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.

Tax strategies are the 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, consider the following options:

• 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 or not 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.

• 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 benefits 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, currently set at $800,000. 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.

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. When working with trusts, in particular, it's important to get advice from a financial expert because they can be complex.

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.