SUCCESSION PLANNING FOR FAMILY BUSINESS

Michael Bronstine & Todd Gotlieb

Estate Planning Considerations for Family Business Owners

Once you have set your succession plan, you should then ensure that your estate planning goals are coordinated with this plan. When coordinating the estate and succession planning, balance is critical. There are many tools you can use to maximize your estate, but you also need to ensure that the steps you take do not have a negative effect on your succession plan. In the rest of this section, we discuss estate planning considerations within the framework of a succession plan.

In many respects, family business owners face the same estate planning issues as individuals in general. However, as the investment in the business is the most significant asset held by most family business owners, there are several important estate planning issues that need to be addressed for these individuals.

• Freezing the Value of Your Shares
• Use of Insurance
• Retirement Planning
• Shareholder Agreements
• Preserving Your Estate

Freezing the Value of Your Shares

As we discuss in the Estate Planning bulletin, an individual is generally deemed to dispose of their assets at fair market value at the time of death. Exceptions to this rule include the transfer of property to your spouse at their tax cost and an intergenerational rollover that is available for certain transfers of qualifying farm property.
Where a tax rollover isn’t available, you will be subject to tax on accrued gains on your assets, including your investment in the business, at the time of death. For many business owners, the investment in the business will have a high value and a low tax cost, and consequently, a significant tax liability will arise on death. This problem is compounded by the fact that many businesses, although profitable, do not produce a significant cash flow since profits are reinvested in the business.
Finding a way to reduce, or at least defer tax on death is crucial if the business is to remain in the hands of the family. Most business families use two important estate planning tools to deal with this issue: an “estate freeze” and life insurance.

Defer tax with an estate freeze

Although it is difficult to reduce the tax payable on gains that have already accrued, there is a common technique, called an “estate freeze,” that you can use to limit your capital gains in the future. By freezing the value of your investment, future gains will accrue to shares held by your heirs and the gain won’t be taxed until they sell their shares (or have a deemed disposition on death).

In addition to ensuring that tax on future gains will be deferred, an estate freeze will allow you to effectively lock-in the tax liability that will arise on your death (subject to changes in tax rates in the future). You can then plan to ensure that this tax liability can be met without disrupting the business. For most businesses, life insurance is an excellent tool for providing liquidity on death.

How does an estate freeze work?

There are many ways to accomplish an estate freeze. One common method is to transfer the assets you wish to freeze, such as shares of your operating company, to a holding company. By taking back fixed value preferred shares, the transfer of assets to the corporation can be accomplished on a tax-deferred basis using special tax rollover rules. Your heirs (or a trust for their benefit) can then subscribe for the new growth shares (generally common shares) of the operating company. At the time of the estate freeze, the value of these common shares would be nominal, but as the value of the business grows, this growth will accrue to the new common shares held by your family or a trust.

In many cases, a business owner will take back two classes of shares on an estate freeze: the preferred shares we just described, plus a special class of low-value voting shares. By holding these shares, you can retain control over the corporation, provided that the special voting shares carry more votes than the new common shares. This will be especially important if you intend to have your preferred shares redeemed over time.

You can also freeze your estate by using a trust. Under this alternative, you can transfer the assets you wish to freeze to a trust, whose beneficiaries would be your intended heirs. This will allow future growth to accrue to your beneficiaries without giving them control over your assets.

The major difference between using a trust and a corporation for an estate freeze is that it is generally not possible to transfer property to the trust on a tax deferred basis. Consequently, tax may have to be paid on any accrued gains on the assets at the time of the transfer. For this reason, this form of an estate freeze is not common for an owner of an established family business.

However, if accrued gains are small or the gain arising from the transfer can be offset with a capital gains exemption claim, freezing with a trust can be advantageous, as assets held in the trust will not be subject to the deemed disposition rules that apply on death. It should be noted, however, that assets held by a trust would be subject to a deemed disposition for tax purposes every 21 years, at fair market value.

When to freeze?

To maximize your deferral, an estate freeze should be carried out as soon as possible, as this will limit the growth of your shares and ensure that future growth accrues for the benefit of your children. However, before you freeze, there are two important issues you need to address:

• If you freeze the value of your shares now, will this leave enough value for you to live on in the future?
• Has the timing of your estate freeze been properly coordinated with your succession plan?

When dealing with the first question, there is an important point to keep in mind. Although it may be possible to undo (or “thaw”) an estate freeze, when planning for a freeze, it is generally a good idea to assume that you might not be able to access the future growth of the business to support yourself. Consequently, if you’re not sure how much wealth you need to keep, there are two simple alternatives to a full estate freeze:

Defer the freeze: For younger business owners, especially with young children, if you’re not sure how much wealth you need to keep, it may make more sense to simply defer the freeze until you have a better idea of your future needs. At this point, you may still want to determine the tax that will eventually be payable and purchase some life insurance to cover the projected liability.

