The Best of The Blunt Bean Counter - How your Family Dynamic can affect your Estate Planning

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a September, 2011 blog post on how your family dynamic can affect your estate planning.

I have found many parents often ignore the interrelationship of their children in their estate planning, which can often be problematic when the parent dies. So ensure you consider these relationships when undertaking your estate planning.

How your Family Dynamic can Affect your Estate Planning

Estate planning is a complicated and delicate process. Where you have more than one child, the planning process is full of minefields, some are in clear sight, but many are hidden. Parents have to navigate these minefields with respect to the determination of executors, the distribution of family heirlooms and the distribution of hard assets. The above decisions may be impacted by the financial wherewithal of your children, your relationship with your children’s spouses, your grandchildren or lack thereof, and in some cases, favouritism of certain of your children.

The above are what I call vertical family hierarchy issues. These are issues resulting from parents making decisions that will affect their children and potentially, the way their children will view their parents after death.

What parents do not often consider is how these vertical decisions impact horizontally: i.e. how the interrelationship of your children must be considered in your estate planning. Any parent who does not consider these relationships runs the risk of creating a divisive wedge amongst their children as sibling rivalry and jealousies may rear their ugly heads.

In this blog, I will attempt to identify several estate planning issues that not only have vertical consequences, but also have horizontal consequences requiring parents to consider their children’s relationships in context of their planning.

The Family Business

Where there is a family business and the succession plan is to pass on the business to the next generation, several issues must be considered. The issues include the following:

How many children have an interest in the family business?

If you have more than one child, is one specific child best suited to the role of CEO or president? If so, based on your children’s current relationship(s), do you foresee them working together or will they butt heads or worse? If the eldest child is named president, have you reinforced a perception the younger child has held for years, that the eldest is favoured and always assumed the most capable?

How do you value the business?

This is not an issue if all the children are given equal shares of the business, since they will have an equal ownership no matter the actual value attributed to the company. But what if you decide to leave the business to one child and equalize a child or the other children with say cash or other assets? The value of the business can fluctuate wildly over the years, with the result being that the child who inherits the shares may in essence have inherited a significantly larger asset than the other child(ren). Alternatively, the shares of the company may prove to be worth substantially less than the assets distributed to the other child(ren) if business conditions cause the value of the business to diminish. As a parent, can you do anything to avoid potential disparities in value? I have seen situations where asset distributions were equal at the time of death, but the inherited business grew astronomically and the children who did not inherit the company shares felt wronged by their parents.

Finally, if you have undertaken an estate freeze while alive, (see my blog on introducing a family trust as a shareholder and the related discussion on estate freezes) which child will inherit the voting shares? You risk alienating the children who do not receive the voting shares, since they may feel that you did not think they had enough acumen to vote and run the company.

The Family Cottage

The family cottage is often a contentious asset. In some families all the children want to keep ownership of the cottage and in some families only one or two siblings want the cottage. As a parent, you must speak to your children and determine who wants the cottage. Where more than one child wants the cottage, you have to consider whether those children have a good relationship and if they will be able to share ownership of the cottage without starting a world war. If not, do you have to consider selling the cottage in your later years to avoid creating a divisive issue amongst your children?

Another important factor to consider is whether the children interested in keeping the cottage have the financial wherewithal to pay their share of the cottages expenses on a yearly basis? If not, how do you overcome this potential issue, especially if one child has the financial resources and another does not?

Also, where there is a large inherent gain on the cottage, you have to determine whether your estate will be able to pay the income taxes without forcing a sale of the cottage and causing the estate to unwind your original intention to keep the cottage in the family? In this case, you may be able to use life insurance to cover off this issue.

The Will

A will may be construed as a document that reflects a parent’s opinion of their children and confirms the children’s opinion of themselves. If you infer one child is more responsible than the others (by selecting a certain child(ren) as an executor and excluding others), you risk igniting the fire of past resentments amongst the children and potentially causing resentment of you even in death.

Assuming you can navigate the determination of the executor(s) amongst your children without creating jealousy or animosity (if not, a corporate executor may be required), how do you distribute your assets upon death in a manner that mitigates any damage that can occur to your children’s relationships?

The distribution of material items is fraught with danger. How does one ever balance sentimentality and value? If you provide one child a sentimental heirloom, you risk that child complaining the other children got more value, while the other children complain they were not left sentimental heirlooms. What if you have art? How do you balance the value of art that has significant value differentials?

What about the situation where one child has been financially successful and another has not. If your will provides for a greater distribution to the child with less money, how do you ensure you do not create resentment with the financially well-off child? The less well-off child, who should be ecstatic, may actually be insulted, as they interpret the larger inheritance as their parents saying they were "financial losers" as opposed to being grateful for the larger inheritance. In these cases, one must tread carefully, but an unequal allocation may be more readily accepted where you explain your reasoning to your children before your death.

