Business owners need to plan ahead to create the best tax results in a succession, says Florence Marino, Assistant Vice President, Tax and Estate Planning Group at Manulife Financial. Most small business owners lack a succession plan, surveys show, and some plans that do exist are not detailed enough, she says. "When you're looking at options for business succession, consider the tax consequences."
Ms. Marino outlines three common succession plans and what they mean for taxes:
1. Selling personally-held shares to an outside party
Business owners usually prefer to sell shares of their corporation instead of selling the assets. Selling shares results in a capital gain or loss, and just half of the gain is taxable to the business owner. If the shares are qualified small business corporation shares, and held personally, the owner may be able to use the lifetime $750,000 capital gains exemption to offset all or part of the capital gain.
Following the sale of the shares, the business owner can use the after-tax proceeds personally to invest, fund retirement, or pass along to heirs. One strategy is to use a portion of the proceeds from the sale of the business to fund a life insurance policy. The policy could be used to increase the funds available upon death, or to provide tax-deferred growth to supplement future retirement income needs.
2. Selling corporate assets or corporately-held shares to an outside party
An alternative to selling personally-held shares is selling business assets or shares of an operating business owned by a holding company. In those cases, income from the sale is taxed inside that corporation. The tax treatment depends on the type of assets sold (e.g. equipment, land, shares of an operating company, goodwill) and the income generated (active business vs. investment income). The former business owner is left with a corporation holding the after-tax proceeds. The insurance option can apply here too. But now the owner has two choices, Ms. Marino says.
One, close down the corporation after selling the assets, with the cash and/or investments distributed to the shareholders, and subject to personal income taxes. Paid-up capital, shareholder loans and capital dividends can be distributed from the corporation to shareholders tax-free, and are generally distributed first. The remaining capital in the corporation typically goes to the shareholders as taxable dividends. After all assets are distributed, and all income tax filings are completed, the corporation can be dissolved.
Two, keep the corporation, which can invest the after-tax proceeds from the sale inside the corporation. The advantage here is the deferral of personal tax on the distribution of sale proceeds. Because of how investment income is taxed in corporations, usually, it is more tax-efficient to distribute investment income to shareholders on a regular basis as dividends, retaining the capital arising from the sale of the business until needed. Again, consideration should be given to using some of this capital to fund insurance to increase estate values.
3. Transferring to a successor
When the business owner has identified a successor, such as a family member, the planning process could involve a gift, a fair market value sale, or an estate freeze – a strategy for freezing capital gains tax at current levels. What works best is up to the owner.
With a gift, the business owner is deemed to dispose of the shares of the corporation at a fair market value. This doesn't burden the successor with paying for shares. The owner will, however, have a capital gain at the time of the gift, so will have to pay tax without having any proceeds to fund that payment.
Instead of making a gift, the owner could sell shares of the business to the successor. The proceeds can then fund the business owner's tax liability. The owner can also use some of the proceeds to help equalize the estate among the heirs.
If the business owner wants to sell the shares at a discounted price, a good solution is to sell a portion of the shares at fair market value and give the remaining shares as a gift. The owner could fund the purchase by taking a promissory note in exchange for the shares, to be repaid over a number of years. This allows the owner to spread the taxable capital gain.
Another way to transfer ownership to a successor is through a tax planning strategy called an estate freeze – a transfer of assets, usually common stock, to the company in return for preferred shares. The company then issues common stock to the beneficiaries or a trust for the beneficiaries. This approach allows the business owner to lock in the value of the shares and "freeze" the tax liability at that point. The successor can come into the business with minimal capital contribution.
Where succession has not yet been contemplated, it is wise to have a contingency plan in the event of a business owner's death. Life insurance can provide funding for tax liabilities that arise in respect of shares of a corporation, when a business owner dies.
In considering these and other succession choices (such as transferring or selling the business upon death), doing what makes business sense comes first. "Don't let the tax tail wag the dog," Ms. Marino says, but adds that it is critical to have a tax expert weigh in, along with a financial advisor, lawyer and others on an advisory team.