Use a partial estate freeze: When you freeze, there is no requirement that forces you to give up all your common shares. Therefore, you can choose to freeze only a portion of your holdings. This will allow growth to start accruing for the benefit of your children while allowing you to retain an interest in future growth for yourself. If you’re sure you won’t need all the expected future growth in the business for yourself, but you still aren’t ready to give up all the growth, a partial freeze makes sense. Also note that once your future become clearer, you can use a second estate freeze in the future.

A partial freeze can also provide an added benefit. Although we have focused on the use of an estate freeze as part of an overall succession plan, a partial freeze can allow you to multiply the availability of capital gains exemptions, should you decide to sell the business. Where a family trust holds common shares, the gain arising from these shares can be allocated by the trust to your children. Your children may then be eligible to offset some or all the gain with a capital gain exemption claim. More sophisticated plans can give you more flexibility, as well. Ask you BDO advisor for more information.

Coordination with your succession plan

For an effective estate freeze, your children must own at least some of the common shares of your company, either directly or through a trust. But as we discussed earlier, depending on your succession plan, you may want your successor to have a greater interest in the business than other children who will not be active. Consequently, you’ll need to consider this when planning for an estate freeze.

As most business owners are reluctant to turn over full ownership of common shares to their children (especially if they are minors), a family trust is generally used to hold the shares until they are ready to turn over ownership to the children. If the trust is discretionary, the division of the common shares among your children can be deferred. However, even with this flexibility, the timing of your estate freeze is still important.

Family trusts are a powerful planning tool, but they also have limitations. One important limitation is the 21-year deemed disposition rule. Under the tax rules for family trusts, your trust will have a deemed disposition every 21 years. Therefore, if the trust still holds the shares 21 years after the estate freeze, the trust may be subject to tax on a capital gain, equal to the gain that has accrued over 21 years.

Most trusts don’t pay tax on this gain, as there is a way to defer its taxation. If the trust transfers ownership of the shares to your children before the first 21 year deemed disposition, this transfer will occur at the tax cost. Consequently, the taxation of the accrued gain will be deferred until the child disposes of the shares. Due to these rules, there is an important question you should answer prior to an estate freeze: Will I be able to divide the common shares among my children in 21 years?

This issue highlights why the coordination of your estate freeze and succession plan is so important. For example, if your children are very young and you freeze your estate now, they will only be in their early to mid-twenties when it comes time to divide and transfer the shares of the corporation. At that age, it may not be possible to identify a successor, and therefore, decide on how the shares should be divided.

The two options described earlier – deferring the freeze or using a partial freeze – are also effective ways to address this issue. By deferring the estate freeze, the first 21-year anniversary of the trust will also be deferred, and hopefully by that time you will be able to finalize your succession plan. A partial freeze can also be useful if you’re sure that all your children will receive some shares. You can use a partial freeze immediately and perform an additional freeze later for the shares that will be transferred to the child who will be named as your successor.

The best method for you will depend on several factors. Discuss these issues with your BDO advisor.
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Use of Insurance

As discussed earlier, life insurance is a powerful tool when used alongside an estate freeze. For many business owners, insurance provides the only real option for dealing with the income tax that will be payable at death, short of selling the business. Once you freeze your estate, you can purchase enough insurance to pay the projected tax liability.

Life insurance has a second important use in estate planning for family business owners. As discussed earlier, we suggested that treating your family fairly doesn’t necessarily (and often does not) mean treating them equally when it comes to your business. Splitting the shares of a family business equally among children who have varying decrees of involvement in the business can cause problems. To avoid these problems while being fair, insurance can create an “instant estate” that can be used to provide for children who are not active in the business.
There are several ways insurance can be used for this purpose. For example, the insurance proceeds can simply be paid to children who are not active in the business, as an inheritance. Or, you can bequest shares to all your children, and the insurance proceeds can be made payable to the corporation, which will use the proceeds to redeem shares held by non-active family members. The best plan for you will depend on several factors, such as the relative number of active and inactive children, and the value of the business compared to the value of the estate.
Retirement Planning

As we just discussed, if you are freezing the value of your investment in the business, it is critical that you determine your needs for the future. Consequently, it is a good idea to review your plans for retirement at the same time as your estate freeze. As we mentioned earlier, once your investment in the business has been frozen, you may not be able to “thaw” the arrangement.
As an owner of a business, you do have flexibility when it comes to creating a source of income in retirement, and you should consider each of these retirement savings options when planning for retirement:

Maximize RRSP Contributions:

Maximize RRSP Contributions: If you receive a salary from your corporation, this salary will be earned income for making RRSP contributions. As discussed in our Answering Your RRSP Questions tax bulletin, you can contribute 18% of your previous year’s earned income up to a maximum amount for the current year, less your pension adjustment (PA) for the previous year. For the years 2000 to 2003, the maximum amount is $13,500, less your PA for the prior year (if you are a member of a pension plan).

Pay Yourself a Retiring Allowance: You can make an additional contribution to your RRSP on retirement by having your corporation pay you a reasonable retiring allowance (which the company can deduct). If you worked actively in the business before 1996, a retiring allowance paid to you can be transferred to your RRSP, up to the following limits:

• $2,000 for each year of service before 1996, plus
• $1,500 for each year of service before 1989, if you were not a member of a company-run pension plan.

