The complexities of business succession and how to promote success

For many successful business owners, there is a basic life cycle that may generally describe the path and stages they have gone through with their businesses: start-up, development and establishment, and maturity. Specifically within the maturity phase, this often marks a time when the mentality for business owners begins to shift to questions around the future of their company. Of course, tackling thoughts as to what happens next and preparing to exit a business may often be extremely emotional and challenging for many owners, especially given the vast array of factors to consider in business succession and planning in this regard.

When it comes to the transition of assets and wealth as a whole, there is a general lack of preparedness among Canadians, and this is something that carries through to business owners as well. In fact, as findings noted in the recent “RBC Wealth Management 2017 Wealth Transfer Report”, one in three individuals (including professionals, entrepreneurs, business owners and retirees) have done absolutely nothing to prepare. And while a shortage of plans is likely to have certain negative consequences for all types of wealth transfer, it may have even greater implications for business owners from personal, family, wealth, tax, retirement and estate perspectives, given the different stakes and complexities associated with business situations. As such, it is vitally important to recognize not only the value of proper business succession planning in general, but also how crucial it is to take the right steps ahead of and during decision making in order to implement appropriate methods and effective approaches.

Business owner realities in Canada

In looking at the overall population demographics within Canada and the significant shift taking place in the coming years as Baby Boomers move into their retirement years, it is important to recognize what this means from a business owner standpoint, as well as the large-scale impact on individuals, families, businesses and the economy. From an age standpoint, statistics indicate that the highest percentage of small (1–99 employees) and medium-sized (100–499 employees) business owners in Canada are between the ages of 50 and 64; and, the second highest percentage are those between ages 40 and 49. Furthermore, these two age categories specifically represent 73.5 percent of all small business owners and 78.3 percent of all medium-sized enterprise owners.¹ With those statistics in mind, it is clear that as a country, we are nearing a massive turnover of business ownership and assets, and this is confirmed by recent findings in a report from the Canadian Federation of Independent Business (CFIB). In its survey results, it was noted that approximately two-thirds of business owners plan to exit their business within the next five years. Of those owners, 85 percent say retirement is their reason for exiting.² And with growing numbers of female entrepreneurs in recent decades — according to 2014 data from the Government of Canada, women have equal or majority ownership in over 35 percent of small and mid-sized enterprises (SMEs) — considerations around planning for succession are crucial among both genders.³

Despite these striking statistics, however, the unfortunate reality is that despite age factors and exit intentions, very few business owners actually have succession plans in place. According to CFIB data, only nine percent of business owners have a formalized, documented succession plan. While approximately 40 percent do say they have some sort of informal plans, that still leaves just over half with no plans at all.⁴ At individual company, industry or sector, and national levels, the implications of this lack of planning may be both significant and far-reaching, especially given the fact that small and mid-sized enterprises employ more than half of all employed Canadians.⁵

Exploring various options

One of the main overarching questions many business owners struggle with is whether to transition their business to a family member or whether to sell it to a third party. Some individuals may have an idea as to their intentions for the future of the business, and it is often common among owners to have a natural desire and hope to pass on the business to successive generations and keep it in the family. Here it becomes important to remember one of the central principles of succession planning, which is that in order for a plan to be successful, it needs to balance the needs and goals of family and business; with that in mind, it may therefore prove very beneficial for business owners to follow a general planning framework as a guide and point of reference. Further to providing a level of organization in the planning process, a general framework also ensures important business, family and personal aspects are properly addressed and may often function as a source of motivation and commitment for family members, as it provides a clearer picture as to what is and will be planned. The basic structure of this framework should focus on three phases:

1. Discussing the vision and setting clear and defined goals.
2. Gathering decision-making inputs.
3. Identifying and analyzing options.

