The hand-off

Try wrapping your head around this: About a trillion dollars in Canadian non-business assets will change hands within the next decade when boomers start handing down their wallets to their kids.

The legacy, however, will also stir one of the most unsavoury aspects of intergenerational wealth transfers—hydra-headed sibling squabbles. Nothing drives a quicker wedge between families than greed for heirlooms, inheritances, cottages and family-owned businesses. And the chasm only gets wider when business succession plans are ill-conceived.

The appallingly low fruition rate of successions within family businesses is already becoming an extremely pressing issue because of the staggering value locked up in these companies. In addition to the direct asset transfers, boomers will collectively leave more than $1.2 trillion in retained earnings in their companies with nary a plan— in many cases not even a wish and a prayer for how that wealth will transfer.

A new study, sponsored by U.S. Trust, Bank of America Private Wealth Management, finds a majority of owners of ultra-high-networth (UHNW) family businesses are leaving their professional and personal interests vulnerable by failing to adequately plan for business succession, asset protection and estate issues. While these families are highly successful in building and managing their businesses, they’re often less successful when it comes to transitioning companies from one generation to the next, with only 15% of family owned businesses lasting past the second generation.

Canadian Association of Family Enterprise (CAFE) statistics, meanwhile, show 71% of entrepreneurs plan to exit their businesses within the next 10 years, and 65% have no succession plans. Furthermore, while some HNW owners do have wealth transfer plans in place, most of those plans have lapsed. Driving succession planning solely on tax issues doesn’t work. Had that been a lasting solution, we would see a higher rate of family businesses succeeding to the second generation.

And that’s exactly where your trillion-dollar opportunity lies: Small business owners are looking for advisors who can provide a wide spectrum of succession, estate and tax planning solutions. With the right game plan, advisors can seamlessly position themselves to tap into the greatest source of new client capital in this country’s history.

The bad news is that succession is hard. But the good news is that few have mastered it, leaving the field wide open. So advisors who can drive a client’s succession plan will own the plan, the client, and the entire family. And advisors who can bring a family together to collaborate on an intergenerational plan in an open, trusting and respectful way will redefine their value propositions.

Think of it as a Trojan Horse Strategy of managing generational wealth: Speak the language, authenticate the deep emotional turmoil that exists in every family business, get invited into the tent, and then combat the wealth- and family- destroying forces with all the steely logic, training and passion that you can summon.

WEALTH PLANNING Let’s look at three fundamental aspects of wealth planning: tax planning; estate maximization and retirement planning; and investment management.

1. Tax Planning We receive numerous emails from advisors inquiring about the benefits of incorporating. And it’s likely you too will get questions such as: “What are the benefits of incorporation?” “When should I incorporate?” “Can I split income with my spouse?” Or, “How should I invest my money in the corporation?”

Incorporated businesses offer three major benefits, which include tax deferral, income splitting and sale of a business. A solid understanding of these benefits is extremely valuable in helping you grow an enduring book.

i) Tax Deferral Using a corporation provides tremendous tax-deferral opportunities as the tax rate on the first $400,000 of active business income in a corporation is just 16.5% (in Ontario). It is precisely this smaller business rate that’s crucial to the viability of incorporation, especially when it’s compared to the top personal rates in each province—around 45%.

But tax deferral exists only as long as the owners are able to leave some money in the corporation. When they pay themselves a dividend, there’s a second layer of tax, which brings the total up to roughly the top marginal rate in each province. So if your clients use up all their cash flow for personal living expenses, the benefit of incorporation is reduced or eliminated.

ii) Income Splitting Tax deferral is key, but not the only reason your client would benefit from incorporation. Another incorporation advantage is income splitting—one of the

most effective ways of minimizing tax liability. But the correct circumstances need to be in place, because in certain instances it might be inappropriate to initially structure the share capital of a corporation that’s needed to accomplish an income split.

Take for example when a new business is started and its success is uncertain. Ideally, income splitting is done after the corporation has existed for some time, and is generating enough income to justify an income-splitting arrangement. The attribution rules are a hurdle that must be surmounted before a successful income-splitting arrangement can be achieved. A properly structured corporation will allow spouses who are in a low tax bracket to receive dividend income, resulting in a lesser total tax liability as compared with what the owner/ manager would pay had he or she earned all the income personally.

iii) Sale of a Business The Lifetime Capital Gains exemption on the sale of a small business corporation [SBC] is currently $750,000. Strategies that business owners should consider in order to take advantage of their allowable remaining capital gains exemptions are: › Consider crystallizing this exemption to preserve future potential tax benefits; and › Plan to reduce the CNIL (cumulative net investment loss) balance before selling a capital asset in order to maximize the capital gains exemption.

