Do you have a plan in place to ensure you get a great price for your business should you become sick, disabled, die or decide to retire?
Why you need to plan ahead
If you own a business that’s growing or at least making you a decent living, chances are it may be worth a fair deal and quite possibly represents one of your most valuable assets. So to ensure you get paid what it’s worth if you intend to sell it, or to minimize taxes on passing it to one or more of your children, you need to plan ahead for that day.
And since your ‘exit’ may not be at the time of your choosing – should you become sick, disabled or die, you need to plan now!
Without a succession plan secured with a Buy-Sell Agreement or a Shareholders’ Agreement, your business might:
- not survive your death,
- survive but be worth substantially less as your intended successor chooses not to pay a ‘high price’ for your business,
- survive but materially hurt as customers are taken by competitors or ‘stolen’ by disenfranchised employees.
Your planning should consider the business acumen/capability and desires of your family members and employees in addition to your needs. This can affect who you might sell to – be it family members, a partner, key employees, or even a supplier, customer or competitor.
You might even find that the most profitable solution might be to “grow” your own successor. By hiring a younger person with the right skills, similar integrity as yours, and working closely with them for a few years, you’ll increase the odds that you can dictate a premium price.
The more time you have to plan, the greater the chances you’ll get more money after tax. It takes time (read years) to find the best successor who is willing to pay the price you want, establish a Buy-Sell Agreement or Shareholders’ Agreement, fund the agreement to guarantee payment to your family should you die, get the successor up to speed with your business so that he or she has the skills needed, and ensure the structure will qualify for a tax effective transfer.
Selling assets or selling shares?
When you sell your incorporated business, you’ll have to decide between two general approaches. Either you can have the corporation sell assets of the business, or you can sell shares of the corporation.
- Taxation on the Sale of Shares to an Arm’s Length Party
If you sell the shares of the operating company, the disposition of shares results in a capital gain or loss. The amount by which the proceeds of disposition exceed the Adjusted Cost Base of the shares is a capital gain; one-half of the capital gain is a Taxable Capital Gain (and this amount is taxed like investment income).
If your shares are held by you personally and are considered “Qualified Small Business Corporation Shares”, “Qualified Farm Property” or “Qualified Fishing Property”, up to $800,000 of your gain may be exempt from tax. If your Family Trust holds these qualifying shares, it may be possible to multiply this exemption by allocating capital gain proceeds amongst beneficiaries such as you, your spouse, adult kids, and parents.
(Budget 2013 increased the lifetime capital gains exemption limit to $800,000 of capital gains realized by an individual on qualified property, effective for the 2014 taxation year and will be indexed to inflation thereafter.)
Your capital gains exemption is reduced, however, by investment losses. The amount that your exemption is reduced by is the Cumulative Net Income Losses (CNIL) from all previous years. The CNIL itself is reduced by these amounts: interest costs on investment loans, carrying charges and interest on any business that you do not have direct control over, losses on partnerships or co-ownerships, rental or leasing losses and capital losses deducted versus capital gains that aren’t eligible for the exemption. So, you might plan to clean this up by taking dividends over a few years. The exemption may also be restricted if you ever claimed an Allowable Business Investment Loss (ABIL) in which case you need some capital gains that are taxable.
- Taxation on the Sale of Assets to an Arm’s Length Party
No capital gains exemption is available if you sell business assets. So from your point of view, it’s better to sell company shares. If you sell the assets from your company, the proceeds from the sale are taxed inside a company. You’ll also have GST/HST sales tax on asset sales.
How the proceeds are taxed depends on the type of assets sold and the income generated. If you are selling depreciable assets, such as equipment, this results in recaptured depreciation if the sale proceeds exceed the Undepreciated Capital Cost (“UCC”) up to the original purchase price, thereafter you’ll have a capital gain. Recaptured depreciation is included in income and taxed as active business income. If sold for less than UCC, one has a deductible terminal loss.
The sale of non-depreciable assets, such as land and building (or shares of an operating company by a holding company), result in a capital gain equal to the sale proceeds less Adjusted Cost Base. One-half of capital gains is included in income and taxed as investment income (assuming it is on account of capital and not as an inventory item being sold). The non-taxed half is added to the Capital Dividend Account where one might elect to pay out a non-taxed capital dividend. The sale of land may result in land transfer tax.
Gains on the sale of intangibles and goodwill are also included in taxable income at a 50% inclusion rate; the taxable portion is taxed as active business income as opposed to investment income.
The type of income (i.e. active business income versus investment income) and type of corporation (for example, a Canadian controlled private corporation (“CCPC”) versus a non-CCPC) determine the corporate tax rate.
If you are trying to sell your business, the buyer may prefer to purchase assets which is usually much cheaper. The buyer gets a higher cost on depreciable assets which will help generate more Capital Cost Allowance (CCA) or tax depreciation to offset future income. Buying assets and not the shares is less risky to buyer as it doesn’t include your business liabilities or tax risk of potential future reassessments.