Another issue is grandchildren. Where the number of grandchildren is different in each family or one child does not have any family, do you give equal amounts to each family or equal amounts per child? How about where one of your children may be incapable of providing for a grandchild’s education and you feel a trust would be appropriate? Will any consideration other than equal consideration be construed as favouritism by your children?

Finally, many parents have provided loans to their children to assist with university, purchasing a house or what have you. How do you deal with prior gifts or loans? If you forgive the loans, you may have an unequal distribution and cause an issue among your children? Thus, you may want to consider a reduction of any distributions in the will for any outstanding loans.

This whole blog may be construed as ludicrous on a certain level. Some may say this blog is evidence as to why they will not leave anything to their children. Others may say I will leave my children whatever I feel like and if the distribution is unequal, so be it. However, it has been my experience that the majority of parents truly do not want to create any dissension among their children and aim to provide for an equal distribution. Even though they will have passed on, many parents still don’t want to alienate any of their children or cause resentment upon their death.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Financial Ethical Wills - For Estate Planning and Managing Family Wealth

Last week, you read about the benefits of an ethical will. These wills are a way for you to share your personal beliefs, spiritual values and hopes for the future with your family. Today you will discover how some people are using ethical wills, to set forth their financial principles and values.

As a parent, a financial ethical will can help you accomplish one or all of the following:

1. Allow you to explain your estate planning
2. Assist your family in maintaining the wealth you created
3. Provide your family guiding principles of how to conduct business
4. Set forth how you hope your monetary legacy is to be used 
5. Discuss your philanthropy values and principals.

Estate Planning - Explaining Your Decisions

As you may have read in my blog titled One Big Happy Family - Until We Discuss the Will, I am a proponent of family meetings to discuss your estate planning (or at least parts of it). Given that many people are uneasy with having a family meeting to discuss money and inheritances, an ethical will provides you the opportunity (albeit after you have died) to clarify for your family your thinking and decision making process in respect of your estate planning.

However, be mindful; if the objective in writing your ethical will is to be positive and motivating, you may need to consider whether the clarity you wish to provide to your family relating to your estate planning decision making process, is in keeping with this objective.

Business - An Ethical Will Provides Guidance for a Family Business

Given the tremendous failure rate of second and third generation businesses (only 30 percent of all family-owned businesses survive into the second generation and only 12 percent will be survive into the third generation), an ethical will can be used to convey the guiding principles of your family business, and even set forth the challenges and opportunities you foresee for the company going forward.

In his article "Reintroducing the Ethical Will: Expanding the Lawyer’s Toolbox", written for the American Bar Association, author Scott E. Friedman provides the following insightful comment:

“In contemplating the scale and variety of intra-family conflict, we have come to the conclusion that many such conflicts are, in part, attributable to the death of a leader who had not thought to clearly transfer his or her intentions, wishes and wisdom to the surviving family members. Lacking direction and the benefits gleaned from a legacy of insight and wishes passed on by the patriarch or matriarch, surviving children often become absorbed in the negative emotions of selfishness, resentment and jealousy, which all inevitably leads to trouble for the business”.

Thus, any guidance and direction you can provide to your children may be invaluable as they try to navigate through the issues of succession of a family business.  

Philanthropy - Setting the Tone for Family Giving

You can use an ethical will to ensure your philanthropic values are carried forward by your children. Here is a quote taken from an article by Eric L. Weiner, Ph.D. written for the practice management section of the Financial Planning Association, in which a parent said the following:

“I would love to see you become responsible members of the community and philanthropists. To that end, I have set up a donor-advised fund as the main conduit for our philanthropic interest. This fund will give you and possibly your children the ability to make grants to worthy causes. I want portability so that you can direct grants to your own communities, as well as to national and international interests”.

Alternatively, instead of setting up a charitable fund, you could just encourage philanthropy by speaking to the importance of charity in your ethical will and hope you lead by example and your children follow in your charitable footsteps.

Ethical wills provide you with a tool to impart both your spiritual and financial values and beliefs and principles to your children. You may therefore, wish to consider using an ethical will in addition to the traditional Last Will and Testament.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

The Best of The Blunt Bean Counter - Estate Freeze - A Tax Solution for the Succession of a Small Business

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a June, 2014 blog post on Estate Freezes. If this topic interests you, there were two follow-up posts based on noted author Tom Deans, that suggest an Estate Freeze could be the wrong solution for family succession and a discussion of some vital issues when transferring a family business.

Estate Freeze – A Tax Solution for the Succession of a Small Business

Winston Churchill once said, “Let our advance worrying, become advance thinking and planning.” Small business owners often worry about their exit strategy and/or succession plan. They may also be concerned about what would happen to their business if they have a health scare or receive an ultimatum from a child working in their business. Often a small business owner’s worry becomes their anxiety, instead of their advanced planning.

