Mapping out your business’ future within your close circle of family and friends can be a tricky feat. Here’s what to consider in order to guarantee smooth sailing when it comes to succession planning.
by Mehreen Shahid
As a business owner, you know that the work doesn’t stop just because you’ve gotten your venture off the ground and all operations are in full swing. If you’re smart about your future, you know that succession planning is a vital part of solidifying the success of your business down the road. But success doesn’t always come easy, especially when you take into account factors like your will, your assets, and the ever-essential taxes.
Let’s take Mr. X, for example. He’s running a successful business called Jewel “R” Us and has money in his account in the form of RRSPs and RRIFs. What happens to all of that when he passes away?
The total value of all assets is taxed according to provincial income tax brackets, says Anna Malazhavaya, a Toronto-based lawyer at Milow Law. The Income Tax Act requires that the fair market value of a deceased person’s RRSPs and RRIFs be included in his or her terminal tax return (a tax return filed for the departed person).
“Mr. X’s assets on death were shares of his business, Jewel “R” Us, and $100,000 in RRSPs,” she says, referring to the arbitrary example. “He purchased his shares for $200,000 many years ago. The business developed really well and at the time of Mr. X’s death, the shares of Jewel “R” Us were worth $1,200,000. Under the tax rules, Mr. X was deemed to have sold his shares immediately before death for $1,200,000 and realized $1,000,000 in capital gain. His estate had to include one-half of the resulting capital gain ($500,000) and value of RRSPs ($100,000) in Mr. X’s terminal tax return and pay tax at the applicable marginal tax, which in this case would be approximately $270,000.”
A common mistake business operators may make is to ignore the significance of a will. They don’t realize that their assets may not necessarily be transferred to their family members untaxed.
“In Ontario, a married spouse gets a preferential share of the estate of a deceased spouse who has died without a will,” says Kathleen Robichaud, lawyer at the Law Office of Kathleen Robichaud in Ontario.
According to Malazhavaya, a simple clause in the will could mean that a number of exceptions from the general rule can be brought on so that no tax or only a portion of tax would be payable on Mr. X’s death in the example above.
“There would be no immediate tax if Mr. X’s spouse or common-law partner inherited his shares of the RRSPs,” she elaborates.
Malazhavaya adds that experienced tax and estates lawyers can help navigate through all potential tax traps and identify various saving opportunities depending on the business owners circumstances.
Annie Chen, associate lawyer with Faskin Martineau in Toronto, says that having a will prepared in case of death, incapacitation or disability can help avoid other complications. Keep in mind the following three factors when an individual passes away without a will.
- If no successor has been identified, the estate will be held by the province, and the family will have to pay an estate administration fee, whereby an executor will be appointed by court. Generally, in British Columbia, administration fees are 1.4 per cent of the value of the assets and 1.5 per cent in Ontario.
- This process can become messy and take years to resolve and legal fees accumulated during that time can become burdensome.
- Moreover, once the case goes to court, all information regarding the business becomes public record and competitors can take advantage of it.
When writing a will, Robichaud warns that, “If you have a prior business agreement, look at it.” Clauses in a corporate business agreement affect the terms of a will. And, she says, a way of avoiding the administration fee later on is to appoint a “key person” in case one of the partners/investors/shareholders passes away or becomes disabled.
Malazhavaya suggests formulating how you want the business to operate or dissolve after your death and discuss it with your lawyer.
“If your business continues, who is your successor?” she says. “If it dissolves, who is responsible for the dissolution process?”
Remember to also address matters related to social media such as, “What do you expect to happen to the store’s website and social media presence? Who would have access to important passwords and secret information?”
When selling your business, Chen says that a clean sale is dealt with differently from one that involves a family member, such as a child or spouse. Malazhavaya proposes an “estate freeze” as a way of transitioning the business over to a family member.
Being an active and healthy man in his fifties who is very much involved with his business, Mr. X needs a succession plan but he’s not ready to transfer all of the operations over to his son just yet. Jewel “R” Us is growing steadily and its value is expected to reach $3,000,000 in the next decade. The estate freeze will allow Mr. X to freeze the value of his Jewel “R” Us shares by exchanging his common shares for new fixed value preferred shares on a tax-deferred basis. This means that the value of shares held by Mr. X will remain frozen at the time the contract is decided, however, all gains and advances in the value of those shares will be attributed to his son, Mr. Y.
With the value of Mr. X’s shares “frozen” at $1,200,000, potential tax liability at death in respect of the shares would also remain frozen: Mr. X’s property will be assessed at $1,000,000 in capital gain. Implementing the structure, if done with the help of an experienced lawyer, does not trigger any immediate tax liability, and Mr. X, being a shareholder, still retains a certain degree of control over the business.
As far as transitional changes go, Chen says a similar change can still be made if a business owner wants to sell outside of the family. She also suggests considering a right of first refusal, whereby business shares will be offered first to employees before they are sold off to the highest bidder in an open market. This strategy helps create a trust in the employees and invites them to become involved in the company at a deeper level. It also paves the way for a successor from within the company.
Any time a sale or transfer is made, says Chen, the terms of the lease are also affected. The landlord must be involved in such transactions, so he/she is aware of the existence of the new owner and the name that needs to be put on the new lease agreement.
These and many other legal issues can be avoided by careful planning in collaboration with consultants such as lawyers, bankers and accountants. It’s also important to keep the successor involved every step of the way in order to ensure a fruitful transfer.
Checklist from the Canada Revenue Agency:
- You may need a new business number
- When the owner of a sole proprietorship or one of the partners in a partnership or one of the members of a corporation’s board of directors changes, it is important that you contact your tax services office
- Depending on the partnership agreement and whether or not the business was registered using legal names of each partner or the provincially registered partnership-operating name, death or departure of a partner could trigger a legal name change or require the registration of a new business number (BN) and CRA accounts
- Treat the value of the inventory as a purchase of goods for resale, and include it in the cost of goods sold in your income statement at the end of the year. CJ