What entrepreneurs need to know about business succession planning

Canada does not have an Estate Tax, but it does have something almost as expensive, called a “deemed disposition” which arises upon a person’s death. The deemed disposition is a mechanism in our Income Tax Act that causes taxes on a capital gain to be triggered, based on the fair market value of any taxable assets you hold at the time of passing. If you leave your assets to a spouse or to a spousal testamentary trust, a tax-free asset rollover to the survivor is allowed. However, when your spouse passes, the deemed disposition cannot be avoided.

This “death tax”, together with probate formalities (which vary by province) may be considered in advance of your passing as part of your estate planning. It must be remembered too that if you own foreign assets (e.g., a Florida home) upon passing away, your estate may still face estate taxes in other countries like the U.S. which must be carefully considered.

Besides the tax and legal issues that arise at death, whenever Canadians own valuable businesses or real estate, there is also a risk that their heirs may disagree over what to do with those assets. This can be very worrisome, as it can lead to disputes and relationship or business breakdowns.

The risk of disputes can be heightened when estate assets include a family business where only some children work in the business and other children do not. That’s because the heirs who don’t work in the business often prefer to receive their inheritance from other estate assets and not be left as a passive minority co-owner with their working siblings, even if they have voting shares.

Shareholder and co-ownership agreements can be helpful tools to allow multiple owners to make harmonious decisions and avoid disputes. Your legal advisor can help determine their suitability and help ensure that they are drafted correctly.

Imagine leaving a substantial estate, but it causes your children to stop speaking to one another because of the way the estate was structured. This can be an unforeseen outcome when families fail to properly plan. Appropriate wealth planning, with fewer opportunities for misunderstanding or surprises, and with measures in place for the tax bill arising on death, can help a family business or significant real estate portfolio transition to the heirs.

Families with substantial assets should consider planning early to help determine the best way to pass on assets to their loved ones and manage any taxes or other expenses that may be payable.

In response to the growth of successful family-owned businesses across Canada, and the aging population, a new planning service has emerged called “Business Succession Planning."

Many business owners and entrepreneurs expect to transition the management or ownership of their businesses to the next generation. Those who aren’t thinking of passing down the business often contemplate selling or bringing in new shareholders. Yet, even with all these major changes being contemplated, many business owners simply do not have a formal succession plan in place.

Dying without a business succession plan can trigger a big tax bill. Consider the example of someone who immigrated to Canada with his spouse and two university-aged children in the late 1980s. After moving to Toronto, he invested in several retail shopping plazas and commercial buildings which he renovated and leased, taking advantage of the strengthening real estate market. Through hard work, risk taking and timing, the man amassed a property portfolio valued at $51 million today. The property is held in a Canadian holding company and he is the sole shareholder. The initial cost of his properties was around $21 million, and he therefore has a capital gain of $30 million.

He intends to leave his wife all of his assets and have her take over and run the rental property portfolio when he passes away. Canada’s tax laws allow him to leave his assets to his wife on a tax-free rollover basis.

He was advised to create a will. If a person passes away without one, the government has a set formula for how assets pass to heirs. Under the law in Ontario, his wife would not automatically inherit all his assets, as the set formula gives her the first $350,000 of his asset value and a further one-third of his assets, but the remaining two-thirds of his estate would go directly to their two grown children. While that first third of his estate would flow to his wife as a tax-free rollover, the two-thirds share of his assets passing to his children would cause an approximate $20 million capital gain (two-thirds of $30 million gain), and a tax bill of around $5 million.

The man was shocked by the tax estimate that awaited his estate and the reality that his wife would not automatically inherit all his properties if he passed away without a will.

There are practical solutions he can put in place now to mitigate some of the tax risks that await him. For example, he could consult a lawyer about putting a will in place to designate his wife as the beneficiary of his estate or make her the beneficiary of a trust set out in the will (testamentary trust). His wife may also want a similar will should her death precede his. These solutions could allow a deferral of the capital gains tax. He could also explore having multiple wills which could allow this person's private company shares (and certain other private assets he owns, including his rare watch and art collection) to bypass probate and save the 1.5% (approximate) probate fee in Ontario.