2. Estate Maximization For most business owners, the company is their largest asset, and they depend on it for retirement cash flow. To safeguard client interests and facilitate a smooth transition of wealth from one generation to the next you mustensure your clients have a valid and up-to-date will.

i) Intestacy Dying intestate (without a will) means assets will be distributed according to a pre-defined intestacy schedule. Each province has statutory rules, which govern who gets what, and they are very in- flexible. Rarely do the rules governing distribution of assets consider the needs of the deceased’s beneficiaries or how they would like the estate to be handled.

So if a business owner suddenly dies, the shares of his or her corporation will form part of the estate. And in the absence of a will, there’s no provision to leave the company shares to a spouse, and benefit from the spousal rollover. This likely means a massive capital gains tax will have to be shelled out.

ii) Multiple Wills The use of multiple wills was first recognized in Ontario by the Courts in Granovsky Estate versus Ontario, a case in which Philip Granovsky died leaving two wills. The primary will dealt with all of his property except for shares of certain private corporations. The assets excluded from that primary will totalled nearly $25 million, and were dealt with in a secondary will, which was not submitted to probate. Consequently no probate fees were paid on the value of the assets governed by that will.

This precedent made it non-necessary in Ontario (and certain other provinces) to obtain probate when dealing with shares or debt obligations of private corporations. The secondary will need not be submitted for probate, which means the directors of the company may transfer shares through corporate resolution (the company directors deal with the transmission of the shares and are prepared to deal with the estate trustee or trustees).

iii) Retirement Allowance Your business-owner clients can also pay themselves a retirement allowance before they retire. If they have been incorporated since 1996, mention to them that they should consider making a corporate resolution, which states that the company is going to pay out an allowance when the owners retire. Having this resolution already on file means it will be no problem to pay this out in the future.

3. Investment Management

i) Interest Income There is no tax-deferral advantage to earning investment income inside a corporation. In fact, in most provinces, a tax cost results once tax is paid at the corporate level and also at shareholder level after a dividend is distributed. Investment income is subject to a refundable tax on interest and other investment income in a Canadian Controlled Private Corporation. These refundable taxes are paid back to the corporation only when it has paid out sufficient taxable dividends.

With the addition of this refundable tax on investment income, interest income is taxed at close to 50% in most provinces. Due to the higher tax rate associated with interest income, your corporate client should consider keeping interest income to a minimum, while concentrating on investing for capital gains, particularly deferred capital gains, such as corporate class mutual funds. Corporate class funds are an excellent investment option for corporate clients, especially during the accumulation phase of their lives. If your client prefers interest exposure, the purchase of a corporate class money market fund taxed as capital gains income could help meet both investment and tax objectives.

ii) Eligible Dividend Income Eligible dividend income earned in a corporation retains its character and can be paid out to shareholders—the 33.3% Part IV tax that dividends are subject to is refunded entirely to the corporation when the dividend is subsequently paid out to shareholders.

This dividend income is taxed at the investor’s marginal tax rate (subject to the preferred rates for eligible dividend income). For business owners who are at the stage where they’re living off the investment income in their corporations, investing to earn eligible dividend income is a great option.

This dividend income is taxed at the investor’s marginal tax rate (subject to the preferred rates for eligible dividend income). For business owners who are at the stage where they’re living off the investment income in their corporations, investing to earn eligible dividend income is a great option.

iii) Tax-Free Capital Dividends The capital dividend account (CDA) is a notional account that accumulates the untaxed portion of net capital gains as well as any insurance proceeds paid to a corporation. A recommendation for your client is that when the balance in the CDA account is positive he or she can consider paying a tax-free capital dividend to shareholders. Even if your clients do not need the funds, it may make sense to crystallize this amount when the balance is positive, so that future capital losses won’t reduce or eliminate the CDA account. Your client can then loan these funds back to the corporation as a shareholder loan. The shareholder loan account can be accessed if cash is needed at a future date—an advantage since such loans can be drawn down taxfree to the shareholder. Another advantage of shareholder loans is that debt outstanding at the time of death can also be included in the secondary will, avoiding probate.

