for the business, but it can provide liquidity for you in the long run. Estate freeze If you want to begin to transfer the business value while retaining some control of the company, recapitalization may be the answer. Using this method, new preferred shares are issued to replace the common stock that you currently hold with a new class of common stock issued for a nominal cost to the intended heirs. This “freezes” the value of your shares while future growth accrues to the new common shares. Voting rights and restrictions can be assigned to the share classes to ensure that control remains with you for as long as you feel it is appropriate. The estate freeze has a secondary benefit in that it is deemed to be a disposition of the original shares and can provide access to the capital gains deduction if the business is a qualified small business corporation. This shelters the gain on the transaction, increases the cash available to the shareholder, increases the ACB of the preferred shares issued to the original shareholder, and reduces the tax payable in the year of your death. Sale You may choose to sell your business to someone who is not currently involved in your business – a competitor, an existing customer, or a supplier, for example. This can be done as a lump sum sale or in the form of an instalment sale that spreads the payments and the tax implications over a number of years. The sale of the business can be structured as a sale of assets, a sale of stock, or a combination of both. As a business owner, you are motivated to sell the stock in your business in order to take full advantage of the capital gains deduction and to realize a return on the goodwill in your business. Further, a sale of assets could subject a portion of the gain to ordinary tax rates as recapture or gains on inventory held by the company. However, the market and other factors may dictate the nature of the sale. You should discuss the options available to you with your advisors. In Canada, there are strict rules governing the use of reserves. Where a down payment or first year instalment is relatively small, it is possible to trigger a tax liability that exceeds the amount of cash realized in the year of the sale. Be sure to consult with your professional advisors before undertaking such a financing arrangement. Liquidation If there is no market for the business as an ongoing entity, or if other options are not available, you may choose to liquidate the assets that the business holds, and close the business. In such a case, you could be eligible to claim a business investment loss. The timing of a business investment loss is important and is sometimes controllable. Consult with your professional advisors to determine the best approach and the best time to liquidate. Buy-sell agreements What will happen if you or a partner wishes to retire? Or if one of you dies prematurely? Or becomes permanently disabled? Or gets divorced? (You may end up with an unintended partner – the divorced spouse!) Most closely held businesses need to have a buy-sell agreement in place when other partners, principals, or shareholders are involved. Most commonly, this agreement states what occurs in the event a partner/shareholder should die, but it should also include provisions for retirement or other departure, disability, and for the divorce of a partner. If you are an individual business owner, many of these items still apply; you simply have the added challenge of determining who will purchase your business in the occurrence of one of these events. A properly structured buy-sell agreement stipulates in a binding contract what occurs in each of the events outlined below. Death There are two general approaches to creating buy-sell agreements that deal with the death of a shareholder. Either the shareholders themselves have the right to buy some proportion of the deceased’s shares, or the corporation has the right to redeem the shares. In the first option, the other shareholders will typically agree to the right to purchase shares on a proportionate basis so that no one’s degree of control is changed if they all exercise their right to purchase. If one or more do not exercise the right, there is often a secondary agreement that either allocates the right to the unsold shares to the exercising shareholders, or allows the corporation to redeem the shares and reduce the number outstanding. The more shareholders involved in such an agreement, the more complex and unwieldy the transaction will become. Where the shareholders buy the shares, there will be the usual capital gains considerations and the deceased’s estate will generally have access to the capital gains deduction. Where the corporation redeems the shares, the cash paid to the deceased’s estate is not capital gains, but is more commonly a “deemed dividend”. This cash will not be eligible for the capital gains deduction, but is eligible for the dividend tax credit. Both methods of dealing with shares on death are usually supported by insurance policies to guarantee that there are sufficient funds to buy the shares at their fair value. Additional policies are often used to protect the estate from the tax burden that may exist at that time. Disability If a partner becomes disabled, how long will the company continue to pay his/her salary? How long would he/she remain a partner? A disability buy-out provision specifies the method and timing for the buy-out of a disabled partner. This can be done with an instalment sale (providing the company can afford the payments) or more likely with a disability buy-out insurance policy. This policy provides a lump-sum benefit to purchase the business shares from the disabled partner. An agreement dealing with the share transactions on disability will generally include the same options and alternatives as the agreement dealing with the death of a shareholder because the concerns are so similar. Divorce A divorce decree or the operation of provincial law can stipulate that all assets are divided between the spouses, including business interests. Unless the buy-sell agreement states what happens in this event, the business may end up with a new, and potentially unwanted, partner. Where the shares are divided equally between two spouses, one controlling shareholder may become two minority shareholders and the primary capacity to influence the direction of the business may be shifted to another shareholder. Generally, Canadian courts require that one spouse or the other purchase the other’s interest in the business and new shareholders are not introduced in this fashion. However, divorces can take time and a well-crafted agreement can remove some of the uncertainty for the business that is not involved in the divorce proceedings. Retirement
Perhaps the most complex of all situations is retirement. Who will buy your shares at your retirement? If the existing shareholders want to ensure that an unwanted relative or third party does not gain an interest in the business, they will craft a buy-sell agreement to address the eventuality. This agreement will generally resemble the procedures that the shareholders want to follow when a shareholder dies so that the respective levels of control are retained. Some agreements contain provisions that will enable tax counsel to bring about the wishes of the group in the most tax-efficient manner available at the time of the transaction.
Paul is a Certified Financial Planner (CFP) licensed by the Financial Planners Standards Council; Financial and Estate Plans are provided under that license.
The information contained in this website is intended to provide general guidelines only. The application and impact of the law can vary widely from case to case based on the specific or unique facts involved. Accordingly, the information in this article is not intended to serve as legal, accounting or tax advice. Users are encouraged to consult with their professional advisers for advice concerning specific matters before making a decision.
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J. Paul Wilson,CFP®, ChFC®
Certified Financial Planner
27 Blue Thistle Road Halifax, Nova Scotia, B3S 1M3