A will review is just one of the important areas covered in a comprehensive business succession plan. As well as a will, he is a candidate for an “estate freeze” and family trust strategies for his estate and tax planning. An estate freeze is a strategy that puts in place provisions to defer tax on an estate and to pay any tax that does arise from resources that don’t require the sale of principal assets. This helps the beneficiaries who can’t easily sell or don’t want to sell certain assets, such as a business or family cottage. In this example, it was possible to estimate the ultimate final capital gains tax liability payable on who dies last — either himself or his wife — and purchase corporate-owned life insurance to pay the income taxes arising at death. This would allow his heirs to inherit the company assets without having to sell or encumber them to pay the tax.

With the growing numbers of successful entrepreneurs and real estate investors living in Canada from abroad, many may not be aware of Canada’s tax laws. Many may not know about the deemed disposition on death, the importance of having a will in place or the consequences that await their survivors in the absence of a well-thought-out succession and estate plan.

Given that a family business or real estate portfolio may be the single most valuable family asset, it is critical to develop an orderly succession plan, as early as possible.

When it comes to business succession, there are two main aspects that need to be attended to: a plan for transferring ownership of assets and the transition of business management. Often, these two go together (i.e., leaving ownership to someone who takes over management). But in some cases, a family can retain the ownership of assets but hire professional management to manage them if this makes more sense.

Business succession planning involves creating the framework for the future transfer of ownership and management of a business or valuable real estate to a chosen successor. This could be a family member, business partner/shareholder, professional management company or third party. Equally, it is a plan that seeks to maximize value, family harmony, and overall security for all interested parties.

A well-thought-out business succession plan takes a comprehensive approach to evaluating all the relevant elements that need to be considered and implemented for the asset transition for it to be successful. Ordinarily, a succession planning review can cover:

• Options available to exit either during life or on passing
• A management transition plan,
• The perspectives of the different stakeholders and what they would like to see happen
• Business valuation, and how to optimize value prior to an exit
• Advance retirement planning
• Tax strategies
• Buyer financing
• Discussion of estate planning tools and strategies (e.g., wills, powers of attorney, estate freeze)
• Understanding life insurance, and,
• The possibility of a business sale (e.g., a sale outside the family or inside the family) and understanding who can help to sell the business

Business succession planning for owner-managed businesses typically includes a management transition plan. This may involve a list of tasks including:

1. Defining the timeframe for the current owner(s) and or manager(s) to exit
2. Identifying the skills needed in a successor
3. Scoping out compensation determining if a suitable internal candidate exists, or if there is a need to conduct an external search
4. Discussing the succession plan with a proposed candidate and the board of directors to set expectations
5. Discussing the succession plan with the senior management team, grooming the successor to take over and implementing and communicating the succession plan to any third parties

Normally, management transition is one of the longest and most complex steps in implementing a succession plan and can take several years. If the potential successor only possesses some of the skills needed to succeed, the deficient skills need to be filled by a combination of skills training where possible or hiring additional skilled managers to fill the gap. In the case of a family business where the next generation (i.e., child of the owner) wishes to participate in management but does not possess all the skills needed to succeed, sometimes a partial equity sale to key non-family senior management may be practical to lock-in the extra skills required. Another option is to implement compensation or incentives to lock-in externally hired managers whose skills are essential to see through the transition.

Planning an exit well in advance of retirement is prudent and may involve developing arrangements for future scenarios. For example: before an illness strikes, before liquidity may be needed by the family, to diversify the family’s concentration of risk, when a suitable successor is groomed and ready to take over, when market timing assures a good valuation and ample buyers exist, before declining market conditions deteriorate the business value or when partners and stakeholders signal, they are getting anxious about succession.

Business succession planning is a relatively new specialty advice area and can be pursued through professional advisors and financial services firms who have specialists in tax and estate planning, high net worth planning and insurance solutions to provide advice.

Request a call from TD Wealth to begin to put your plan into action.

Business owners who don’t have a succession plan often make various excuses. These often include not having the time to plan, feeling it is too early to plan, finding it too complex a process, saying they can’t find adequate advice or tools, saying that they don’t want to exit their business yet, or saying they fear causing a family conflict. The potential benefits of implementing a well-thought-out business succession plan, however, are numerous and may include:

• helping to ensure the smooth transition and continuity of the business/real estate
• maximizing the value of the business/real estate
• minimizing taxes payable
• minimizing probate fees
• minimizing estate taxes and inheritance issues
• providing financial security for the family
• preserving family harmony
• inspiring confidence in family, management, employees, customers, suppliers and bankers