Preparing your business for sale
Having your accountant structure your ownership and cleaning up the company for sale at least 24 months in advance so it qualifies for the qualified small business capital gains exemption is just one aspect of preparing your business for sale.
You might also take steps to prepare your business so it’ll command a higher price. For example, all of your client knowledge and details in running the business smoothly needs to get put on paper (or even better into a computer database). If your business can be run with little or no involvement by you, then the business is worth more as there’s less key person risk.
You might also be able to increase your sales price if you strengthen its competitive position (or competitive advantage) – like operating profitable business niches with little to no competition or developing the business so that it is the lowest cost competitor. In addition to the niche business potentially being very profitable, it might also have higher odds of transition success – where customers have little other choice to buy products or services from your business.
If your family business has more than one range of business operations, you might find that splitting it into logical focused businesses and selling each piece to the highest bidder might be more profitable than selling the whole pie to just one buyer.
When to sell?
Deciding on the best time to sell your business can be difficult. But generally you should be able to command a significantly better price if you sell when business prospects are good and you’ve got a few years of great historical financial results.
For example, if you forecast growth of 20% and can show for the last three years 20% year over year growth, you have a good case for a premium price that reflects the prospect of future growth.
Another option might simply be for you to hold onto your business as long as you can manage especially if multiples for your industry are low. But if this means the business isn’t well looked after and customer service deteriorates, your selling price could be accordingly affected. So, you might end up working a few extra years and not be ahead financially.
One common problem small business owners have is that of not being able to objectively arrive at a fair price. That’s because there may not be a “stock market” to tell them the value of their business. So any offer that isn’t a premium offer for their baby may seem too low.
Rules of thumb used in your industry may be a helpful starting point to get some ballpark basis of worth.
A business valuator might be able to improve on this rule of thumb estimate or might possibly help bring the buyer and seller together if they agree on valuation principles. Four common valuation techniques used are:
- Comparable Company Analysis – this is an attempt to measure value by employing the market values of public companies possessing similar attributes to your business;
- Comparable Transaction Analysis – this is similar to the previous technique except companies used as models are those that have been recently bought or sold;
- Discounted Cashflow – here the worth of the company is based on the total amount of after-tax cash it can generate (usually the most expensive price); and
- Liquidation Analysis – here the worth is derived through selling off assets less the cost of satisfying debts (usually the most cheapest price).
From the amount determined based on one or a combination of the above techniques, there may be one or more valuation discounts applied such as:
- Lack of marketability discount – this applies to closely held businesses where there is virtually no market;
- Minority interest discount – this applies to where a buyer purchases a minority interest (less than 50% interest) in the business and doesn’t end up with control;
- Key-person discount – this applies where the company’s success is dependent on a key person and the loss of the key person would result in adverse consequences.
With a valuation, the assumptions used can have a drastic impact in the resulting estimate of value. So it’s important that both the buyer and seller are in agreement with the assumptions or you might end up wasting your money on the valuation.
Carefully structured, an earn-out arrangement can be a win/win in that the seller likely receives a higher value for the business while the buyer minimizes the risk of goodwill impairment and obtains favourable internal financing.
And if you don’t offer an earn out, you’ll likely eliminate many prospective buyers who’d be more than willing to pay a premium.
Converting part of the business value to tax deferred proceeds
For a larger business, the use of an Individual Pension Plan (“IPP”) or a Retirement Compensation Arrangement (“RCA”), could help you save a substantial amount in taxes.
An IPP can be thought of as a super RRSP. In most cases, IPP contributions can be substantially higher than RRSP contributions – possibly more than double what you’d otherwise be able to save in an RRSP.
Should business liability be an issue for you, an IPP comes with creditor protection (note that there is some degree of creditor protection through provincial legislation for RRSPs and RRIFs). Although an IPP has setup fees and maintenance costs, for some people, the added savings and creditor protection are well worth the costs.
An RCA might be used to spread proceeds over several years. It might be especially of value where you are considering becoming a non-resident and take up residency in a lower tax jurisdiction.
Spreading the gain over several years
When you sell your business, you might find it tough to get all of your money up front – it might instead be spread over a number of years.
So you might consider offering the buyer financing that may be more attractive than might otherwise be available through traditional bank financing. And in the process you might receive some tax relief through a capital gains reserve.
This reserve allows you to bring the capital gain into income over a maximum five-year period. Without the capital gains reserve mechanism, you’d be liable for tax on the entire capital gain triggered by the disposition in the year of sale, even though you would not yet have received the entire sale proceeds.
Note that if you are selling to your children or grandchildren the shares of a QSBC, qualified farm property, or qualified fishing property to your children or grandchildren, you can claim a reserve over a 10-year period.
A Buy/Sell Agreement is a contract between two parties that defines how an owner will sell a particular business interest and how a buyer will buy that interest under certain situations.
A Buy/Sell Agreement may be general in nature to cover unplanned sales (in case of death or incapacity) or it may be very definite in nature tailored to a planned sale to a known buyer (in the case of a planned retirement).