As a small business owner, at the end of the day, there are essentially only two exit strategy/succession options you need to plan and/or consider:

(1) A sale of your business, typically to a competitor, sometimes to current management or very infrequently, an actual sale to a child or other family member; or

(2) A transfer of the business to your children without a sale (for purposes of this article I will refer to this option as an “estate freeze”).

My blog post today discusses estate freezes. How you can transfer your business tax-free to a successor (typically your children, sometimes to existing management) while continuing to control and receive remuneration from your business.

As noted in the links in the first paragraph, Tom Deans the author of Every Family's Business (the bestselling family business book of all-time) believes a business should in most cases be sold and never handed over to the next generation (such as done with an estate freeze) without the parent(s) adequately being compensated for the business, including their children.

What is an Estate Freeze?

The most tax efficient manner to transfer your business to your children is to undertake an estate freeze. An estate freeze allows your child(ren) to carry on your business, while at the same time you receive shares worth the current value of your business. In addition, once your share value is locked-in, your future income tax liability in respect of your company’s shares is fixed and can only decrease. Keep in mind that when you freeze the value of your company you are not receiving any monies for your shares at that time. There may be ways to monetize that value in the future, but on an estate freeze, you typically only receive shares of value, not cash.

The key risk in any estate freeze is that your children may partially or fully devalue these shares and your company. So while an estate freeze may be the most tax efficient way to transfer your business, it may not be the best decision from an economic or monetization perspective. 

In a typical estate freeze, you exchange your common shares of your corporation on a tax-free basis for preferred shares that have a permanent value (“frozen value”) equal to the common shares’ fair market value (“FMV”) at the time of the freeze. Subsequently, a successor or successors, say your children or family trust can subscribe for new common shares of the corporation for a nominal amount.

This concept is best explained with an example. Assume Mr. A has an incorporated business worth $3,000,000 and wants to undertake an estate freeze. In the course of the freeze, Mr. A is issued new preferred shares worth $3,000,000 and his children or a family trust subscribes for new common shares for nominal consideration. Mr. A’s tax liability in relation to these shares on death, is now fixed at approximately $750,000 in Ontario at the high rate. Often, a key aspect of an estate freeze is a plan to reduce the tax liability by redeeming the preferred shares on a year by year basis as discussed below.

If you have access to your lifetime capital gains exemption (currently at $813,600 but indexed for inflation), your income tax liability may be reduced when the shares are eventually sold or upon your death if you still own them at that time. Finally, you may choose to crystallize your exemption when you freeze the shares.

The preferred shares received on the freeze can be created such that they allow you to maintain voting control of your corporation until you are satisfied your child(ren), is(are) running the company in the manner you desire. This maybe a double-edged sword, as you may tend to hold onto control long after your successors have proven themselves. This may become a contentious issue.

Preferred shares can also serve as a source of retirement income. Typically what is done is that your preferred shares are redeemed gradually. So, for example, if you need $100,000 before tax a year to live, you can redeem $100,000 of your preferred shares each year. Let’s say you live 20 years and redeem a $100,000 a year. By the time of your death, you will have redeemed $2,000,000 ($100,000 x 20 years) of your preferred shares and they will now only be worth $1,000,000 ($3,000,000 original value less $2,000,000) at your death. Your income tax liability on these shares at the time of your death will now only be approximately $250,000.

The Benefits of an Estate Freeze

1. On death (something we should all be planning for), an individual is subject to a deemed disposition (i.e. a sale) on all of his/her assets at FMV, which would include his/her shares of the business. An estate freeze sets your maximum income tax liability upon this deemed sale and as discussed above, this liability can be lowered over the years by redeeming the shares.

2. Family members will be able to become shareholders of the business at a minimal cost and be motivated to build the business (although Tom Deans would dispute this assertion).

3. Instead of having children directly subscribe for new common shares, you can create a discretionary family trust to hold the common shares. Every year, the corporation can pay dividends to the family trust which can then allocate the dividends to family members with lower marginal tax rates. This mechanism allows for great income splitting opportunities.

4. On the eventual sale of the business, the children or family trust may realize a significant capital gain. Assuming that the business qualifies for the capital gains exemption, the family trust can allocate this capital gain to each beneficiary who may be able to use his/her own lifetime capital gains exemption limit to shield $813,600 or more of capital gains from income tax.

