Planning can help you significantly reduce your tax liability in a succession. Failing to do so could mean the business has to close or be sold. Or perhaps it might have to incur an unhealthy level of debt.

Taxes are one of the main considerations when it comes to family succession. Without proper planning, you can wind up with a larger-than-expected tax bill in a family succession and have no way to pay it.

It’s important to get started early on to structure the transaction in a way that minimizes your tax liability. It can take several years to implement the optimal structure.

Here are the steps to consider. (Note: You should get professional tax advice about your specific situation. Also, rules differ for fishing and farming businesses.)

1) Start early—Consult a tax expert early on about the tax consequences of a succession. Many entrepreneurs wait too long and the transition ends up happening in a crisis—for example, due to a health issue or death. That can lead to lost opportunities to save on taxes.

The worst-case scenario is that the business passes to a child on death, but the family doesn’t have the means to pay the tax on the accrued capital gain.

2) Minimize capital gains tax—Whether you pass on your business in a sale or give it as a gift to a family member, it’s deemed to be disposed of at its fair market value. You are taxed on half the gain in the company’s value (as a capital gain) at your top tax rate. The capital gain is calculated on the difference between the business’s initial share cost and today’s share value.

(There is an exemption for a transfer to a spouse, in which case the gain and tax are deferred until the spouse sells or gifts the business.)

If the business is a qualified small business corporation, you can claim a lifetime capital gains exemption to reduce this tax. The exemption is $824,176 in 2016, meaning a gross gain of up to this amount is tax-free. The exemption is indexed to inflation and, hence, increases each year.

To qualify for the exemption, a company must meet several conditions. For example, it must have been owned by the same person for the past 24 months, and at least 90% of its assets must be used for business primarily in Canada at the time of transfer. See a detailed list of the conditions here and more information on the capital gains exemption here.

3) Consider an estate freeze—An estate freeze is a way to essentially lock in the gain (and capital gains tax) based on the company’s value. A common way of doing so is by exchanging your common shares in the company for fixed-value preferred shares, and then issuing common shares to your children. Any future growth in the company’s value goes to the common shares and isn’t taxed until your children in turn sell or gift their shares. The shares can be held by the children directly or in a trust.

4) Think about incorporating—If you haven’t already incorporated your business, think about doing so. Owners of an unincorporated business don’t qualify for the lifetime capital gains exemption and generally can’t do an estate freeze.

5) Defer taxes—You may be able to defer some of the capital gains tax if you help finance the sale and are being paid over several years. In this case, you may be able to declare the capital gain over the duration of the payments, for up to 5 or 10 years depending on the circumstances.

Planning a successful business succession takes years. According to experts, transitions can take up to five years to complete and, in the case of a family business, as many as 10, depending on the firm’s size and complexity.

A recent survey of 2,500 entrepreneurs found that five out of six entrepreneurs surveyed estimate that the process will be completed in two years or less from the time they meet with potential buyers to the moment the eventual sale goes through.

For entrepreneurs planning to sell their business, the best strategy is usually achieved by not rushing things and by taking the time needed to ensure a smooth transition.

Creating a succession plan is a great way to ensure you get the full value for your business or are able to pass it along the way you had hoped. This is especially true if unexpected trouble arises, such as a surprise health problem.

Here are five reasons why you shouldn’t wait to start succession planning.

1. It clarifies your options

You may have an idea in your mind of what your succession will look like, but you may be in for a surprise when you go ahead with it. For example, your plan may be to sell your business to an external buyer. But many entrepreneurs struggle to find an outsider willing to purchase their company. Instead, an internal successor—such as a family member or manager—may be your best candidate to take over.

2. You can prepare your successor

If your successor is a family member or manager, you need time—five years or more is normal—to get them ready. They need to learn how all parts of the business work, gain needed expertise and build relationships with employees, suppliers, and customers.

3. You can prepare your company

You need time to optimize the sale value of your company. This means making sure it has good growth prospects, a record of profitability and a solid balance sheet. You may need to invest in the business, remove personal expenses from the books and consult an accountant on how to structure the sale to minimize your tax liability.

You also need to prepare your company to operate without you. For example, you should document your business processes so that someone new can easily take over. Your employees should get training so they consistently execute these processes as documented.

4. You can arrange financing

You need to start talking early on with bankers about financing for the transition, especially if it involves an internal successor who doesn’t have a lot of capital to invest. You may have to use a mix of financing, including the buyer’s investment, vendor financing, a term loan, and mezzanine financing.

5. It’s an emergency plan

Many entrepreneurs have a hard time letting go of their business. But having a succession plan in hand is useful as a just-in-case emergency contingency, even if you’re not planning to exit any time soon.

If you leave it until a health issue comes up and you need to sell, you’re not going to optimize your company’s value and you’re probably going to leave your family with a larger-than-expected tax bill. And that’s not to mention that the business will have a hard time continuing normal operations.

You started your business 30 years ago with a few family members and now you have a 100-employee company and your adult children are actively involved.

Mentoring, trust and a deep knowledge of the business have been the keys to a smooth transition from one generation to the next. One of the benefits of your children growing up around the business is learning the business from its patriarch. Seeing the business through their eyes, their values, work ethic and love of the business.