Whether you leave by choice or by chance, a Buy/Sell Agreement ensures your business interest will be transferred at a guaranteed price and on guaranteed terms.
Having the agreement in place improves the odds of the business successfully transferring at a price that can provide adequately for your family and removing uncertainty to employees and partners that depend on the business.
Whether you sell your company’s shares or assets, the buyer will likely want you to sign a non-competition agreement to protect the value of the business. The payment you receive for signing this (or the implied value associated with this) may be fully taxed as regular income. However, if requirements, such as filing an election with the CRA, are met, it may be taxed at a lower rate as a capital gain.
Maximizing after tax business proceeds on death
On the last to die of you and your spouse, shares of your incorporated business is deemed disposed at market value resulting in capital gains taxes. Taxes are payable a second time where company assets are disposed of (creating taxable capital gains) and proceeds distributed to shareholders (which might be in the form of dividends subject to tax). So, your company investments are subjected to double tax – once at your death and then again when realized and distributed.
If your company has surplus assets, it may be possible to reduce these taxes where the company owns an insurance policy on the life of the shareholder. Here surplus company assets are used to pay insurance costs which reduces the pool of surplus assets. What this does is convert surplus assets to a death benefit that can be excluded in valuing the company for tax purposes. Most or all of this death benefit (above the policy ACB) is credited to the Capital Dividend Account that can then be paid to your heirs as a tax-free capital dividend.
The result is that through insurance you may be able to reduce capital gains taxes at death. And this reduction in taxes can be greater than a plan to simply redeem company shares at death. The sooner you plan for this, the cheaper your cost of insurance.
Are there holes in your business exit plans?
Below are some questions to help you begin thinking about your business planning and the status of your business succession.
- Have you thought about what will give you a full and meaningful life? Have you priced this out so you know when you can afford to retire? If your business is worth more than what you need, why are you not planning your exit? What are the costs to your spouse and family of working hard in the business versus retiring?
- Have you thought through the implications to you and your family in the event of a serious illness, disability, or premature death? In such events, have you developed a disaster plan to ensure that you’ll get a good price for your business backed up contractually with a Buy-Sell Agreement or a Shareholder’s Agreement? Or have you obtained sufficient disability, critical illness and life insurance to financially ensure you and your family’s well-being?
- Are you dependent on your business to meet your retirement cash flow needs? Are you growing your investment portfolio so that it will eventually be able to provide you with a satisfactory pension?
- Do you know what your business is really worth if it were sold tomorrow? (Have you had an independent person appraise your business so you know what a market offer looks like?)
- Do you have enough liquidity to avoid the forced sale of your business on death?
- Who will be taking over, or will you sell the business? Have you considered the importance of family involvement in leadership and ownership of the company? If family is involved in leadership, have you thought through how to fairly deal with your family who are active and those that aren’t active in the business?
- Is selling your business to a successor (like a capable employee or employees) the best way to maximize the proceeds from selling your business? Do you have a successor in mind for your business? Is the successor competent, honest and trustworthy? Is your successor someone who would want to own your business? Is the successor ready to succeed you – does he / she have the qualifications needed? Is there an incentive plan for your successor with effective non-compete clauses? Have you developed a training plan for your successor? Have you put in place a Buy-Sell or Shareholder’s Agreement with the successor? Is the agreement secured with resources or funded by insurance to guarantee cash will be available to be paid to you or your family on your planned or unplanned departure?
- Are you currently using techniques to reduce or eliminate income tax and estate tax?
- Are you planning to utilize the Small Business Capital Gains Exemption as a way to obtain tax-free proceeds on your business exit? Have you structured the ownership of your business so that the company qualifies? Have you structured the ownership so that you’ll be able to multiply the exemption?
- Have you considered alternative corporate structures, stock-transfer techniques, IPPs and RCAs to reduce or defer taxes as part of your exit plan?
- Are you doing everything you can do to make your business more valuable to a buyer? Are you making yourself redundant so that it can eventually operate without your showing up to work every day? Have you looked at your staff to determine the effect should on or more persons leave? Are your staff happy and properly compensated compared to your competitors? Do you have a backup for each key staff person should someone leave so that your business can continue to operate?
The next step
If you’ve got a saleable business and would like to put together your exit plan, please call our financial planner, Steve Nyvik. Some of the things that Steve can assist you with include:
- reviewing your current plans and provide some constructive comments;
- preparing a financial roadmap (otherwise called a retirement projection) so that you can know when you can afford to retire;
- structuring your investment portfolio to resemble a pension so that it can eventually replace the income provided from your business so that you are financially independent;
- working together with you and your tax accountants, lawyers and pension benefits consultants to help you implement a tax effective plan backed with a Buy-Sell Agreement or Shareholder’s Agreement;
- reviewing your insurance program to determine its adequacy to fully fund the buy-out in the event of your serious illness, disability or premature death.