One of the more critical aspects of an estate freeze is the determination of the fair market value ("FMV") of your business. In order to ensure that an estate freeze proceeds as smoothly as possible, the FMV of the company must be calculated. In the event that the FMV determined is challenged by the Canada Revenue Agency (the “CRA”) the attributes of the preferred shares will have a purchase price adjustment clause that will let the freezer reset the FMV. The CRA has stated in the past that they will generally accept the use of a purchase price adjustment clause if a “reasonable attempt” has been made in valuing the company. Engaging a third party independent Chartered Business Valuator to prepare a valuation report is generally accepted as a “reasonable attempt” in estimating the FMV.

Issues to Consider Before Implementing an Estate Freeze

An estate freeze does not make sense for all business owners. While the above benefits do sound very enticing, it depends on each owner’s personal circumstances. Issues to be considered include:

1. Are you relying on the value of the company to fund your retirement? If so, it may be best to sell and ensure you have a secure retirement.

2. Do you have an identified successor, i.e. child, able and willing to work in your business?

3. Can you bring one child into the business without creating a dispute amongst your children?

4. Are your children married and how may a divorce or separation impact the business?

Long-time readers of my blog will know that I am a proponent of family discussions and getting over the money taboo. I cannot overstate the importance of having a detailed discussion with your family if you plan to hand your business over to one or more of your children. If you pass that hurdle, you must speak with your accountant and lawyer to ensure you understand the implications of the freeze and how to properly implement the corporate restructuring. Finally, your tax advisor will want to structure the freeze such that it can be “thawed” if the business suffers a setback due to the economy, or your child(ren) prove incapable of running the company.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Are Estate Freezes the Wrong Solution for Family Business Succession? - Part 2 and Giveaway

On Monday I discussed why an estate freeze may not be the right solution for a family’s business succession plan and why Tom Deans considers an estate freeze to generally be the absolute wrong way to go about transferring a family business.

Today, I discuss my interpretation of Tom’s thoughts based on a panel discussion I participated in with him, my reading of his book and a review of interviews he has given. To be absolutely clear, these are my interpretations and Tom has not reviewed or commented in any way. Finally, I have a 4 CD audio set giveaway of Tom's book Every Family's Business.

Buy the Business, Are You Kidding Me?

In the postscript to Tom’s book Every Family's Business: 12 Common Sense Questions to Protect Your Wealth, he says the one part of his presentation that always elicits an uneasy response is when he says ‘in this room there are children who believe their parents will gift their business to them and parents who believe their children will purchase their business”. He goes on to say “this lack of clarity over the future ownership of the business is the greatest source of conflict and wealth destruction in a business".

What Tom is poignantly noting is the lack of communication between parents and their children and the unspoken assumptions that are often far from the truth. A parent needs to be honest with their child(ren) if their expectation is that their child(ren) will have to purchase the family business. Children need to be honest with their parent(s) about whether or not they are willing to purchase shares in the business or if they even have an interest in carrying on the business. The best business families are able to talk openly, honestly and frankly about money, business and family succession.

Just Sell the Damn Thing

Tom says “The legacy is not the business. The legacy is the family”. Many business owners believe their greatest legacy is their company and their job as entrepreneurs is to transition that business into their children’s hands. Tom suggests that owners need to grant themselves permission to take care of themselves first by selling for cash and looking at their business as an instrument of wealth creation. Although the business will typically be sold to competitors, Tom has no problem offering the business to children, as long as they purchase it on commercial terms and take on the risk of ownership (children may get preferential payment terms).

Tom says that when children find out they will not be gifted the business (through an estate freeze) they are often perturbed, however, when it is explained to them that someone is paying mom or dad millions of dollars, some of which may be allocated to them immediately or will ensure a significant inheritance for them in the future, they suddenly change their tune. Essentially, Tom is saying that the equity in your business does not have to be passed down as shares in the business, but can be passed as liquid wealth to your children down the road. To deal with the liquid wealth created by a sale, Tom wrote a second book entitled Willing Wisdom: 7 Questions to Ask Before You Die.

Transitioning Your Business to Your 65 Year Old Child

If a parent decides against selling the business and undertakes an estate freeze, often the parent becomes their own worst enemy. Tom half-jokingly noted during our panel discussion that when your parent has a heart attack at 71, twenty years ago they died. Now doctors put in a coronary stent and your parent is good for another 20 years. So when parents tell a child it will all be yours one day, that one day could be when you turn 65 and up until you obtain control of the company, your parent(s) may keep their thumb(s) on you (since they often maintain voting control as per my estate freeze discussion last week). Parents; skipping a generation is not succession planning! 

Find the End Before it Finds You

Tom says that in many cases your succession plan as an owner is no plan and until you suffer a health event, there is no urgency to plan. He suggests that it is important to start planning from day one, while you are healthy and clear of mind. Determine if there is a buyer in the house (family member) and as noted above, do not assume your children will be the buyer. He feels that if your children will not put up their own money (or obtain their own bank financing) to buy some or all of your shares, you should look elsewhere. If a child is not willing to risk their own capital, Tom feels that means they are either not committed to the business or they truly feel the business is old and past its freshness date.