Starting from their high school years, your children can begin to learn every aspect of the family business. While these are invaluable lessons, higher education should be encouraged such as business, accounting & finance.

Learning the business from the ground up

Transition processes are some of the most important and delicate challenges in the life of an entrepreneurial business.

One thing that can make the transition process easier is to begin to hand major decision-making to the children gradually. The key is to let them problem-solve on their own. It’s important for them to learn from their mistakes while maintaining their confidence in making decisions.

Not every decision can be made by family

Family-run businesses face the same questions that most entrepreneurs have to face at a certain point: How to make sure to have the right management structure in place for growth? Consider engaging a management consultant for help. An outside consultant can help you make the difficult decisions necessary to grow your business.

Out of the process also flows the need to hire a controller—mainly to find ways to save on costs, develop departmental budgets and better understand margins. Consider introducing performance reviews for employees with a focus on developing their skills.

Most of all remember we all hope that our children will take over the company. But just because they share the last name doesn’t necessarily mean that they are the best for the job. They will have to prove that they are the best leaders for the company.

Situations when contributing to an RRSP isn’t worth it

Your Ontario Teachers’ pension benefit is linked to your RRSP contribution room.

The greater the value of your pension benefit, the less room you will have available to contribute to an RRSP.

Every member of a registered pension plan receives an annual pension adjustment (PA). Your PA, which appears on your T4, reflects the value of the pension benefits you earned in a year. This is the Canada Revenue Agency’s (CRA) way of leveling the playing field between those who are members of a defined benefit pension plan and those who must rely solely on RRSPs for retirement income.

You can find your RRSP contribution room on the Notice of Assessment provided by the CRA each year.

Payout

Teachers receive a pension based on their years of service and their best five years’ average salary. A teacher who retires with a full pension worked for 32 years and earned a best-five-years average salary of $60,000 would have a basic pension of $38,400. A teacher earning $90,000 a year with 32 years of service would have an annual pension of $57,600. The pension amounts are reduced once teachers are old enough to begin collecting CPP payments because the teachers’ pension plan is designed to be integrated with CPP.

When does an RRSP not make sense?

When you expect to be in a higher tax bracket when you withdraw the funds. 

If you have higher taxable income when you withdraw the funds, then you could be paying a higher rate of tax.

Start by getting a Second Opinion Portfolio Review to map out your retirement plans, you might not realize how the various income sources integrate. Focus on these particular areas; what, where, when & how much are the income streams at retirement? When will you start to use your retirement assets? Where will this income stream come from – Pension, RRSP, TFSA, savings, investment properties, private mortgages? What type of income is it – pension income, dividend income, interest income.

The average age of retirement for teachers is 57 although in recent years its been 61. Many teachers find that age too early to stop working and decide to open a business or become a consultant. This while being a great idea to keep busy, will also compound your tax issues at retirement.

When you have a sizeable employer plan or other taxable income sources.

If your employer has a pension plan available, then your already going to build a taxable income stream in retirement. Adding an additional taxable income steam such as an RRSP will only contribute to paying more income tax. As a teacher, your pension adjustment will limit the amount you can contribute to an RRSP anyway.

As mentioned previously, having additional income streams at retirement is ideal however, you want to plan ahead as to how to mitigate the tax treatment of those income streams. 

What teachers are saying about David

Diversification and financial management are key strategies

The recession of 2008-09 may have occurred nearly a decade ago, but it’s still a painful memory for many entrepreneurs. More recently, the decline in oil prices has caused a slowdown in producing regions that have hurt business owners.

Unfortunately, economic downturns are a fact of life when you’re running a business. But there are steps you can take now to prepare your business to weather a storm and emerge even stronger.

Entrepreneurs often know they should be prepared for tough times, but they don’t always take the necessary steps.

Here are five ways you can recession-proof your company.

1. Grow your customer base

It’s hard to overemphasize the importance of increasing the number of customers you have. According to a recent study, nearly one in six well-established businesses had encountered financial difficulty because of losing a single client. Very often, businesses are not prepared to deal with the unexpected loss of their biggest client or contract.

2. Focus on your finances

Solid financial management is vital for ensuring your company is ready to weather an economic downturn. Entrepreneurs need to have early warning systems to let them know when trouble is brewing. The numbers tell you the truth about your business and you need to embrace them.

Consider setting up a cash flow planner. To do so, use a spreadsheet to record projected revenues and expenses for the next 13 weeks and then update it each week. This allows you to get a handle on when payments from customers are expected versus when suppliers must be paid. You can then plan for periods of tight cash flow, coming projects and financing needs.

Consider setting up a financial dashboard, showing four or five key performance indicators on the financial health of your business.

3. Offer new products and services

It’s easy for business owners to get comfortable with the products or services that have been successful for them in the past. However, broadening your line-up may be the key to surviving during the next recession.

In fact, you may not even have to come up with something completely new. Instead, you might be able to repurpose your products for another market. For example, manufactured products used in the oil and gas sector could be effective in other areas with just a few changes. Research showed that having a range of products and service lines can be an important form of diversification.

