The nagging question of succession, while planning for retirement...

Local case study: The Black family (all names have been changed)

For the past three decades, Mr. Black (64 years old) and Mrs. Black (62) have operated retail stores. Their two sons, Peter (38), and Paul (35) currently manage the business. When the youngest son graduated from university, the business expanded to two locations, with each son in charge of a single location.

For 10 years each son has been learning the business alongside their father and mother.

Mr. and Mrs. Black would like to retire next year. The business is profitable and usually generates about $300,000 in after-tax profits (after about $500,000 in salaries have been paid to all four family members). However, most profits are reinvested in inventory and leasehold improvements, which are substantial. Total sales for the past three years have been in the area of $8 million.

The subject of succession has never been broached with the sons. Mr. and Mrs. Black still own the company that operates the two stores, and about 10 years ago Mr. Black set up an operating company that owns the building housing one of the retail stores. That has been the extent of his corporate planning. Mr. and Mrs Black have two $250,000 “Term 100” life insurance policies.

Paul, the youngest son, is married with two teenage children while Peter is single (once divorced), but is planning on moving in with his girlfriend of two years. She has two similar-aged children.

Mr. and Mrs Black still have some RRSP contribution room (about $40,000). The Blacks own one of the retail stores (the other is leased) through the operating company, own the family home, a cottage and a Florida condo they purchased three years ago.

Mr. and Mrs. Black would like to sell the business to their sons, but are struggling to determine a formula that will ensure their retirement without inhibiting their sons’ financial success. They want to ensure the business will remain owned by their sons, and would also like to know how to value their business and how they can finance a sale transaction.

The Black family’s situation is similar to many entrepreneurs: The assets are concentrated in business assets and real estate. While these investments have been profitable in the past, only the real estate will provide the liquidity required for retirement.

Therefore, the goal should be to maximize the asset value of the business and minimize tax implications, in order to convert the active business income the Blacks used to earn into passive investment income in retirement.

Entrepreneurs need to consider things such as tax planning, insurance, estate planning, legal, financial planning and investment management when making these types of decisions.

Legal and estate planning

1. Set up a holding company

The building is currently owned by the Black operating company and can be easily attacked by creditors. The best way to protect the assets of an incorporated business is through the use of a holding company (holdco). Because the Blacks have excess earnings in the operating company each year, they could pay this excess capital to their new holdco as a tax-free dividend and protect those earnings.

2. Enter a shareholders’ agreement

A shareholders’ agreement sets out the privileges and responsibilities of the shareholders, and provides a structure for setting out the principles upon which the shareholders intend to run the business. In other words, a shareholders’ agreement defines the way in which the company should be governed and managed so as to avoid messy and expensive disputes in the future.

3. Use family trusts to maximize income-splitting

The Black brothers should consider owning their shares through a family trust. The benefits of this include:

(a) Income splitting: A well-structured family trust allows for the splitting of income earned by the trust among the various beneficiaries (subject to specific rules)

(b) Funding of children’s education

(c) Capital gains exemption: An individual may be eligible to multiply the $750,000 capital gains exemption

4. Prepare primary and secondary wills

Each member of the Black family should be advised to have a primary and secondary will drafted and executed. A primary will would hold assets that require probate, and a secondary will would hold the remaining assets not requiring probate (i.e. privately held shares). This strategy would result in lower provincial probate taxes.

Hugues Boisvert, LLL, LLB, corporate lawyer at Andrews Robichaud P.C.

Tax planning

A common approach used to transfer a business to children is an “estate freeze,” which involves exchanging the parent’s common shares for preferred shares of equal value. The preferred shares are typically redeemed and the redemption is treated as a taxable dividend. To lessen the tax burden, the redemption is done over time – subsequently, the company issues zero par value common shares to the children.

Unfortunately, we have often seen brothers fighting and families destroyed over ownership and perceived inequities. Assuming that the stores are equivalent, each brother should get one store.