Whether you want your business to be enticing to your children or an arms-length buyer, you must ensure your business adapts to changes and risks in the market place and that you continuously strive to improve operations and efficiency. By doing such, you make your company more valuable to an outside party and more attractive for a child to risk their own capital and carry on the business.

If you own a business, I strongly suggest you buy Tom’s book. In the end, he boils family succession planning down to 12 commons sense questions that start the family succession conversation but also cleverly have the ability to end the conversation quickly. I hope the two posts this week and last week’s blog on estate freezes, has given you plenty of food for thought.

Every Family's Business 4 CD Set Giveaway

I have two copies of a 4 CD audio set of Every Family's Business narrated by Tom. If you would like a copy, email Lynda@cunninghamca.com and I will randomly select the two winners and announce them on June 16th.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Are Estate Freezes the Wrong Solution for Family Business Succession?

Last week I discussed how an estate freeze provides an efficient income tax solution for the succession of your family business by allowing you to lock in the value of your business and pass the ownership tax-free to your children. However, a freeze does not provide you with immediate liquidity, nor does it require your children to risk their own capital. Some family succession experts believe an estate freeze is a misplaced income tax solution; when what is really required, is a business

solution.

A few months ago, I was one of the “experts” on a panel that discussed family succession. The guest speaker and main attraction for the night was Tom Deans (yes, believe it or not, I was not the draw). Tom is the author of Every Family's Business: 12 Common Sense Questions to Protect Your Wealth, the best-selling family business book of all-time with more than 300,000 copies in circulation. Tom is an outspoken advocate of parents taking care of themselves, which often means selling their business, whether to a competitor, their own child or management, rather than just handing it over to their children for free (via an estate freeze). 

Tom's suggestion to monetize your business, rather than hand it over to your children, runs counter to the commonly held belief that your business is your legacy and that the ultimate family business is multigenerational. For many business owners, I would suggest that Tom’s advice to sell and safeguard your retirement is often the prudent decision.

Tom says an “estate freeze usually sets the stage for what I like to describe as the beginning of the ‘perpetuity project.’ This is when a family shifts its thinking away from the business as a money-making asset and toward the business as a legacy, with the goal of ‘longevity’ trumping all other strategic options for creating value.”

With statistics suggesting that only 30% of family businesses transition successfully to the 2nd generation and a meager 10% to a third generation, Tom may be correct that many parents are compliant in destroying their business by trying to ensure its perpetuity.

Why Parents May Choose to Undertake an Estate Freeze

In my experience, parents often cite three reasons for preferring an estate freeze over an outright sale to an arms-length party or to one of their children.

1. They see the family business as an annuity, so why sell for $4,000,000 ($3,200,000 or so after-tax) when it will make $4,000,000 every 4 to 5 years indefinitely if the business continues as it is or grows.

2. They feel they can easily redeem enough of their frozen shares each year to cover their living expenses so why burden the children with additional debt.

3. What is the point in selling shares to their children, if their children need to borrow from the bank to purchase the shares; especially since if the business goes sour, the parents figure they may need to step-up and cover the default anyways?

What Is so Bad About an Estate Freeze?

As many accountants can attest to, often a well- intentioned estate freeze that has saved the family thousands or even hundreds of thousands of dollars in tax ends up being the catalyst to family conflict and/or the ruin of the families business. Here are some of the downsides to an estate freeze:

1. In undertaking a freeze, shares are issued for no consideration. The children have no risk capital invested in the company, which can alter their commitment to the business. (More on this on Wednesday.)

2. Whether a company’s share value increases due to market forces or because of the children’s efforts or non-efforts is irrelevant; your children may end up making far more than you ever did, despite you handing them a turnkey operation (that may be fine with you).

3. An estate freeze requires decisions regarding which child(ren) will work in the business, how they will be compensated and which of them get shares and what percentage of the shares. All these decisions can blow-up. For example, let’s say you undertake an estate freeze and give your daughter who will work in the business all the shares of the business (which are in theory worthless at the date of the freeze, since you have all the current value in your special shares, say your shares are worth $2,000,000 in this example). You leave your other two children say $100,000 each in your will to “compensate” them for not being involved in the freeze. Imagine the sibling conflict if the business grows to $3,000,000 in value. The child working the business has benefited to the tune of one million dollars ($3,000,000- $2,000,000 freeze value) plus a full-time job, compared to the $100k the other children will receive in the will.

4. Parents often like the concept of freezes because it locks in the maximum amount of income tax they will owe on death, however, the freeze is also often viewed as a way for them to slow down and move away from the business. If the child who takes over the business makes a mess of the family company, mom or dad or both are often forced to step back in to save the company – not exactly the stress-free retirement they imagined.