Individual Pension Plans: It may be possible to set up a pension plan for yourself, and other family members, known as an individual pension plan or IPP. For older business owners, the potential retirement benefits provided by an IPP can exceed the benefits provided by regular RRSP contributions. The rules are complicated, however, and these plans are costlier to run when compared to a conventional RRSP.

Redemption of Freeze Shares in Retirement: If you implement an estate freeze, you will generally hold fixed-value preference shares after the freeze. Once you retire, these shares can be redeemed over time, providing you with dividend income from the corporation. These redemptions will also reduce the accrued gain that will be taxable on death.
Given that there is risk associated with all businesses, it is usually prudent to use some or all the methods discussed to save for retirement. Should the business fail or experience cash flow problems, you should have other sources of income to fall back on.

Shareholder Agreements

If you are transferring ownership of your business, either directly to family members as part of your will, or as part of an estate freeze, a shareholder agreement is a key tool that should be considered.

A shareholder agreement is an agreement that governs the conduct of the shareholders and it should address all areas of possible concern. With such a broad mandate, the possible contents of a shareholder agreement are endless. Each business will have different concerns, and the importance of the issues will vary. But, in general, a shareholder agreement for a family business will usually deal with the following key issues in addition to more general business concerns:

Share ownership rules

For many family businesses, the rules that govern who can own shares are the most important part of the shareholder agreement. Specific areas that should be addressed include:
Who will be allowed to hold shares of the business? In most cases, ownership will be restricted to family members. For example, many shareholder agreements will exclude in-laws as owners.
What happens in the case of marital breakdown? Most provinces provide for family property equalizations. Therefore, where the shares of a family business constitute a large proportion of the value of a couple’s property, there is a chance that some shares can become property of the soon to be ex in-law. There are several ways a shareholder agreement can deal with this. For example, the agreement could require that each family member must have a marriage contract which excludes the shares as family property as a condition of becoming a shareholder. Or, the agreement can provide that the shares must be immediately offered for sale to the rest of the family on marriage breakdown.

Buy/sell rules

You will also need to set rules on how shares can be transferred. For example:

Can shares be transferred to non-family members? There are two basic scenarios that should be addressed: a sale of shares by one family member and a sale of the entire business by all family members. For a sale by an individual family member, the agreement can be restrictive. For example, all shares must be owned by the family, so only transfers between family members will be allowed. Another option would be to allow for a sale of shares to non-family members but require that the shares must be offered to the rest of the family first. For a sale of the entire business, you may also want some special rules. For example, for the approval of such a sale, will a simple majority be enough, or should a higher threshold be set?
How will the shares be valued? As most agreements will allow share transfers at least within the family, the agreement should set out rules for valuing the shares.
New shareholders must be a party to the agreement: Where share transfers are allowed, the agreement should also require that the new shareholder must sign on to the shareholder agreement as a prerequisite for share ownership.

Disability of a shareholder

What happens in case of disability of a shareholder? The agreement should address the procedures to be followed when a shareholder becomes disabled, especially where that shareholder is an employee. The agreement may provide for disability payments, and perhaps a requirement that the shares be sold to other family members in the case of prolonged disability.
Death of a shareholder: Finally, the agreement should set procedures to follow on the death of a shareholder.

Can shares be transferred to the shareholder’s heirs on death? Depending on the succession plan for the family business, the family may want to restrict who, if anyone, can inherit shares on death. If there is a requirement that the shares must be sold or redeemed, insurance can be used to provide the funds required.
Use of proceeds from corporate-owned life insurance: Where the corporation holds the life insurance on the business owner, the shareholder agreement should set out how this insurance is to be used. For example, the proceeds could be used to redeem the deceased’s shares or can be paid to other families to buy shares from the deceased’s estate. As mentioned earlier, you’ll want to discuss the use of insurance with your BDO advisor.

This is by no means a complete list of issues that you should address in a shareholder agreement. You should also provide rules that will help deal with any other issues you think might arise. By setting the ground rules in advance in a shareholder agreement, the potential for family conflict will be lessened in the future when these issues arise.

Preserving Your Estate

In our Estate Planning tax bulletin, we discuss the importance of asset preservation as part of an estate plan. For family business owners, this issue is even more important, as most forms of business involve risk. If you’re an owner-manager, there are several steps you can take to protect your business assets.

For example: If you own the real estate used in your business, you may want to consider holding this real estate in a separate holding company. If creditor claims are made against the operating company, the real estate may be sheltered from these claims.

A holding company can also be useful if your business generates cash flow more than amounts required for business investments and cash paid to you as a salary or dividend. If a holding company holds the shares of your operating company, the excess cash can be paid to the holding company as a dividend on a regular basis, and again this cash may be protected from creditors. The intercompany dividend will generally be tax-free.

If you need to borrow money for the business, investigate all your alternatives before borrowing personally or giving personal guarantees. Although arranging for financing using personal resources is often the fastest way to raise cash for a new venture, there is risk associated with committing personal