KEY TO SUCCESSION PLANNING In its essence, a succession plan simply states when and to whom ownership of a business will transfer. But the who and when is the tricky part, and this is where bringing a family together for a broader discussion of dreams, aspirations, skills and desires needs a full and open airing.

Aging clients who have left a large portion of their net worth in their businesses want to keep an eye on that nest egg and usually bristle at the idea of full retirement. Consequently, they typically frustrate the efforts of the succeeding generation to fully develop its own vision, passion and mastery of the business. An advisor’s goal, as an objective third party, is to re-wire the family business to protect the wealth from the biggest threat of all—the family itself. This can be achieved by introducing the concept of a Family Blueprint, whereby each year a series of questions can be asked by parents and children to trigger an in-depth discussion on the subject of succession or sale of the business. It would also be easier if a third party, like a financial advisor, steered this process by requesting that those involved in the business complete this blueprint on an annual basis.

Most family business owners believe their children will purchase their shares and fund their retirements. There are equal numbers of children who believe their parents will gift them their businesses outright. Parents and children are very often on completely different wavelengths. Often, the most glaring and simple questions are never asked. The first two questions in the Family Blueprint that can be asked each year are: › For both parent and child (if each holds stock): “Are you interested in selling your stock? And, if yes, to whom?” › And for the child: “Are you interested in buying stock and acquiring control?”

There are no wrong answers. The object is to achieve clarity. A child working in a family business, who loves his or her job but rejects the idea of risking capital to purchase the business, is in effect rendering a verdict on the capacity of the business and his or her talent to generate future earnings as an owner. Therefore, this simple declaration of future ownership intentions by both generations is key to preserving generational wealth. In this particular example, the business owner can pursue an alternative succession plan, perhaps selling the business to a group of key managers, selling to a competitor, or to a private equity firm. Clarifying future ownership is central to business succession planning.

Another simple, but fundamentally important, question that advisors can recommend business owners and children pose each other annually deals with the issue of selling the business to a third party. The question could begin along these lines: › For parent and child: “Do you understand and agree that in the interest of maximizing shareholder value this business can be sold to a third party at any time? Yes or no?”

The very notion of selling the business from which so many family members derive their employment, income and status can lead owners to remove selling to a third party from their strategic options. In managerial firms, it seems inconceivable a CEO would utter the words “we will never sell”—but across the street at Family Inc. the seeds of wealth destruction are planted and watered every day as families pursue their own idea of success— by defining their legacy through the longevity of the firm in family hands.

Markets will continue to devour family businesses that subjugate the sale option. Businesses that fail to heed the advisors, who correctly, dispassionately, and strategically drive the sale of a business to someone else, will systematically destroy shareholder value, because if it’s not for sale, it’s already devalued.

But what would compel children working in their parents’ businesses to pursue a sale that puts them out of work? The key here is for the advisor to recommend following up with special compensation for the heirs and to keep them involved in the entire potential sale process. The following questions, included in the annual blueprint, can be posed: › For parents only: “I agree that within the next 60 days I will put in place a special compensation formula for my child in the event the business is sold in the next five years. Yes or no?” And for parent and child: “As a fundamental principle, I understand that from time to time I will receive unsolicited offers from third parties to acquire the business. These offers will be considered and accepted at the discretion of the controlling shareholder and supported by the child. Yes or no?”

The moment an advisor can convince a HNW business owner to financially reward his or her children to drive the finality of the business through its sale, either to themselves or to a third party, is the precise moment a family business begins to position itself to crystallize its wealth at the peak of the enterprise’s value. A family business that consistently probes the market for its sale is poised for generational success. When an advisor can help a HNW client broaden the definition of success to include more than the perpetuation of his or her company’s name or brand—only then can a proper wealth preservation plan be contemplated. And only then can we harbour any realistic hope that the $1.2 trillion of retained earnings will actually transfer intact to the next generation.

One of the questions we get asked a lot by family business owners tends to centre around the idea that running a business is satisfying, and deeply rewarding. And that means all the talk of selling misses the point about the family working shoulder to shoulder to create something unique and enduring. The driver of this perspective, however, usually comes from a founder who has enjoyed consistently high earnings, and whose business experience leads him to conclude that he could never achieve a comparable return on invested capital from a portfolio of investments.