5. In a blog posting by Tom, he states that an estate freeze “magnifies family genius – and incompetence – precisely because the market rules of ownership were violated through gifting, all in the name of saving tax. Families pay the highest price when they lose their mutual trust and respect for one another when gifting goes bad. And when trust is lost, family members resorting to litigation is the saddest progression of a family business in decline”.

The Benefits of Estate Freezes

My personal experience with estate freezes has been good. While the overwhelming majority of my clients over the years have sold their businesses, there have been several that have frozen their companies and everything worked out. I would say that is because most of these clients were able to distinguish which child(ren) deserved to work in the business and were committed to the business (in most cases, the children have been uniformly intelligent and often academically brighter than their parents, though not necessarily as street smart). The parents also gave significant thought to how they would compensate the children both involved in the business and those excluded from involvement. Finally and probably most import, the parents tried to understand the sibling dynamic within their families and whether a freeze made sense within these family dynamics.

When I spoke to Tom about this before his speech, he asked me “If all these children were so committed to the business and so bright, why would they not have agreed to purchase shares from their parents?”

After reading this post, you may be thinking to yourself that an estate free may not be the succession planning panacea it is marketed as; at least from the non-tax perspective. On Wednesday in part two of this post, I will discuss the issues Tom considers vital in regards to selling or transitioning your family business. In addition, I will give away two copies of a 4 CD set of Every Family's Business narrated by Tom.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Estate Freeze – A Tax Solution for the Succession of a Small Business

Winston Churchill once said, “Let our advance worrying, become advance thinking and planning.” Small business owners often worry about their exit strategy and/or succession plan. They may also be concerned about what would happen to their business if they have a health scare or receive an ultimatum from a child working in their business. Often a small business owner’s worry becomes their anxiety, instead of their advanced planning.

As a small business owner, at the end of the day, there are essentially only two exit strategy/succession options you need to plan and/or consider:

(1) A sale of your business, typically to a competitor, sometimes to current management or very infrequently, an actual sale to a child or other family member; or

(2) A transfer of the business to your children without a sale (for purposes of this article I will refer to this option as an “estate freeze”).

My blog today discusses estate freezes. How you can transfer your business tax-free to a successor (typically your children, sometimes to existing management) while continuing to control and receive remuneration from your business.

Next week I’ll discuss Tom Dean’s thoughts on this matter. Tom who is the author of Every Family's Business (the bestselling family business book of all-time) believes a business should in most cases be sold and never handed over to the next generation (such as done with an estate freeze) without the parent(s) adequately being compensated for the business.

What is an Estate Freeze?

The most tax efficient manner to transfer your business to your children is to undertake an estate freeze. An estate freeze allows your child(ren) to carry on your business, while at the same time you receive shares worth the current value of your business. In addition, once your share value is locked-in, your future income tax liability in respect of your company’s shares is fixed and can only decrease. Keep in mind that when you freeze the value of your company you are not receiving any monies for your shares at that time. There may be ways to monetize that value in the future, but on an estate freeze, you typically only receive shares of value, not cash.

The key risk in any estate freeze is that your children may partially or fully devalue these shares and your company. So while an estate freeze may be the most tax efficient way to transfer your business, it may not be the best decision from an economic or monetization perspective. 

In a typical estate freeze, you exchange your common shares of your corporation on a tax-free basis for preferred shares that have a permanent value (“frozen value”) equal to the common shares’ fair market value (“FMV”) at the time of the freeze. Subsequently, a successor or successors, say your children or family trust can subscribe for new common shares of the corporation for a nominal amount.

This concept is best explained with an example. Assume Mr. A has an incorporated business worth $3,000,000 and wants to undertake an estate freeze. In the course of the freeze, Mr. A is issued new preferred shares worth $3,000,000 and his children or a family trust subscribes for new common shares for nominal consideration. Mr. A’s tax liability in relation to these shares on death, is now fixed at approximately $750,000 in Ontario ($3,000,000 x capital gains rate). Often, a key aspect of an estate freeze is a plan to reduce the tax liability by redeeming the preferred shares on a year by year basis as discussed below.

If you have access to your lifetime capital gains exemption (currently at $800,000 but indexed beginning in 2015 for inflation), your income tax liability may be reduced when the shares are eventually sold or upon your death if you still own them at that time. Finally, you may choose to crystallize your exemption when you freeze the shares.

The preferred shares received on the freeze can be created such that they allow you to maintain voting control of your corporation until you are satisfied your child(ren), is(are) running the company in the manner you desire. This maybe a double-edged sword, as you may tend to hold onto control long after your successors have proven themselves. This may become a contentious issue.