4. Expand internationally

International expansion is another great way to diversify your business. If your sales dip in Canada, you may be able to make up the shortfall in markets with stronger growth.

Exporting opens up a lot of opportunities. Canada has cultural and economic ties with the U.S. and Western Europe, and our small and mid-sized businesses can often be very successful there. Those markets, in turn, can be a launching pad to higher-growth emerging markets.

5. Stress-test your business

As the last recession proved, some circumstances simply can’t be foreseen.

That’s why it’s important to run through various scenarios now, including how you’d handle a sharp drop in sales. While you’re at it, look at different crisis and disaster scenarios and put contingency plans in place to deal with them.

Look at things like: What happens if our input prices rise because of the weaker dollar. What if key people in your business were all of a sudden unable to come to work because of illness or a natural disaster? Unexpected developments can derail businesses.

Lessons learned

• Innovation counts—Successful businesses offer new products and services often and quickly adopt new technology.
• Get help—Networking, hiring consultants and setting up an advisory board are ways successful businesses get external advice.
• Map it out—Developing a strategic plan with specific targets will help to keep your business on track even as economic conditions change.
• Master financial management—Keeping tabs on your finances allows you to plan better, see trouble brewing and react quickly.

Borrowing too little or too late can jeopardize your business

Getting a business loan can be the fuel your company needs to reach the next level of success.

But you have to prepare yourself and your company to get the money and make sure the loan is right for you.

1. Borrowing too late

You may be tempted to finance your expansion projects from your cash flow. But paying for investments with your own money can put undue financial pressure on your growing business. You may find yourself needing to borrow money quickly and doing it from a position of weakness.

When there’s a sense of urgency, it usually indicates to a banker there was poor planning. It’s often harder to access financing when you’re in that position.

Solution—Prepare cash flow projections for the coming year that take into account month-to-month inflows and outflows, plus extraordinary items such as planned investments. Then, visit your banker and discuss your plans and financing needs so you can line up the funding before you need it.

2. Borrowing too little

You’re right to be careful about how much debt you take on. However, low-balling how much a project will cost you can leave your business facing a serious cash crunch when unexpected expenses crop up.

Solution—Develop a cash flow forecast for each individual project including optimistic and pessimistic scenarios. And then borrow enough money to ensure you can cover your project, unforeseen contingencies and the working capital required to bring your project to completion.

3. Focusing too much on the interest rate

The interest rate on your business loan is important, but it’s far from the whole story. Other factors can be just as important, or even more so.

• What loan term is the lender willing to offer?
• What percentage of the cost of your asset is your lender willing to finance?
• What is the lender’s flexibility on repayments? For example, can you pay on a seasonal basis or pay only interest for certain periods?
• What guarantees are being asked from you in the case of default? Do you have to pledge personal assets?

There are qualitative items in a loan agreement you have to think through very carefully. Some entrepreneurs will skim over the loan terms and conditions because they think they’re just legal jargon or standard terms requested by all lenders. But the truth is that terms and conditions can differ greatly between lenders.

Solution—Shop around among financial institutions for the most attractive package, keeping in mind the importance of the terms other than the interest rate.

4. Paying your loan back too fast

Many business owners want to pay back their loans as quickly as possible in an effort to become debt-free. Again, it’s important to reduce debt, but doing so too quickly can cost your business. That’s because you may leave yourself short of cash. Or the extra money you’re devoting to debt reduction might be better spent on profitable growth projects.

Solution—Compare your projected return on investment to how much interest you’re saving by paying down your loan faster than required. If you expect to earn more investing the money in your business, consider slowing down your repayment pace.

5. Failing to keep your financial house in order

It’s all too common for busy entrepreneurs to let record-keeping and other financial chores slide—with potentially disastrous consequences. It’s essential to keep good financial records, including year-end financial statements. Messy financial records can leave you in the dark about how your business is performing until it’s too late to take corrective action. It can also make it difficult to approach a banker for a business loan because not only do you lack documentation, but you’ve also shown a lack of managerial acumen.

Solution—Be diligent about keeping financial records and spend the money to hire an accountant. Also, consider getting help from a consultant who specializes in financial management to get your business on the right track.

6. Making a weak pitch to your banker

You can see how much sense your project makes, but you won’t get far if you can’t persuade your banker to get on board. MacKean says too many entrepreneurs are unable to clearly explain their company’s business plan, past performance, competitive advantages, and proposed project. The result is a polite “no, thanks.”

Solution—Prepare your pitch and practice it repeatedly. Focus on explaining your business and how you’re going to use the money you want to borrow in clear and compelling terms. Remember a big part of your sales job is persuading your banker to have confidence in your management smarts and ability to build a strong business (and pay back the loan).

7. Depending on just one lender

Having a relationship with just one financial institution can limit your options, especially if your business hits a bump in the road. You don’t want one lender holding all the cards should something go wrong. So, just as you would diversify your suppliers or customer base, or your own personal investments, you want to diversify your lending relationships.

Solution—Meet with other lenders and consider using different institutions for different types of financing products.