Within this basic framework, there are also some key assessments that should take place as part of an overall detailed review of both business and family circumstances and goals. The following are four main assessment areas owners need to critically examine as part of the decision-making process that account for both internal and external factors:

• Assessing a child’s, children’s or other family member’s desire and capabilities to take over the business. Among some business owners, there may often be an assumption that children or other family members want to participate in the business; however, this may not always be the case and reinforces the importance of communication among family members, understanding views and interests of all family members, and the potential value of qualified professional services to help assess and facilitate this decision. Given its centrality, this assessment should be one of the first matters to address.
• Assessing the future viability of the business. This assessment should begin with the industry within which the business exists and then move on specifically to the business itself. It is important here to understand risks such as future competition, potential challenges, potential changes in law or legislation, and merits of keeping or selling the business. Developing this clearer understanding of the business landscape should also include a review of the company’s strengths and weaknesses.
• Valuating the business. This exercise is required not only to determine value, but also to put a financial context to the owner’s succession. It assists in clarifying the financial viability of the business owner’s exit and/or retirement and how much risk they can afford to take to achieve their individual goals. Additionally, valuation is a useful exercise to understand how to drive value prior to exit.
• Assessing the saleability of the business. This assessment may be closely linked to the viability evaluation and may depend on a variety of elements including type of business or industry, dependence of the business on the owner-operator, location, economy or otherwise. Sometimes, factors beyond the owner’s control may prevent the sale of a business, even when keeping the business may not be the preferred alternative. In these cases, the family’s broader objective of maximizing wealth from the business would likely be the deciding factor.

As these assessments illustrate, following a thorough and appropriate decision-making process is so crucial to the creation of and ultimate success of succession plans. Through performing and properly utilizing these assessments within the larger framework for business succession planning, it then becomes easier to map out specific outcomes and appropriate actions to take to help achieve those outcomes.

Source: RBC Wealth Management Services. Succeeding in succession: a guide to keeping family harmony through your business transition. 2014.

When business meets family

For many business owners, a central source of worry or challenge is trying to maintain family cohesion, in advance of, leading into and throughout the succession process. In fact, it is often a strong sense of fear around creating family disharmony that deters many individuals from putting succession plans into place, or from even having discussions about it with family members. Unfortunately, while it may seem easier from an emotional standpoint to follow the path of least resistance, pushing discussions and decisions off won’t avoid the eventuality of succession. Instead, it only increases the likelihood for conflict, stress, uncertainty, and the potential faltering or failure of the business in the long-run. As such, a shift in thinking and perspective may be needed to recognize succession not as an event, but rather a process that requires a great deal of advance thought, discussion and planning.

In general, priorities need to focus on every family member gaining shared insight, because harmony and family cohesion are generated when the views of all family members are considered and respected and are then woven into the family’s overall value system. Ultimately, the development of these values will help to define common family goals, and one of the best ways to facilitate this is through regular, inclusive multi-generational discussions and structured family meetings. Here, it is also important to establish boundaries as to when, where and how that communication takes place, so there is a distinct separation between focused business discussions and conversations at family gatherings, for example.

Turning a focus to communication and dialogue

To build and facilitate ongoing and open communication among all family members, scheduled family meetings may be very useful. In general, family meetings are more effective when properly planned with agendas and discussion points tailored to the family’s circumstances and dynamics, and there are certain steps families can take to help achieve open, transparent communication. These may include creating a code of conduct for meetings, including all family members in the discussion of potential options and consequences of decisions that are being considered, supporting an open forum where family members can share their opinions, and selecting a competent family leader or independent facilitator to initiate and lead the process.

The value of communication in business succession planning is something that was commonly noted within the qualitative data collected in complement to the “RBC Wealth Management 2017 Wealth Transfer Report”. A number of business owners specifically stressed the powerful and central role of conversations and discussions with the next generation, often focusing on values as they related both to the business and the family. Those conversations took place more formally through meetings, but informally as well, sometimes even through conversations at the dinner table, and what these respondents consistently noted was the positive impact that communication had in smoothing the overall process and educating the next generation. Given that every family and business is unique, what it really comes down to is finding the right format and balance that works for your family and suits individual dynamics.

Benefits of comprehensive plans

In contemplating and considering the wide range of components, aspects and potential issues associated with business succession, it becomes increasingly clear that the process may often be quite complex, especially when family dynamics, tax and legal considerations, business realities and goals, and financial risks or opportunities are tightly intertwined. For this reason, taking the time to give advance thought to, discuss, discover and analyze planning options is vitally important. Formal, comprehensive and documented plans serve a central purpose in succession and beyond the larger considerations and aspects, they also account for so many additional details that informal plans simply cannot, including the mechanics for the purchase or transfer, how successors will be trained for their roles, a process for resolving disputes during the process, and timetables, for example.