Preferred shares can also serve as a source of retirement income. Typically what is done is that your preferred shares are redeemed gradually. So, for example, if you need $100,000 before tax a year to live, you can redeem $100,000 of your preferred shares each year. Let’s say you live 20 years and redeem a $100,000 a year. By the time of your death, you will have redeemed $2,000,000 ($100,000 x 20 years) of your preferred shares and they will now only be worth $1,000,000 ($3,000,000 original value less $2,000,000) at your death. Your income tax liability on these shares at the time of your death will now only be approximately $250,000.

The Benefits of an Estate Freeze

1. On death (something we should all be planning for), an individual is subject to a deemed disposition (i.e. a sale) on all of his/her assets at FMV, which would include his/her shares of the business. An estate freeze sets your maximum income tax liability upon this deemed sale and as discussed above, this liability can be lowered over the years by redeeming the shares.

2. Family members will be able to become shareholders of the business at a minimal cost and be motivated to build the business (although Tom Dean's would dispute this assertion).

3. Instead of having children directly subscribe for new common shares, you can create a discretionary family trust to hold the common shares. Every year, the corporation can pay dividends to the family trust which can then allocate the dividends to family members with lower marginal tax rates. This mechanism allows for great income splitting opportunities.

4. On the eventual sale of the business, the children or family trust may realize a significant capital gain. Assuming that the business qualifies for the capital gains exemption, the family trust can allocate this capital gain to each beneficiary who may be able to use his/her own lifetime capital gains exemption limit to shield $800,000 or more of capital gains from income tax.

One of the more critical aspects of an estate freeze is the determination of the fair market value ("FMV") of your business. In order to ensure that an estate freeze proceeds as smoothly as possible, the FMV of the company must be calculated. In the event that the FMV determined is challenged by the Canada Revenue Agency (the “CRA”) the attributes of the preferred shares will have a purchase price adjustment clause that will let the freezer reset the FMV. The CRA has stated in the past that they will generally accept the use of a purchase price adjustment clause if a “reasonable attempt” has been made in valuing the company. Engaging a third party independent Chartered Business Valuator to prepare a valuation report is generally accepted as a “reasonable attempt” in estimating the FMV.

Issues to Consider Before Implementing an Estate Freeze

An estate freeze does not make sense for all business owners. While the above benefits do sound very enticing, it depends on each owner’s personal circumstances. Issues to be considered include:

1. Are you relying on the value of the company to fund your retirement? If so, it may be best to sell and ensure you have a secure retirement.

2. Do you have an identified successor, i.e. child, able and willing to work in your business?

3. Can you bring one child into the business without creating a dispute amongst your children?

4. Are your children married and how may a divorce or separation impact the business?

Long-time readers of my blog will know that I am a proponent of family discussions and getting over the money taboo. I cannot overstate the importance of having a detailed discussion with your family if you plan to hand your business over to one or more of your children. If you pass that hurdle, you must speak with your accountant and lawyer to ensure you understand the implications of the freeze and how to properly implement the corporate restructuring. Finally, your tax advisor will want to structure the freeze such that it can be “thawed” if the business suffers a setback due to the economy, or your child(ren) prove incapable of running the company.

As noted above, next week I will discuss Tom Dean’s views. Tom feels an estate freeze is not a succession plan or the best way to liquidate or sell a business.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Sibling Rivalry-Parents Beware, it is not only a Childhood Issue

This past summer, while driving to a golf course 30 minutes outside of Toronto, my friend and I played a game of high school geography. After playing the game for a few minutes, he asked me if I had heard what had happened to Tiny and his younger brother Tim. I said no, and my friend then related this tragic story.

As part of a family business succession plan, Tiny and Tim were given control of Papahasdough Co. This succession plan was well-founded as both Tiny and Tim had worked in the business for years and were ready to take the business to a new level. Although the brothers were given equal shares of Papahasdough Co., Tiny assumed the role as CEO and Tim was named CFO. However, Tiny, as he had all his life, acted as Tim’s older brother/boss and not his equal. Tim, who had resented Tiny since childhood for acting superior, rebelled. The brothers had a severe falling out and lawsuits followed. The story gets far uglier, but I’ll spare you the gory details.

In this sad saga, sibling rivalry moved from childhood to adulthood. One may think this uncommon; however, according to a 2004 article by Offra Gerstein Ph.D, titled How to deal with Adult Sibling Rivalry, sibling rivalry can significantly impact relationships between adult siblings.

Dr. Gerstein states that “the need to restore one’s worth in one’s eyes may take the form of life long competition. If I “win” and my brother “loses”, then I may prove that my parents were wrong in favoring him. This may not be a conscious thought but the action may reflect this motivation.”

Jane Mersky Leder in her article titled Adult Sibling Rivalry says “Western culture has an obsession with sibling rivalry that began with the story of Cain and Abel and was elaborated by Freud, who labelled and dwelt on the competition between siblings for parental love and attention. It's colored our perception of sibship ever since.”

