Business Succession
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Succession
Of The Family Business
Family-owned
businesses thrive, but they don't always survive.
Even when successful, they don't always succeed at
succession. Of every ten businesses in Canada, eight
are family-owned and generate almost half the
country's gross national product. Statistically, only
three out of ten will continue as a family enterprise
into the second generation and by the third
generation, merely one will survive as a family owned
and managed business. The average life of a family
business is just twenty-four years.
Numerous studies of
family business with publicly-traded stock have shown
that these stocks significantly outperform the rest
of the stock market. They provide financial security
and status for their founders and for their families,
accompanied by a sense of pride and commitment to the
heritage and future of their enterprises.
Paradoxically, families
rarely address the crucial issue of succession
despite being aware of the necessity to plan for the
inevitable passing of the business from one
generation to another. Thinking about and dealing
with succession of a family business can be extremely
demanding, both emotionally and intellectually. As a
result, it is not unusual for the patriarch and
matriarch of the family to avoid consideration of the
problems of succession which invariably results in
discord and chaos. Left without clear directions from
the founders, the next generation is racked by bitter
family squabbles and power plays for control. Our
media has been replete with notorious examples of
crises in large family business, all of which have
led to expensive litigation, often with
unsatisfactory results. The Biles family and Canadian
Tire, the Ballard family and Maple Leaf Gardens, the
Steinberg family and their food empire and both the
McCains and Mitchells with their huge family-owned
food companies are a few whose situations exploded as
a result of a failure to plan an appropriate transfer
of the family business.
These publicized examples
of large Canadian enterprises, which subject
themselves to potential genocide, are typically no
different on analysis from the more modest, yet
significant businesses, which envelope the Canadian
business landscape.
Succession Planning
Today
The field of specialized consulting services to
family business has grown dramatically since the
seventies when some consultants began to focus on the
distinctive problems that beset family succession.
Pioneers in the field like Leon Danco, the founder of
the Centre for Family Business, in Cleveland, and
author of books on the subject, did much to draw
attention to the compelling need for succession
planning.
Today, the number of
specialists as well as organizations and associations
is mushrooming. For example, the Institute for Family
Enterprise is "an international organization
created to ensure the future of families in
business" and the Canadian Association of Family
Enterprise (CAFÉ) is "a national organization
with chapters across Canada, which was established in
1983 to promote the well-being and understanding of
families in business". A wealth of information
on matters relating to the family business can also
be found on the Internet.
In recent years few
disciplines have attracted as much professional
interest as that of "family succession
planning" which, in turn, has spawned the
development of expertise in the area from a diverse
group of advisors, including life insurance planners.
Although there will always be some overlap in the
roles of the professionals, there will often be a
degree of complementary purpose and team work.
Succession planning is not a short term process, nor
a simple one. There are usually no absolutes, no
black & white, with each case being different
mainly because of the intangibles involved. It is an
organized process that involves discussion,
information gathering, evaluation, research,
knowledge, skill and creativity.
For most family
businesses, the technicalities of estate tax
planning, insurance and liquidity needs are essential
but they should be the end product of the planning
process only after the personal and family-related
issues are resolved.
The multi-faceted nature
of the process emphasizes the need for talents in
several areas including legal, accounting, insurance
and estate planning, management consulting and
psychological. Wills, shareholders' agreements,
estate freezes and marriage contracts have a definite
legal and accounting bent. Funding of income and
estate tax obligations and needs as well as the
buy-out of disinterested or retiring family members
will involve insurance experts and management
consultants. Understanding and resolving areas of
friction among different family members may require
the assistance of psychiatrists or psychologists.
There will be other aspects of the planning process
that require the talents of some or all of these
professionals.
Invariably there is a
need for someone to facilitate the process and to
orchestrate the professional team. That facilitator
will, at times, be one of the key professionals
already involved whose task will be to recognize when
various other experts will be required and to
consider and understand their roles in the process.
An essential
responsibility of the facilitator will be to explain
to the involved family members the nature and
objective of the process, its complexity, length and
cost. The number of interlocking and delicate issues
will have to be addressed patiently and diligently.