In much the same way that every family and business is different, so too are succession plans, and it is the unique and complex aspects that highlight the value of the guidance and expertise that comes with comprehensive professional planning services. With a team of qualified professionals spanning from business strategy and planning, to tax and legal, to retirement and estate planning to effectively address complexities and facilitate the process in each area, business owners can gain the assurance that their plans are fully integrated and appropriately aligned for a smooth and effective transition in a way that best suits family and business circumstances and goals.

For business owners who are beginning to think about or are nearing the transition or succession of their business, it is understandable that there are heightened emotions and perhaps reluctance in letting go. In addressing this challenge, it may be very beneficial for many business owners to shift their thinking to the significant time, effort and planning they put into starting, building and maturing their business. This very same mindset should be carried through and applied to succession and is imperative for successful planning, as it will help ensure the best outcome for the business in a way that optimally supports family harmony.

Tax aspects and strategies to consider when selling a business

The following list includes some strategies that may be useful in helping to minimize the tax consequences for individuals selling their active business to an outside buyer. Note: Given that this list is non-exhaustive and that every business situation and structure is unique, it is critical to consult with a qualified tax professional to ensure your specific circumstances have been appropriately evaluated.

1. Determine if the purchaser is interested in purchasing the assets or the shares of the business. If they are interested in purchasing the assets, then you will not be eligible to claim the capital gains exemption ($835,716 in 2017). As a result, individuals should consider negotiating a higher sale price to factor in the additional tax that will be incurred on the sale of the assets of the corporation and the after-tax sale proceeds the corporation will pay out to you as a taxable dividend. The capital gains exemption can only be claimed by an individual on capital gains resulting from the sale of qualified small business corporation shares or qualified farm/fishing property.
2. If the purchaser is willing to purchase the shares of the business, then ensure the shares qualify for any remaining capital gains exemption available to use. If all or substantially all of the business assets are not considered active Canadian business assets at the time of sale, then the shares will not qualify for the capital gains exemption. As a result, the shares may need to be “purified” prior to the sale. Non-active assets generally consist of an investment portfolio not used in day-to-day business activities. Furthermore, more than 50 percent of the assets throughout the 24 months prior to sale must have been used in an active Canadian business in order to qualify for the exemption.
3. Consider having your advisor prepare a financial plan to determine if the expected after- tax sale proceeds are adequate for you and your family to meet your retirement income and estate planning goals. Your advisor can also have a discussion with you regarding effective structures for the post-sale proceeds to achieve goals such as maximizing retirement income, minimizing tax and maximizing your estate.
4. Consider the pros and cons of setting up an Individual Pension Plan (IPP) or a Retirement Compensation Arrangement (RCA) prior to the sale of the business. An IPP is a defined benefit registered pension plan that your corporation can set up where contributions made are deductible from your corporation’s income. Similar to an IPP, an RCA is an arrangement where contributions are made by the company and provide an immediate deduction to the company. Depending on individual circumstances, an IPP or an RCA may help you defer some of the tax upon a future sale. If the sale is structured as an asset sale, then the employer’s contribution to these retirement plans may assist in reducing the corporate tax and deferring your personal tax. For this strategy to work, it is recommended that you continue to receive T4 income and pensionable service from the corporation that set up the IPP or RCA for a few years after the sale.
5. If you have a prospective purchaser for your unincorporated business (a commercial enterprise that is owned privately by one or more individuals), consider incorporating and selling the shares to use the capital gains exemption.
6. If the sale isn’t imminent and the value of your business is increasing, an estate freeze and reorganization of your corporation may allow future capital gains to accrue to other family members and possibly multiply the use of the capital gains exemption.
7. If the shares of your business are sold, consider reinvesting some of the proceeds in the shares of another active Canadian private company in the year of sale or within 120 days after the year of sale in order to defer some of the capital gains tax on the sale.
8. Use some of the sale proceeds to make a charitable donation in the year of sale. The donation tax credit may help minimize the tax on any capital gains realized on the sale. If the donation is expected to be at least $25,000, consider the benefits of setting up your own charitable foundation in the year of sale through the RBC Charitable Gift Program.
9. Consider receiving the sale proceeds over several years using a capital gain reserve to spread the gain and the resulting taxes payable over a longer period of time.