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 claim a $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.
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
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
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