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If this is the case, it would be advisable to develop a plan as soon as possible that allows the business to thrive without the current owner’s in-depth involvement.
Developing a succession plan also helps you to identify and take advantage of a number of strategic tax advantages:
If you’re looking to have a family member continue your business, you may want to consider undertaking an estate freeze. An estate freeze allows a business owner to lock in the current value of his or her shares, thereby allowing future appreciation of the share value to accrue in the hands of the family member continuing the business.
Upon death, there is generally a deemed disposition at fair market value of one’s assets. The business owner’s frozen shares should result in less tax to the estate as the tax on any appreciation that accrued to the succeeding family member, is deferred. As a result, entering into a freeze earlier – assuming the value of the business is expected to appreciate – can be beneficial.
Undertaking an estate freeze and having a discretionary family trust own the new common shares may allow for multiplication of the capital gains deduction upon an eventual sale of the business to an arm’s length purchaser. Capital gains realized on qualified small business corporation shares by a discretionary family trust can be allocated to various individual beneficiaries of the trust, each of whom can claim the capital gains deduction.
For the 2015 taxation year, the lifetime capital gains exemption allows up to $813,600 of capital gains on the disposal of eligible property (or $1,000,000 for qualified farm and fishing property disposed after April 20, 2015) to be realized without generally incurring income tax (minimum taxes may apply).
That being said, waiting to undertake an estate freeze and have a discretionary family trust purchase the new common shares can put your potential tax savings at risk in a number of ways:
First, in order for a beneficiary of the trust to claim the capital gains deduction, the trust must have owned shares of the corporation for at least two years. Although the business owner may not think the business will sell within the next two years, an offer to purchase the business may be received prior to that time. The business owner may then have to choose between waiting to sell the business to take advantage of the tax savings or to take the offer.
Second, even if the trust owns the shares for more than two years, only the appreciation in value from the time of the estate freeze will accrue to the shares owned by the trust. To demonstrate with an example, consider an estate freeze that is implemented when a corporation is worth $850,000 and years later, the corporation is sold for $4,000,000. The capital gain on the trust’s shares would be $3,150,000. In this situation, assuming the shares qualify, there is potential to use multiple capital gains deductions. However, this scenario looks different if succession planning is not implemented until the corporation is worth $3,000,000. The capital gain to the original business owner is much larger and the capital gain to the trust is only $1,000,000. The potential to shield the capital gain from income tax has been greatly reduced and theoretically, the delay in succession planning has cost the family unit several hundreds of thousands in additional income tax as illustrated below:
There are several reasons why it is important to consider succession planning early. The specific items outlined here represent only a few of the reasons why waiting too long can be costly.
For more information, contact Loren Kroeker, CPA, CA, Vice President of Taxation Services at 250.753.8251 or [email protected]
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