Above all, the facilitator will have to overcome the
deep-seated inclinations to avoid facing the issues
of succession. The founder and the family will have
to be persuaded that succeeding at succession, no
matter how arduous it may be, requires making tough
decisions and an unwavering commitment to planning.
Dynamics of The
Family Business
In some ways, the family business has all the
ingredients to make it successful: a defined leader,
a sense of commitment, pride, a cohesive group with a
sense of cooperation, and a work ethic that should
produce a "whole that is greater than the sum of
its parts".
Often, however, family
members in business together are not able to become a
fully functional team simply because they are family.
Family problems and decisions are mixed with business
problems and decisions. Solutions to problems are
rarely pure business or pure family in nature so that
any attempts at complete separation are
counterproductive. Family and business are discussed
at both the dinner table and the boardroom table.
The dynamic of the family
business makes it difficult to recognize problems and
needs relating to succession. The emotional bonds of
the family, coupled with the desire for family
harmony and the financial well-being of all members
of the family, leads to repression of good business
judgment especially in regard to succession.
Consider the typical
array of issues that arise in a succession planning
scenario:
- Inner conflicts arise between
the founder's role as a parent and as a
businessman. He or she may be torn between
what is good for the business and what is
good for the family. In some cases, they are
mutually exclusive.
Emotionally the founder wishes to deal with all children equally and identically even if one is more active or capable than the other. The parent must agonize over difficult decisions which if wrong can either destroy the business or break up the family.
At the same time the founder may be concerned about loss of power and respect in the business and meddles in the business, even at a stage when no longer involved on a day to day basis. Clashes ensue.
- The next generation has multiple
perspectives owing to its composition: sons
and daughters who enter the business, their
siblings who don't, the spouses of the
founder's children and the founder's trusted
employees. For each of these groups, there
are issues of career, finances, opportunity,
vision, power and control, fairness of
treatment and family relations.
- Children may feel that they did not receive their entitlement and be bitter or may be jealous of being passed over to run the business or be resentful that they are working to benefit non-active siblings who only see the business as a source of earnings to support their lifestyles. Sometimes those directly affected bring in other family members not directly involved, e.g. grandchildren and use them in subtle and not so subtle ways to accomplish their ends, creating substantial family disharmony.
In
dealing with business problems, the founder can go
home and usually get away from it all. In a family
business milieu, the founder has no respite at home.
In fact, it can be worse there.
Succession Planning
Issues
Most people think of succession planing for a family
business as centering around estate and tax issues,
liquidity planning and other technical financial
issues. There may even be the expectation that the
succession plan will follow a certain format because
of legal and tax considerations. Certainly most plans
involve estate freezes and the alteration of existing
business structures, family trusts and shareholder
agreements, but there is a need to look beyond these
issues in planning for succession. It is appropriate
to divide issues that need to be addressed into two
main categories.
"Soft" issues
relating to the human side, with the focus on
continuity, ownership and distribution of power in
the most harmonious and orderly way.
"Hard"
technical, tax, legal and business issues concerning
the transfer of distribution of assets and financial
resources in the most effective way.
Soft Issues
In most cases, the personal and family related
issues are the thorniest. When parents have
established a thriving business it is natural to want
some or all of their children to continue the
business after them. Choosing the right child or
children to manage and control the family business,
is often an agonizing decision compounded by the
'blood' connection. Generally, there are three broad
philosophies on choosing successors. Each works well
in given situations and each has advantages and
disadvantages.
The Loyalty Philosophy
Old world in concept, in this scenario a
pre-designated child, such as the oldest son, is the
choice solely because of his position in the family.
The system of English landowners in the last century
is the classic example. Aside from the obvious
prejudicial treatment of women this system prevented
the fragmentation of the family estate through the
generations.
However, because the
appointment is not necessarily based on ability to
run the company, it frequently falters unless the
successor develops the requisite business acumen or
has the wisdom to step aside before it is too late.