The business is viable and growing, therefore using a going concern valuation method is appropriate. An important component is estimating future maintainable earnings. All non-recurring items should be excluded, in particular if the parents take their retirement and won’t be replaced

As for the building, it should be excluded from the sale. The building should be kept in a distinct company and rent should be collected.

On the financing, the inventory can leverage up to 70 per cent and the remainder of the purchase price can be financed by term debt and/or an earn-out.

Michael B. McCrann, CA, partner at Bessner Gallay Kreisman

Insurance strategies

For the purpose of this situation, we must assume that the buyout by the sons is going to occur over a period of time. To protect all parties, a consideration can be made for the corporation to secure life coverage on the elder Mr. Black in the amount of the purchase price. Upon Mr. Black’s death, if prior to this shares have all been purchased by the sons, proceeds will flow into the corporation to fully buy out the remaining value of the unpaid loan and create a nest egg for Mrs. Black independent of the future profitability of the business.

Mr. Black should consider taking out life insurance to pay off the $300,000 mortgage at time of his death. After the sons have taken over, there should be life and critical illness insurance placed on them to provide money for share purchase as well as additional coverage for possible “key person” needs. The sons also need to consider proper disability insurance outside the group plan, which exhibits reverse discrimination against executives.

The existing $250,000 life policies can be structured to provide a charitable donation on death to the Blacks’ favourite charity and thus reduce any possible tax liability on their terminal return. In this manner, taxes are reduced, and the family can leave a legacy.

Shawn Ryan, CF, senior insurance and estate planner at TK Group

Investment strategies

Four things to keep in mind:

1. Cash flow planning

The first step in the investment process should be to establish their monthly cash flow needs. This “burn rate” number will drive the asset allocation decision as the goal for the Blacks should be to generate the monthly cash flow from investment income.

2. Individual pension plans (IPP)

These are defined benefit plans where the business takes on the responsibility of providing an actuarially determined nest egg at age 65. IPPs are flexible in terms of investment options, creditor-proof, often enable higher contributions than RRSPs and when initially set up, can offer substantial tax savings.

3. The building

Depending on the location and condition, the building might prove to be an additional retirement cash flow generator. Strategies to maximize rental income such as refinancing and extending the mortgage amortization should also be studied.

4. Investment portfolio

A collection of corporate bonds along with a well-researched list of stocks - in companies that both pay a measurable dividend income and have consistently grown their dividend in the past and an ability to continue to do so - should be the cornerstone of the Black Family retirement portfolio. It is important to remember that markets are not always willing accomplices to generating capital gains for investors. Sufficient cash flow from income insures that an investor does not have to sell securities at a disadvantageous time.

Benoit Poliquin, CFP, CFA, VP and portfolio manager at Pallas Athena Investment Counsel

Something everyone should do right now: The estate List

Here is a great article written by Benoit Poliquin, CFA, CFP & VP / Portefolio Manager at Pallas Athena Investment Counsel:

Yes, that is right. Tonight, while you are watching your favourite television program, once the kids have gone to bed and you are thinking whether you should turn on your laptop and catch up on work, clean your Inbox or finish that book you started....don't! Instead, make the following list: The Estate List.

As a portfolio manager, I am called in at the best of times (when someone or a family) comes into large amounts of capital, or at the worst of times (death or illness). Well, recently, I have been helping a client through some difficult family health issues. During these trying times, the simplest of task becomes much more complex.

To make things easy, here is the list:

Will and Power of Attorney: Make sure you have an updated will, and make sure your executors know that they are indeed executors, and where they can find the will. Do you have a power of attorney in case you are unable to make decisions for yourself? Call your lawyer this week and get it sorted out.

Insurance: Do you have any? Is it sufficient? Where are the policies? Do you have all of them ? If you are uncertain, contact a competent insurance professional for an insurance audit. As for the copies of the policies, keep them in a safe yet accessible place.

Safety deposit box: Do you have one? more than one? Could your executor find the key? Could they have access to the box? Get that sorted this week!

Passwords: In this day of online security...we all have a collection of passwords. What if you were not around to make that monthly bank transfer? Make sure your online banking does not breakdown because you are not around.

