Business Succession - Turning your Business Into Cash

We all need to plan for retirement. As the baby boomers approach retirement age, we can expect more people competing to purchase the same commodities i.e. golf shoes and Florida condos. Therefore, that old adage about planning for retirement has never been more relevant.

For those people who are employed in a pension environment, the process of planning for retirement is greatly simplified. Business owners on the other hand must create their own pension through RRSP savings. Often, however, any excess funds which may have been available for contribution to an RRSP are pumped back into the business for growth and expansion. As such, many business owners find themselves approaching retirement age with their retirement plan trapped within the business. Unfortunately, a private business is arguably one of the most non-liquid of all assets. The trick, therefore, is to turn that non-liquid asset into cash.

Starting the Process

As most financial advisors will tell you, it is never too soon to start planning. When dealing with a business the first step in the process is to consider possible buyers. The available categories include existing business partners, employees, family members and competitors. Each category has its own set of challenges which must be identified and addressed. For example, employees and family members will often require training and, therefore, there will need to be an extensive transition period until they can assume control of the business. It must also be recognized that bringing family members into the business can introduce elements of the family dynamics into the business environment which can create additional challenges. Further, it is often the case that all family members will not become involved in the business and that can, in turn, cause difficulties in the family dynamics. In estate planning it is generally regarded as wise to avoid leaving an interest in a business to uninvolved family members. In such situations there will be a need to develop creative strategies to equalize the distribution of assets among family members on the death of the business owner. When dealing with competitors, the timing of the sale is critical to ensure that the value of the business is maximized. It is easy to get into a situation where the business is a “lame duck” in that it becomes unable to operate without a change of management control.

Sale of Shares vs. Sale of Assets

One of the most crucial considerations in succession planning is the structuring of the sale of the business i.e. assets vs shares. Generally, the vendor of a business will prefer a sale of shares. In large part this is due to the main tax advantage of a share sale which is that a shareholder can shelter up to $500,000.00 of capital gains using the capital gains exemption. Each exemption is worth approximately $120,000.00 in tax savings. In a family owned business where there are multiple shareholders, the tax savings can be significant. The capital gains exemption can even be used following the incorporation of a sole proprietorship immediately prior to a sale. The use of the exemption is subject to several complicated conditions under the Income Tax Act which, with the help of your lawyer, must be carefully analyzed to ensure that the shares are onside.

In order to sell the shares of a business corporation, it is important to identify exactly what assets and liabilities are in the corporation since everything effectively goes along with the corporation on a share sale. There may be ways to separate business from non-business assets prior to a sale but this planning often takes a lengthy period of time to implement, particularly if it is to be achieved on a tax-deferred basis. In an asset sale, on the other hand, the seller and the buyer can agree on which assets are to be sold. The sale of depreciable assets in an asset sale will often give rise to recapture which imposes a substantial tax burden on the vendor. Conversely, the purchaser is able to allocate the purchase price among the purchased assets to achieve optimal tax results. It is important to note that in an asset sale the corporation stays with the original owner and is the recipient of the sale proceeds. Accordingly, the corporation will often be used as an ongoing investment vehicle.

The point of the exercise is to begin the process of analyzing the business structure sooner rather than later. The development of an optimal share structure and the separation of investment and business assets early on can greatly simplify the process of sale and maximize the after-tax proceeds. Another point which cannot be over emphasized is the need for proper documentation. This is particularly important during the transition stages when a new family member or employee is assuming control of the business. Proper Shareholders’ Agreements, Employment Agreements, Consulting Agreements, etc. must be in place to outline the rules of the game for management, control, profit distribution and the various “what if” scenarios.

Tools Used for Business Succession Planning

There are various legal tools available which can help facilitate the business succession process. Your lawyer can help you find the one that is right for your business. The first is the use of a trust as a shareholder in the business. A discretionary trust with multiple beneficiaries can provide substantial income-splitting opportunities as well as the ability to multiply the capital gains exemption amongst available beneficiaries. Besides these obvious tax advantages, a discretionary trust also allows a business owner to defer the decision of share allocation until some point in the future. The discretionary trust allows the business owner to step back and observe how family members are turning out and their degree of involvement and success in the business before making a decision on ultimate ownership of shares.

The next planning tool which may be used in the business succession process is an estate freeze. An estate freeze is a term used to describe the capping of value of an asset in the hands of an individual. In the context of business succession we are most interested in an estate freeze involving shares of a private corporation. This strategy is particularly useful if the business is going to be transferred to an employee or family member where available cash may be at a premium. An estate freeze of shares involves the conversion of the growth shares into fixed value shares at the current value of the business. Immediately following this re-structuring, new growth shares may be issued to the ultimate “purchaser” for nominal value. The fixed value shares can then be bought out over time to complete the transfer of the business. An estate freeze involving shares can normally be completed on a tax deferred basis. Again however, there are complicated rules which must be navigated to ensure that there are no unintended tax consequences.

A leveraged buyout is another vehicle which may be used when cash is at a premium for the buyer. A leveraged buyout involves the use of future business profits to fund the acquisition of the business. This structure is often used to transition the business to
employees. In this scenario, careful
attention must be paid to the issues of
management transition and the consequences of non-payment.

Conclusion

Clearly, there are a lot of issues to consider. The moral of the business succession story is to get your head out of the sand, develop a road map and ensure that each stage along the road is properly documented. And by the way…. you should start yesterday!