The Democratic Philosophy
In this scenario, everyone is treated equally. All of
the founder's children receive their mathematical
share of the operation.
Dividing the company up
equally may be the easiest and satisfactory from the
parents' point of view but after the changing of the
guard, an impasse can develop, effectively preventing
the children from working together. To remedy the
situation, it is not uncommon for the second
generation of family members to step aside and hire
professionally trained managers.
The Performance Philosophy
This prescription is usually the best one, but also
the hardest for most founders to attain. It ignores
the 'blood' ties, tries to be objective and is based
on 'tough love'.
Succession is based on
merit and achieving results, serving the needs of the
business, not the needs of the founder or the family.
Leon Danco calls it "meritocracy" and goes
a step further advocating that only the qualified
should be considered to control and manage which
often means bringing in outsiders.
Sometimes the only or
most satisfactory way to avoid or minimize family
conflict and ensure the survival of the business is
to sell off the company and give each child a share
of the proceeds as part of their inheritance to do
with as they wish. Such was the case with Murray
Koffler who sold the 'Shoppers Drug' franchising
company to Imasco Ltd in the late 1970's rather than
choose one child over another to replace him. Another
solution may be to give each family member non-voting
preference shares in the company. They remain part of
the organization and receive dividends, but the
day-to-day operations are in the hands of
professionals. To avoid having the majority of
controlling shares fall into the hands of non-family
members inter-family shareholder agreements become
important.
Hard Issues
The issues under this heading relate to the mundane
and technical financial, tax and estate matters.
Being tangible, they are issues that are more readily
identifiable and clear-cut, relating to income,
shares and assets. In most cases these issues are
easier to resolve than the intangible ones, by
utilizing the techniques and strategies that have
been tried and tested.
Some of the hard issues
commonly arising in the succession of a family
business are:
- Age
& Health - How long is the
owner-manager likely to maintain control and
remain active in the business? The answer to
this question will influence various other
issues. The age and marital status of the
children is also important.
- Income - A succession plan will ensure that the
family and especially the retiring
owner-manager have sufficient income to
maintain their lifestyles. The plan will
consider the level of income required, the
sources of that income and whether any life
or disability insurance is needed to
supplement that income.
- Personal
Guarantees - Consideration must be given
to the effect of personal guarantees and
other commitments that the owner-manager has
provided to creditors and whether these can
be replaced.
- Wills
& Powers of Attorney - When an estate
holds business assets both documents are
important in granting powers to others to
continue the business in the event of death
or incapacity.
- Intra-Family
Shareholder Agreements - In a family
setting, certain types of buy-sell agreements
are appropriate and others are not. The
agreement will address business, legal and
tax issues that will permit the objectives of
the active and non-active family members to
be attained and their differences resolved.
Consideration should be given to compensation
and tax issues. "Exit" strategies
must be provided when a dispute cannot be
resolved, or a family member has died, or
become disabled or insolvent.
- Valuation - is a critical issue in all buy-sell
arrangements, especially where the parties
are non arms-length.
- Tax - Concerns about the tax liability on the transfer of shares and other property loom large in the mind of the founder. Consideration must be given to "freezing", transferring or deferring the tax bill, which, in turn, may involve gifting, sales, income splitting, trusts, crystallization and consideration of the capital gains exemption for qualifying shares. Tax planning will also have to consider Family Law provisions and the Capital Dividend Stop-Loss Rule. Life insurance to ease the inevitable liquidity issue that arises, becomes a major factor in planning.
- Achieving the 'changing of the
guard' in a smooth harmonious and equitable
fashion
- Minimizing capital gains tax
liability on the death of the owner
- Preserving an income source for
the owner and other family members
- Insuring sufficient liquidity to pay inevitable taxes and to fund the transfer of assets.
Role
of the Life Insurance Agent
The life planner will
always have a role in the succession planning;
occasionally it will be the lead role as catalyst and
facilitator, but in most instances it will be as part
of the supporting cast.