Advisors: Chances are your lawyer, your accountant, your insurance advisor and your investment advisor don't know each other, and most certainly don't speak to each other on a regular basis. Does your executor and your loved ones know who they are, and how to reach them?

Accounts: You might have banking relationships for business and personal accounts at different institutions. Is this know by your executor and loved ones? Are your bank accounts listed in a central place?

Business Assets: You might own a business, a building or units in a limited partnership. Is this a known fact? Is this reflected in your will? What would happen to these assets if you were unable or worse, not around, to make decisions?

In short, you are trying to make things easier for your loved ones who depend on you. Make this list, and make it known to those that it concerns....and keep this list current!

Business owners: Could a family trust help you save up to 32% off your taxes?

As a business lawyer, I meet with entrepreneurs on a daily basis, and for many of them, their most valuable asset is their corporation. For obvious reasons, their first priority is on income-earning activities, such as generating sales. Attention to such activities is, of course, a practical necessity and a hallmark of success. However, the utilization of a proper corporate structure to reduce tax exposure is often overlooked. Business owners are often unaware that the proper structure can save a substantial amount of taxes and be greatly beneficial for them and their family. The purpose of this brief article is to explain to you the benefits of using a Family Trust and to help you determine if you are a good candidate for implementing such a structure.

What is a Family Trust?

In essence, a trust is not a legal entity like a corporation, but rather a relationship that exists whenever a person, called a Trustee, holds property for the benefit of other individuals. The trust arrangement permits the legal ownership of the property to be held by the trustee while the benefits of ownership (income, capital gains) accrue to the beneficiaries. It is common practice for an entrepreneur and his or her spouse to act as Trustees of their Family Trust. Hence, entrepreneurs can still maintain control over their companies, while benefiting from a trust arrangement (subject to their fiduciary duties to act in the best interest of the beneficiaries).

How do I determine if I’m a good candidate to setup a Family Trust?

Here are some key indicators that you should consider a Family Trust:

Ø You are a shareholder in a private corporation.
Ø Your business is generating taxable profits.
Ø You have children(s) and you are paying/will pay for their education(s).
Ø You may want to sell your company in the future.
Ø You want to protect your family from higher estate taxes.

Would it be beneficial for me and for my family?

Some of the benefits of using a Family Trust structure are:

Income splitting.

A well-structured family trust allows for splitting the income earned by the trust among the various beneficiaries. If you are a high income earner you may be able to split your revenue to a lower income earner. (subject to the potential application of the attribution rules and the “kiddie tax”).

Funding of your children’s education.

One of the most immediate benefits is the funding of your children’s education. By having the trust own shares in the family company and having your children as beneficiaries of the trust, it is possible to fund as much as $32,000.00 per child over the age of 18 at a tax rate of approximately 16% through the trust as opposed to funding your child’s education from your personal funds which are usually taxed at a substantially higher rate. If you are a high income earner you will be paying tax at approximately 48%. Basically, with this structure, you can potentially save as much as 32% on your taxes (i.e. a potential saving of $32,000 for each $100,000 earned). This is a substantial savings for each of your children for each year that he/she is in school with little or no other source of income.

Capital gains exemption.

Once in your life time, you may be eligible to claim the $750,000 capital gains exemption. Basically, what it means it that an individual selling his/her shares of a Canadian Private Corporation (subject to a set of specific rules) can receive the first $750,000 on a tax free basis. Hence, the $750,000 capital gains exemption may be multiplied by the number of family members who are beneficiaries of the trust, without direct share ownership.
Reducing tax liability at death. Transferring assets to a trust may limit the size of the individual’s estate, such that tax liability at death is reduced. In addition, probate fees may be reduced.

As you can see, a Family Trust can offer private business owners a great deal of opportunities to benefit and should be further explored. Any individual who is interested in setting up a corporate structure that involves a Family Trust should evaluate all the tax consequences and consult with a knowledgeable professional. For more personalized information and assistance analyzing whether you would benefit from setting up a Family Trust contact me for an appointment.