One of the core pillars of our practice is in working with business owners in and around Calgary. We have been assisting them with proper succession planning, valuation, tax savings strategy, pension and income planning, family security, and eventual estate optimization for a number of years now. In preparation for our fall series for business owners, we will be posting articles and tips that cover some of the key aspects of a succession plan, starting today with Estate and Tax:
In many cases, the owner of a small business wants to pass the business on to succeeding generations, typically children. This can be done through a Will when the person dies but the person may want to do this while they are still alive. There can be compelling tax reasons to do this. An 'estate freeze' is a mechanism where ownership passes to the next generation while the owner is still alive. Here are the different types of estate freezes:
Paying Tax Now
Under tax law, if an asset such as a company is transferred to another party, either to family member(s) or another arm's length party, it is considered to be a sale at the fair market value. This can result in substantial capital gains tax in the year of the transfer if the company has increased in value. However, if you transfer now, any subsequent growth is attributed to the new owners.
Use of Trusts
One way to do an estate freeze is to have the shares of a company transferred into a trust with family members as the beneficiaries. You may be able to establish yourself as the trustee and retain control but if the beneficiary of the trust is not your spouse, you will have to pay capital gains tax since the transfer will be as if you sold the shares. Again, tax on any subsequent growth in the shares is the responsibility of the trust and/or the beneficiary.
Section 85 Rollover
In the previous two examples, there may be immediate tax implications by transferring a company to your family now. A further issue that can arise is that the owner will lose control of the company. The Income Tax Act provides a mechanism that allows an effective change of ownership while still enabling the original owner to maintain control of the corporation. This is the Section 85 rollover.
The Section 85 rollover can be a very practical and tax efficient strategy. However, it can also be rather complex in the details and is another area where professional advice is highly recommended.
Situation:
Lori Strong wants to pass her wholly owned company, Lori Inc. to her two children, Sarah 34, and Chris 32. Her shares of the company have a cost of $1 million. A qualified business valuator has determined the current fair market value to be $5 million so the shares have increased in value by $4 million.
Setting up a Holding Company
A Holding Company, Holdco Inc, is set up. Sarah and Chris are equal shareholders and they each buy 100 common shares for $1 per share.
Using Section 85, the shares of Lori Inc, are transferred into Holdco. In return Lori receives preferred shares of Holdco worth $5 million, the fair market value of the Lori Inc. shares. These preferred shares have voting control over Holdco and are retractable at Lori's discretion, which means she can redeem them for $5 million. Lori can choose a transfer value for the shares of $1 million - her cost. Lori will not have to pay any tax on the preferred shares until she eventually sells them.
Since the preferred shares have a set value of $5 million any subsequent increase in the value of the Lori Inc. shares will accrue to the two common shareholders of Holdco Inc., Sarah and Chris.
By doing this, Lori has managed to keep control of the company, deferred any immediate gain, and has passed on any subsequent growth to her children.
One of the important features of the Section 85 rollover is that Lori will have discretion in regards to the transfer value of the Lori Inc. shares. For example, although the shares currently have a fair market value of $5 million, under Section 85 she may be able to transfer the shares at their cost of $1 million, avoiding any immediate tax since the transfer amount chosen ($1 million) is the same as her cost. The children would have a tax cost of $1 million for the assets (the shares transferred) and the owners of Holdco Inc. shares (Chris and Sarah) will not have to pay any tax until they dispose of the Lori Inc. shares in the future.
Your advisor will be able to provide you with additional general information on Section 85 rollovers and how to proceed if it appears that this strategy would be right for you.
Be sure to update any other documentation that may contain information related to your company, such as the information contained in this personal record keeper and personal and financial log book. Share your personal record keeper with your loved ones including your Executor or Executrix. Provide a copy of your personal and financial log book to your financial advisor so that he/she can have a better understanding on how your financial situation is changing.
Once a month I will be putting up key articles on Business Succession Planning in preparation for our fall series of luncheons on the subject.
*Please forward this on to anyone you know who may be going through the motions of selling or succeeding their businesses in the coming years. (*Early planning is key.)
Or, if you have any questions, or if you would like to meet personally to have a discussion, shoot me a message.
Best Regards.
Eric
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