INVOLVE KIDS IN SUCCESSION PLANNING

Charley Tsai can’t help but smile as he thinks back to a story he heard about succession. The client was a business owner and was thinking about passing his company on to his son.

“He was a real estate developer in his 80s,” says Tsai, vice-president of wealth planning support at TD Bank. “He had a son in his 60s and he said someday [his son would] take over the business.” A little late for that, thought Tsai, since the son was ready to retire himself.

It’s a funny story, but one that’s surprisingly common. While most business owners probably don’t wait that long to figure out a succession plan, many take years to determine what they’re going to do with their companies after they retire. That’s a no-no in normal situations—it’s better to have a transition strategy in case something ever happens to the owner—but when it comes to passing the business on to a family member, the exit plan has to start early, possibly even when the kids are in high school.

Advisors should sit down with the business-owning parents and have a frank discussion about what they want to do with their companies and how they plan to involve their children, says Jenifer Bartman, co-author of Master Your Investment in the Family Business and owner of Jenifer Bartman Business Advisory Services.

“The first step is to find out what the parties want,” says the Winnipeg-based chartered accountant. “What is in the best interest of the business and what is the vision?”

If that vision involves the children taking over, Bartman suggests putting clients’ kids to work, starting them off on the ground floor, possibly in a warehouse or filing papers. If a child is too young to work, advisors could recommend starting out with a tour of the office. “Kids can become familiar with what the company does,” she says. “Then they can see themselves in the role and the parent will be able to set expectations over time.” Things can get competitive if more than one offspring want to take over the business, but Christine Van Cauwenberghe, director of tax and estate planning at Investor’s Group, says parents shouldn’t assume their children will want to run the family company. In many cases, only one sibling is interested in taking control. If the whole brood wants to get involved, the advisor can suggest playing to each child’s strengths: put the finance nut into the financial roles, make a law student a legal counsel and so on.

Advisors should also impart to clients that their kids need to be given meaningful roles, and really earn their paycheques. “A lot of children are given ceremonial titles,” says Cauwenberghe, so advisors should recommend that clients give their children real jobs with real responsibilities.

It may seem odd to have an advisor instruct parents on getting their kids into business-owning shape, if there’s no plan; and if the kids all want to take over, financial hell could break loose. It’s the financial planner’s job to walk clients through the process, Van Cauwenberghe explains. He or she will “probably have to work with the business owner over a period of years,” she says. When an advisor does get involved, nothing should be assumed. He or she should talk to the kids, the parents and anyone else who might have a stake in the company. “Once you have an idea where they’re at, then start making suggestions on getting the kids into the business.”

There’s another reason why the advisor has to get involved—if the business transition from parent to child isn’t done properly, it could mean significant tax implications. Business owners should think twice about simply giving their kids common shares. “Doing that could trigger a huge tax liability,” says Van Cauwenberghe. It will also make the children direct shareholders, which may not be ideal if the parent isn’t ready to give up control.
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A good way to mitigate the tax hit of bringing a client’s kids into the business is to start with an estate freeze, which freezes the company shares at their current value and defers capital gains taxes until a later date. Essentially, “you freeze the value of the client’s interest in the business,” says Doug Carroll, vice-president of tax and estate planning with Invesco Trimark Investments. “From that point forward, you can pass on future growth.”

After the shares are frozen (they’re usually exchanged for preferreds), new common shares can be issued to the parent and the child at nominal value. This method allows the parent to keep control over the company through the voting shares they’ll continue to hold, Carroll says. The estate will eventually have to pay the capital gains on the frozen shares; in most cases, when the parent dies.

While the shares remain at the value they were frozen at, if the business did well before the estate freeze, the taxes could still be hefty. As a result, the advisor may want to suggest that the client take out a life insurance policy to pay for the capital gains. “Calculate the amount of the death benefit to roughly the amount of tax on disposition that will occur on second death,” says Carroll. The corporation could buy the insurance, Van Cauwenberghe adds, pointing out that business owners are entitled to a $750,000 capital gains exemption, so they’ll likely only pay tax on any amount above that.

Before the assets are frozen, though, advisors should ensure business owners aren’t setting themselves up for trouble. If clients need those shares to fund retirement, but lock in at too low a value, they may be putting their golden years at risk.

An estate freeze is a good way to solve the tax problem, but it’s not enough if the kids aren’t ready to own the company. That’s where a business trust comes in. After assets are frozen, the new common shares are placed in a trust, which is usually administered by the parent and possibly a third party. “The trust provides some flexibility,” Tsai explains. If this option is used, the common shares will be owned by the trust. The business owner will transfer the shares out of the trust when they know which child should take over the corporation.

One of the benefits of using a trust is that the shares don’t accumulate value in the client’s hands. If the trust buys 100 common shares and the value of the company increases by $1 million over the next 15 years, then that increase accrues in the trust, says Van Cauwenberghe. The client may want to consider paying a dividend to the beneficiaries, usually the parent and the children. The dividends can also be used for income splitting among the adult beneficiaries.

When the trust is ready to be wound down and the equity given to the children, the shares can be transferred in kind at a nominal cost, even if the shares accumulate in value. While there are other strategies, business trusts and estate freezes are by far the most common. But nothing will work if you don’t plan early.