Tips for effective business succession planning

Transfer your business to the next generation

By minimizing your tax and maximizing the value of your business, you'll be able to enjoy more of the wealth you've spent years creating as well as help your successor get off to a good start.

Many people start a small business with the goal to generate income to support themselves and their families. Unfortunately, many small business owners fail to plan for succession until it's too late to manage it effectively. The end result: at worst a business can fail; at best, a successor may be hit with an unexpected tax bill.

Types of succession

Succession can take place in two forms, "normal" and "forced", and it's important to have a strategy for both. Normal succession typically happens when a business owner retires or leaves the business to move on to other activities. Forced succession can occur for unexpected reasons including mental or physical incapacitation and death.

Choosing a successor – family first?

Because you're the driving force, you've had the vision to make your business a success. But when it comes to handing it over, that vision may become less clear, particularly when it involves family. Here are some important issues to discuss:

• Do your children want to be involved in the business and do they share your vision for the company?
• If more than one person is involved (siblings or perhaps your child or your partner), can they work together and how will authority be divided?
• How will you phase out your involvement in the business?
• When should ownership be passed on? There could be important tax advantages in giving the business to your children while you're still alive. For example, an estate freeze transfers ownership while providing an income stream.
• What's the best leadership preparation – education, apprenticeship, or both?
• If a key employee or business partner is taking over, will they buy you out?
• Will a trust help with the transition and a succession plan?

A family trust buys you time

If want to keep your company in the family but you're not sure who to hand the reins over to, a trust can ensure your business carries on without committing you to a decision. Essentially, the trust can become a shareholder in the business. You own preferred shares with controlling votes that reflect the current value of the business. Your children own common shares, which will reflect future increases in the company's value. These common shares are held in the trust with your children as beneficiaries. This allows you a substantial period of time to "wait and see" before deciding who should get control. Because a trust is a taxable entity, separate tax returns have to be filed.

Selling – realizing the value of your business

If you're not transferring to a family member, you can sell to a key employee, a partner or to outside interests. If you've built up a larger operation, an MBO (Management Buyout) may be a possibility. In any case, getting good value for your business can take considerable time and effort. Enlisting the aid of a specialist to help provide a fair valuation of your business is important. Different methods can be used to arrive at a fair market value, including:

• Examining your assets, totaling up all your investments in the business
• Comparing to similar businesses that have sold recently
• Auditing past earnings and profits
• Comparing sales and net cash flow with liabilities and current market conditions

Tax strategies are key to effective succession planning

The goal of effective succession planning for a privately owned business is to maximize the after-tax value in your business while minimizing the tax burden on you or your successors. Strong tax planning is a crucial element of this process.

To reduce taxes owed during and after succession, here are few options to consider.

Establish a holding company or family trust

Holding companies or family trusts offer advantages when it comes to tax deferral and savings, income splitting opportunities, and protecting assets from creditors. There is no easy answer as to whether a holding company or family trust is right for you or your business and many people are unsure how a holding company is structured and when best to implement. However, depending on the situation, they do offer significant benefits.

Implement an estate freeze

An estate freeze is used to freeze capital gains at their current level. Your assets are transferred to the company, most often in the form of common stock, and in return you receive preferred shares. The company then issues common stock to your beneficiaries or a trust set up for them. The value of your shares is locked in and effectively "freezes" the tax liability at that point in time.

An estate freeze can be a sensible option when you have enough savings to be confident you won’t need to rely on the future growth of your business to make ends meet in retirement. It’s also worth considering when you’ve maximized your Lifetime Capital Gains Exemption, but family members who are shareholders have room available to tax-shelter further gains.

Create a spousal trust

Spousal trusts can be used to protect a privately owned business from capital gains tax. If a husband and wife, for example, own shares in their company, and one of them passes away, the shares of the deceased are deemed to have been sold and are subject to capital gains tax. However, the shares can be put into a spousal trust so that taxes aren't immediately payable, and the business can continue uninterrupted.

Insure against capital gains tax

A very effective strategy to cover forced succession due to death or incapacitation is to use the proceeds of life insurance to pay capital gains tax. Total life insurance premiums are often much less than the capital gains tax owed when a business owner dies. This is particularly true if your business has real estate holdings that have increased in value.

Use your lifetime capital gains tax exemption

If you own shares in a qualified small business corporation, you may be eligible for a capital gains tax lifetime exemption. While the rules around qualified small business corporation shares are somewhat complicated, taking advantage of this exemption can save you tax when your shares are sold.

Transfer ownership over time

Transferring company assets or shares over a period of time is a fairly straightforward strategy. It can lower the overall amount of tax owed from capital gains or at least spread the tax bill into smaller, more manageable chunks.

Over time, assets and shares often rise in value. The earlier they're transferred, the lower the tax on capital gains will likely be.

Gift or sell shares of your company

Finally, if your successor is a family member, gifting shares will not burden them with any tax. However, shares that are gifted are also deemed to have been sold at fair market value, and you'll have to pay capital gains tax owed at the time the gift is made. It's therefore important to make sure you have the money to pay the tax before you gift.

Selling your shares to a family successor is another option, and the proceeds from the sale can be used to pay for taxes owed. Of course your successor will have to have the money available to buy the shares from you.

Put your succession plan in writing

In many ways, a business succession plan is like a will. Besides the need to be up-to-date and legally sound, it should present no surprises to anyone involved. Like any important document, it should be reviewed periodically to accommodate any change in needs or circumstances.

To further safeguard your business legacy, be ready for the unexpected. Your greatest risk is not being around, through either death or disability, to see your plan through. Insurance is the best way to provide income protection for your family.

With careful planning, you'll ensure you get out of your business just as much as you put into it.

Your business advisor can help

Effective succession planning is an ongoing process. It should be started early and reviewed when your company's or successor's financial position changes. It's ideal for your business advisor to work with your personal financial advisor, as well as your lawyer and accountant, to help manage your options as a team. In particular, when working with trusts it's important to get advice from a financial expert because they can be complex.

Together, you can make sure your succession plan covers all the essential areas, including:

• How to structure the deal, its timing, and tax treatment
• The financial benefits for you, your spouse, and other family members
• Insurance planning that takes into account additional funds necessary to keep the business running or provide for the family while it's up for sale
• Changes to wills, insurance, and perks such as company cars
• Agreement on the extent of your ongoing involvement
• Contingency plan for unexpected events such as the death of your chosen successor
• Transitional roles for you and key employees
• How and when to communicate ownership change to employees, customers, suppliers, banks and other third parties.

By minimizing your tax and maximizing the value of your business, you'll be able to enjoy more of the wealth you've spent years creating as well as help your successor to a good start.