FAMILY OWNED BUSINESSES AND THE INTERNAL SALE
Previously we highlighted the importance of succession planning in promoting continuity and stability within the family owned business. In this article we will explore the various considerations which govern the sale or transfer of a business to a related party. We will attempt to demonstrate that the ideal succession strategy is one that treats the internal sale process as though it were an arm’s length transaction.
The ideal succession strategy will seek to:
address how risk and control will be shifted to the next generation of owners;
answer to the financial requirements of those retiring from the business;
achieve equity in the treatment of active and non-active shareholders;
provide a tax efficient structure for all parties to the transaction;
promote the stability and continuity of the business.
The Internal Sale and the Income Tax Act
Within the Income Tax Act, the concept of fair market value applies equally to arm’s length and non-arm’s length transactions. For any transaction (ie share sale, estate freeze, gift) it must be demonstrated that the transfer in question took place at a price that was a reasonable estimate of fair market value. Failing this there is the potential for double taxation.
For this reason it is important to get independent advice on the fair market value of the business and to ensure that a price adjustment clause is inserted in the agreement of purchase and sale. In the event that the value of the transaction is later challenged by Revenue Canada an independent opinion will demonstrate that there was a legitimate belief by the parties involved that the transaction was at the fair market value. As such an adjustment to the purchase price can be made with no adverse tax consequences.
In Canada, succession planning is often motivated by the $500,000 capital gains exemption available upon the disposition of the shares of a qualified small business corporation. Often it would appear that tax planning is given priority over succession planning. While the tax advantages are attractive, these must be carefully weighed against the risks inherent in bringing the next generation into the business before they are able to make the requisite financial commitment and assume the associated risk.
Tax minimization in and of itself may well run counter to the best interests of the business. We believe that tax planning should only be developed once the optimal succession strategy has been chosen. The choice of the optimal strategy will depend on several variables including the need for liquidity by the retiring shareholder(s), the number of other parties with a financial interest in the business, the readiness of the successor to assume the helm and the financial position of the business.
Sale of Shares
Share sales provide the transferor with a large degree of flexibility in implementing a transfer of ownership that is tailored to the particulars of the situation. A share sale can be for all or part of the business and can be structured to accomodate the transferors desire to retain control and an ongoing ownership interest in the business.
A share sale also provides the parent with the flexibilty to recognize capital gains to their best advantage. While such a sale triggers an immediate tax liability the resulting capital gain may be deferred for up to 5 years through the use of reserves.
Problematic in many internal sales is the desire for liquidity on behalf of the transferor. This desire is often at odds with the successor who may not have the financial wherewithal to fund the purchase of the business. Often, where there are others not active in the business the issue of fairness will arise. Other family members with a vested interest may also desire liquidity if their interests are not parallel to those of the successor. From their point of view, fairness is achieved if the successor commits to paying an arm’s length, market price for the business.
However, the next generation of family ownership may view the arm’s length approach as anything but fair, as the following example illustrates. The case in question involved a father and son who had worked together for many years with no formal succession plan in place. The father commissioned a valuation of the business and on the basis of the value determined made a proposal to sell his shares. The son strongly objected to paying a market price for the business, maintaining that he should not be required to pay for value that he had helped to create. Clearly, to avoid such a confrontation expectations must be formalized at an early stage. In this case, the son felt justified in asking that the shares be gifted. On the other hand the father had a liquidity issue to deal with. With the benefit of more time, an arm’s length sale could have been structured that accomodated the needs of both.
The basic objective of any estate freeze is to crystallize the current fair market value of the business so that the future growth in the value of these assets accrues to the next generation of family members.
Many internal sales are structured on the basis of an estate freeze. While an estate freeze accomplishes a shift of wealth and allows tax liabilities to be determined in advance it does not shift risk or answer to the liquidity issue. As such it must be viewed as a tool of succession planning, not a means to an end.
In essence there are three types of estate freeze. The Holding Company Freeze requires the incorporation of a holding company and the subsequent transfer of growth assets to that company in exchange for shares in the holding company. The Internal Freeze involves reorganizing the capital structure of an existing corporation whereby the taxpayer exchanges common shares for debt or for newly issued preferred shares of the corporation. The third method is known as the Asset Freeze which allows for the transfer of some or all of a corporations growth assets to a newly incorporated entity in exchange for debt or preferred shares.
For any estate freeze, the preferred shares or debt taken can be structured to provide the holder with a source of income and control over the shares or assets transferred. Care must be taken to avoid the attribution rules which result should the value of the property transferred exceed the value of the consideration received or should the terms attaching to any debt issued by the holding company be on the basis of non-arm’s length terms. The provisions of Section 85 of the Tax Act dealing with share and asset rollovers are complex. The advice of a tax expert should be obtained before deciding on a course of action.
The Funding Dilemma
Problematic in most internal sale situations is the conflicting desire for liquidity by the retiring shareholders and the need to preserve the financial integrity of the business.
Presuming that there is agreement by all parties with respect to the value of the business the funding dilemma is simplified somewhat by the presumption that the successor will pay for the business as an arm’s length party would. As in an arm’s length sale the successor may choose to fund the transaction externally (ie with his own funds or borrowed funds) or internally, by arranging terms with the vendor. By applying the discipline of the market to the internal sale the vendor avoids the prospect of losing control over the business while still having most of his accumulated wealth tied up in the business. At the same time, if the terms of the buyout are commercially reasonable, the issue of fairness with other non active family members should be satisfied.
Where payment for the purchase will be funded over time from the operating profits of the business, care must be taken to ensure that the payout schedule will not deplete the company. Any payment schedule should allow for the appropriate level of sustaining investment in the business to take precedence over such withdrawals. It is prudent that any proposed buyout also receive the blessing of the bank or other lending institution that the company has a relationship with.
At the same time, to the extent the former owner maintains a financial stake in the business, so should he or she maintain a commensurate level of influence over its affairs. Depending on the goals of the retiree, this can be accomplished by surrendering voting control in proportion to the amount the purchase price received or, alternatively, through retractable and redeemable preferred shares as in the case of an estate freeze.
In attempting to stage the internal sale of the family owned business economic interests must be reconciled within the emotionally charged environment of present and future family relationships. While each situation is governed by a unique set of circumstances each shares a similar set of problems relating to issues of risk allocation, shareholder liquidity and fairness.
We believe that the optimal outcome is achieved by adopting an arm’s length approach to the internal sale process. This approach provides a market based framework for conducting the sale and for ensuring that the transfer of risk and liquidity coincides with the transfer of ownership to the succeeding generation. In this way we believe that the discipline of the market will help to ensure the viability of the business well into the future.