SWOT ANALYSIS In order to address this issue, an exercise both parents and children could go through every year is: List at least three items in each of the following four categories that could affect the health of the business over the next five years: strengths, weaknesses, opportunities, and threats (SWOT).

Advisors who lead HNW business clients through an informal SWOT analysis aren’t required to furnish the answers, just the questions—because it’s the questions that drive a greater degree of introspection. And it’s precisely this introspection that reminds business owners about the fragility of their enterprises, and the temporariness of their wealth. For business succession planning to work well, it’s the role of the advisor to both temper and enthuse business owners.

Another issue that lurks behind every family business relates to founders of these businesses who fail to offer their children any kind of performance feedback. It’s common for children who have assumed the presidency of the family firm, for example, to have no sense of their own achievements. They’re also woefully ignorant of the areas of their performance that require improvement. If succession planning is to succeed on its own terms, advisors need to simply recommend that their HNW business owners ask themselves, and the child involved in the proceeds, the following questions every year: › “Within 60 days of completing this blueprint, I will complete a salary and bonus compensation review for my child. Yes or no?” › “Furthermore, I agree to conduct an annual performance review of my child. This review will measure performance against mutually agreed-on and achievable goals and objectives. New goals and objectives will be set for the coming year. Yes or no?”

These reviews, when conducted faithfully, will always lead back to discussions over the future ownership intentions of each generation—driving clarity over whether or not there’s a buyer in the house. And we know that if the answer keeps coming back “thanks, but no thanks,” it behooves advisors to get cracking on another plan for their clients. And yes, don’t let this new plan be exclusively tax-driven. Far too often the tax cart is put before the ox—estate freezes are put in place without any consideration as to whether the children are actually interested, and/or capable of leading the business once their parents are gone.

Frequently, business owners are inclined, either through indifference to planning or through a deliberate thought process, to gift their operating business to a family member who has already “taken a pass” on purchasing the company. And while this strategy will create a legacy, it won’t be a sustainable one.

Finally, advisors occupy a strategic position that’s vastly different from those of all other professionals who touch a family business. Accountants and lawyers often have a business objective and natural inclination to see the business continue in the hands of family. Advisors, by contrast, must be the countervailing voice nudging their aging business-owner clients to consider selling their business assets, and to diversify investment assets so that generational wealth is protected. This approach takes courage, and an appreciation of family business dynamics.

But most of all, it demands a fundamental belief that asset allocation is still the name of the game. “Passing on” a family business has always been code for “gifting.” With 97% of all family businesses failing to make it to the third generation, advisors don’t need any other reason to make every effort to rescue the $1.2 trillion in retained earnings from the biggest threat of all—the family itself.

PLAYING THE ACE Asking the right questions helps advisors avoid successional disasters A significant portion of family business owners are concerned with protecting their wealth, yet fail to create the kind of asset-protection plans needed to structure wealth, maximize tax efficiencies, and mitigate risk. Most owners of HNW family businesses don’t implement strategies for asset protection in large part because no one has educated them about such options.Often your clients will contemplate an estate freeze, which may involve family members in future ownership structures. It’s important to convince your clients to see a lawyer who specializes in family law if they are contemplating an estate freeze. Grooming multiple succession strategies is important in any business. This sounds simple but it rarely is, and family dynamics further complicate the issue. Inevitably, questions arise. “Will the business be passed on to another shareholder, an employee, a competitor, an outsider or a family member?” These questions need answering, because even normal family squabbles tend to get magnified when a business is involved. And if the child is an irresponsible spendthrift with no discernible work ethic, it further complicates the succession plans. Robin Macnight, a tax lawyer with Wilson Vukelich, says the biggest shortcoming in a family business is the lack of communication. In fact, Canada has a checkered history with respect to succession planning, and unfortunately, the issue is still not being dealt with. Business owners are looking for someone to drive the process, but where should an advisor start? We suggest beginning at the end by asking clients to imagine what the business will look like when they are either incapacitated or dead. We also suggest asking rhetorical questions such as, “On your death, and in the absence of a formal succession plan, is your wife prepared to be the controlling shareholder of your multinational chemical company?” “Has she chaired a board meeting before?” “Will she have insurance proceeds to pay the capital gains tax on your 10,000 shares originally valued at one dollar in 1973, and now worth $897 per share?” Then, ask yourself similar questions. Do you know how much of each client’s wealth is invested outside the business and how much inside? Your answer may reveal how prepared you are to wade into the choppy waters of family business succession planning.