The mix of financial,
tax, insurance, estate planning and psychological
needs facing a typical family business situation
demands the collective expertise and skill beyond the
capability of a single perspective. In some cases,
however, when the life agent is brought in to deal
specifically with the life insurance needs, he or she
often assumes the additional role of advisor and
counsellor on the 'softer' issues concerning family
relationships. We gravitate towards these more
personal and human matters by dint of our background
experience, interest, aptitude and concern for the
need to do something beyond the confines of our
products.
The best insurance
advisor is the one who has the empathy, patience,
wisdom and time to guide the family through the
potential minefield; the one who acts as a sounding
board, listening to the hopes and aspirations of the
family and giving counsel and due consideration to
all points of view presented; the mediator who will
attempt to diffuse family conflicts and act as a
buffer; the facilitator who will attempt to have the
family adopt a plan that will be for the good of both
the family and the business.
At the very least our
role will be to introduce the topic of death into the
succession equation and to apply our skills in the
application of life insurance and other financial
planning tools. Our products are needed to fund
buy/sell arrangements in the event of death,
disability and retirement and capital gains tax
obligations while our specialized knowledge is
required in the matching of needs to suitable
products and designing strategies to maximize the
financial and tax benefits of life insurance. e.g.
'leveraging' exempt life insurance to fund a living
buy-out on the retirement of the founder.
The Planning
Process
There are many steps to preparing and formulating a
succession plan that governs both the business and
the family situation. In most cases the facilitator
will dictate and coordinate the procedure which will
depend on the facts relevant to the situation as well
as the composition of the team. The significant steps
and decisions to be made, in broad terms, are:
- Assessing
the situation, identifying the issues and
establishing the objectives of the business
owner and the family. This step requires
thorough and skillful fact-finding of both
the soft and the hard facts relating to the
business as well as the dynamics of the
family. Data will have to be gathered on
valuations, potential tax liability, incomes
and all relevant documents such as wills,
powers of attorney, shareholders agreements,
trust agreements and insurance should be
examined. It is helpful to obtain an
organizational chart of the business,
ownership and management.
- The
owner-managers in consultation with the
family and advisors, should determine the
objectives for the business succession upon
their departure. Considerations include
having the family continue to own and operate
the business, a sale of the business to key
employees or to competitors, a public issue
and sometimes a wind-up and liquidation of
the business.
- Weighing
possible action plans given the present
situation and the objectives of the founder.
In identifying alternatives, considering
"what if" scenarios will help
ensure that the plan addresses all important
eventualities. For example, if the business
is to be passed on to the founder's children,
but they are too young to manage it, the plan
might include a trust and should in any
event, outline who will manage the business
in the interim period.
- Select
the most appropriate action plan. Ideally
this will be the plan which strikes a balance
between the competing interests of the family
members, which facilitates the harmonious and
smooth 'changing of the guard'.
- Document
the decision. The plan, at least in outline,
should be put into writing. The whole family
and close associates should be familiar with
the plan's important features, so that the
plan can be discussed and be implemented
without disruption to the business.
- Begin
implementing the plan. Some parts of the plan
might require immediate action, even if the
majority of the plan may take years to
complete. For example, the owner-manager
might need to increase his or her life
insurance coverage.
- The plan should be reviewed at least annually. Even the best laid plans need to be amended for any changes in circumstances, objectives or tax legislation.
It
is with these considerations in mind that succession
planning takes place. There are numerous
alternatives, such as selling all or part of the
business to family or outsiders, gifting of the
business to the family, deferred gifts, for example,
arising out of an estate freeze and numerous
permutations and combinations of the foregoing. The
manner in which succession takes place is limited
only by the circumstances, the imagination of the
advisors and the flexibility of the parties in
dealing with their situation.
Inter-Vivos
Planning
1) Gift of Shares
If the founder does not need or desire the cash
equivalent to the value of the shares, the most
straightforward way in which to pass ownership in the
family business is to have the parent gift the shares
inter-vivos to the children without further
formality. Rarely does this occur.
In terms of subsection
69(1) of the Income Tax Act, the parent would be
deemed to have disposed of the shares at fair market
value and the children would be deemed to have
acquired them at that value. This will trigger a
capital gain which may be sheltered in whole or in
part by the $500,000 exemption, if the shares
qualify.
Although a gift is easy
to accomplish, it results in a loss of control of the
business by the donor, unless concurrently the
capital of the corporation is amended to create a
class of voting non-participating special shares for
issue to the donor for a nominal sum, which could
allow the retention of voting control. A gift of
shares exposes the shares to the creditors of the
children. Family Law provisions should also be
considered.
2) Sale of Shares
(a) To the Child
A direct sale to the child may take place for cash or
cash and a promissory note. The parent can have the
shares pledged to him as security for the due and
punctual payment of the promissory note. Sometimes
the promissory note is interest bearing.
If the note is redeemable
on the death of the parent, life insurance on the
parent is always the best way of providing the funds
required to redeem the note. The debt may be forgiven
during the lifetime of the parent or by will. The
parent may alternatively forgive part of the note on
death and transfer part of the note to other children
to equalize them. (see Interpretation Bulletin IT-382
of June 20, 1977)
Where the capital gains
exemption is not available or is insufficient, it is
possible to claim a reserve and spread the
recognition of any capital gains over ten years. (Sec
40 (1.1) of the ITA)
(b) To Outsiders
As a way to preserve some of the business for the
family, the founder may feel compelled to sell a
portion of the shares if a purchaser can be found to
acquire 50%, for example, of the shares and who will
be satisfied to let parent and children continue to
operate the business. This often proves to be an
excellent alternative solution in dealing with
succession for a number of reasons:
- It
provides the parents and family with
liquidity so that parents may enjoy some of
the fruits of their efforts during their
lifetime allowing them to "have their
cake and eat it too".
- On
the death of the survivor of father and
mother, if this cash is still available, it
may be used to pay income taxes that arise
without having to sell assets at a time when
it may be inappropriate.
- If
the sale of the shares takes place on a tax
deferred basis by a section 85.1
share-for-share exchange, no income tax
arises until disposition of the shares or
death. This will provide options where the
acquiring company is a public corporation.
The parent may then sell some of these shares
as cash is required or on the second death
the shares can be transferred to family
members who will not be active in the
business, or sold to pay tax or for other
purposes.
- If the sale is to a company in a similar business, it will provide the founder with comfort that financial resources, business acumen and management will be available to the successors. Employees, banks, suppliers and customers will also find a level of comfort. Many public companies, such as Dylex, have acquired businesses on this share-for-share basis.
- The
potential capital gain arising at the time of
death can be more accurately quantified and
steps can be taken to provide for the funding
of any capital gains tax liability.
- The
freezor, if he wishes, can retain control of
the business through either a class of voting
non-participating shares or by way of a
shareholders' agreement.
- It
provides the ability to crystallize the
capital gains exemption with respect to
qualified small corporation shares.
- Future
increases in the value of the shares can be
divided among members of the family with the
ability to multiply the availability of the
exemption.
- The
ability to cap probate fees.
- The
ability to bring in key employees and others
who will contribute to the business.
- The
ability to split income amongst the spouse
and issue by the distribution of income and
property.
- The
ability to defer tax on the common shares of
the freeze company.
- A
parent can receive post-freeze income by way
of dividends on the special shares or by
redeeming these shares gradually over a
period of time.
- If a parent is unwilling to undertake a complete freeze, it is possible to do a partial freeze, (a 'chill'). In this way the parent retains an interest in the future appreciation of the business.
- A
Section 51 conversion, where not all the
shares must be converted, as is required
under section 86.
- Transfer
of assets, where specific assets of the
business are transferred or separated from
the business.
- A Family limited partnership (FLP) where the business has assets of significant value. e.g. real estate, Opco transfers its assets to the FLP pursuant to subsection 97(2) on a tax deferred basis and becomes a limited partner.
- Family
relations may become strained and the
business may be suffering
- The
ravages of inflation or the other financial
setbacks have diminished freezor's other
assets and he feels he needs more value or
income from the business
- The
value of freezor's frozen shares today are
less than the redemption amount of the shares
at the time of the freeze and he wishes to
have the excess accrue to him or the third
parties
- There
may be a desire or necessity to bring key
employees into the business
- The
business may be so successful that it is
desirable to bring in other beneficiaries
- Family
members who were active in the business and
were beneficiaries of the freeze are no
longer interested in it
- One
of the shareholders who is a beneficiary of
the estate freeze may be experiencing
financial or matrimonial difficulties and it
is prudent to ensure that no increased value
accrues to that shareholder
- A
beneficiary of the freeze dies
- Freezee
may divorce
- Freezor
may divorce
- Freezor
may have a second spouse and a new family
- An
opportunity may arise to sell the business or
merge it with an ideal candidate
- With the effluxion of time, freezor may have different views on the way he originally divided his estate and wishes to amend it
- Father
transfers his shares of the operating company
into a holding company on a tax deferred
basis, in return for preferred (freeze)
shares redeemable at a fixed price. The fixed
price will be the fair market value of the
shares transferred.
- A
discretionary trust is then established to
purchase the common shares of the holding
company at a nominal price, for the benefit
of the children.
- Since the value of the freeze shares is fixed, all future growth in the value of the company will be in the hands of the common shareholder, the trust which holds the shares for his children.
The
use of a trust to hold the common shares can be
particularly attractive for a number of reasons:
- Father
and other cooperative family members or
friends can be trustees. As such, control is
effectively retained by father over the
voting rights of the common shares.
- Provided
the trust is discretionary, the trustees can
determine which of the beneficiaries are to
receive income and capital from the trust.
This could be an effective means of splitting
income and multiplying the availability of
the capital gains exemption on small business
shares.
- It
also does not give any child a direct
interest in any particular asset at a given
time as circumstances may change. For
example, children who are active in the
business at one stage may no longer be active
in the future.
- As
discretionary trust may prevent the spouse of
a child from claiming an interest in the
shares under Family Law legislation.
- On the death of a child, there is the ability to control devolution of the shares and to avoid the deemed disposition if the child owner the share directly and did not leave it to a spouse or spouse trust.
- Dispute
resolution mechanisms. These are critical in
a family situation. Mediation and arbitration
provisions are included to promote
compromises in the interest of preventing
business disputes from becoming family
disputes.
- Valuation
is critical. Since the parties to the
agreement do not deal with each other at
arm's length, put and call rights may be
preferred to compulsory sales to overcome the
tax issue of whether the buy-sell price is
determinative of fair market value.
- "Exit"
strategies should be incorporated which
become operative when a dispute cannot be
satisfactorily resolved, or a family member
has died, become disabled or insolvent or
retired.
- Buy-sell
provisions operative on death of a
shareholder must take into account the
proposed income tax changes to the
"stop-loss" rules, which were
released on April 26, 1995 and since
incorporated in Bill C-69. Due to these
changes, shareholders have to re-examine the
type of tax planning employed to curtail the
impact of tax payable on a shareholder's
death.
- Whether
or not grandfathering from the new stop-loss
rules is available, consideration should
always be given to the use of any available
capital gains exemption and the employment of
the "promissory note" method for
purchase by the surviving shareholder(s) of
the deceased's shares from the estate or
surviving spouse.
- Where
grandfathering is not available and the
deceased's shares vest indefeasibly in the
spouse or spousal trust it is still possible
for the shares to be redeemed by the
corporation on a tax-free basis as obtained
prior to April 26, 1995.
- Provisions should also be made for the total disability of a shareholder.
- Funding
retirement compensation arrangements for
family members.
- Retrieving
an asset such as 'freeze' shares donated to a
charity or family foundation.
- Securing
a loan to fund elements of a succession plan
through leveraging exempt life insurance.
- Key
person insurance.
- Eliminating debt and the retirement of corporate loans which have been personally guaranteed by the business owner.
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Last modified: December 06, 2011