Sibling rivalry can manifest itself in many ways during adulthood, both financially (the distribution of family assets) and psychologically (perceived favouritism). However, in this blog, I am just going to deal with how sibling rivalry can affect the succession of a family business. The issues of business succession are varied and complex even for families without sibling rivalry baggage.

Family succession issues include: Which child does the parent give the voting shares to? Who is named CEO? If the children do not have the same commitment to the business, should they be given equal shares or equal salaries? These issues are intensified when there is sibling rivalry and I would suggest the parents are ultimately responsible for recognizing that this issue can be divisive and toxic, as in the case of Tiny and Tim.

Even where parents are in a no-win situation, at a minimum they must consider options to mitigate potential issues. Alternatives may include selling the business or giving the shares to one child and equalizing the other child through cash or other means.

A 2001 paper by the National Center for Employee Ownership presented by their research council states “sibling rivalry can pose another obstacle to smooth succession in cases where the retiring owner is transferring company leadership to more than one child. While some rivalries are inevitable, these must be managed so as not to impair business judgement or prevent collaboration from taking place. A wide variety of approaches – such as enlisting one of the retired owner’s trusted advisors or a very senior non-family manager as a mediator – can prove successful in preventing rivalry from becoming destructive.”

Phil Thompson in his paper Succession Planning and the Family Business states that “without careful planning and parenting, including outside counselling, sibling rivalry can wreck a succession plan. Unfortunately, sibling rivalry often stays buried until after the parent is dead. Deal with sibling rivalry right at the beginning, and build a plan that will not fall apart over this issue. Problems can arise either when more than one sibling is involved in the business or when only one of your children is involved. The decision you make with the business can affect how other family assets are considered, including houses and cottages."

Many parent(s) work their entire lives to build a family business with the hope of passing it on to their children. It is very sad that childhood sibling rivalries can be carried into adulthood and it is incumbent upon the parent(s) to recognize this issue and plan to mitigate any potential fallout.

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The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

How your Family Dynamic can affect your Estate Planning

Estate planning is a complicated and delicate process. Where you have more than one child, the planning process is full of minefields, some are in clear sight, but many are hidden. Parents have to navigate these minefields with respect to the determination of executors, the distribution of family heirlooms and the distribution of hard assets. The above decisions may be impacted by the financial wherewithal of your children, your relationship with your children’s spouses, your grandchildren or lack thereof, and in some cases, favouritism of certain of your children.

The above are what I call vertical family hierarchy issues. These are issues resulting from parents making decisions that will affect their children and potentially, the way their children will view their parents after death.

What parents do not often consider is how these vertical decisions impact horizontally: i.e. how the interrelationship of your children must be considered in your estate planning. Any parent who does not consider these relationships runs the risk of creating a divisive wedge amongst their children as sibling rivalry and jealousies may rear their ugly heads.

In this blog, I will attempt to identify several estate planning issues that not only have vertical consequences, but also have horizontal consequences requiring parents to consider their children’s relationships in context of their planning.

The Family Business

Where there is a family business and the succession plan is to pass on the business to the next generation, several issues must be considered. The issues include the following:

How many children have an interest in the family business?

If you have more than one child, is one specific child best suited to the role of CEO or president? If so, based on your children’s current relationship(s), do you foresee them working together or will they butt heads or worse? If the eldest child is named president, have you reinforced a perception the younger child has held for years, that the eldest is favoured and always assumed the most capable?

How do you value the business?

This is not an issue if all the children are given equal shares of the business, since they will have an equal ownership no matter the actual value attributed to the company. But what if you decide to leave the business to one child and equalize a child or the other children with say cash or other assets? The value of the business can fluctuate wildly over the years, with the result being that the child who inherits the shares may in essence have inherited a significantly larger asset than the other child(ren). Alternatively, the shares of the company may prove to be worth substantially less than the assets distributed to the other child(ren) if business conditions cause the value of the business to diminish. As a parent, can you do anything to avoid potential disparities in value? I have seen situations where asset distributions were equal at the time of death, but the inherited business grew astronomically and the children who did not inherit the company shares felt wronged by their parents.

Finally, if you have undertaken an estate freeze while alive, (see my blog on introducing a family trust as a shareholder and the related discussion on estate freezes) which child will inherit the voting shares? You risk alienating the children who do not receive the voting shares, since they may feel that you did not think they had enough acumen to vote and run the company.

The Family Cottage

The family cottage is often a contentious asset. In some families all the children want to keep ownership of the cottage and in some families only one or two siblings want the cottage. As a parent, you must speak to your children and determine who wants the cottage. Where more than one child wants the cottage, you have to consider whether those children have a good relationship and if they will be able to share ownership of the cottage without starting a world war. If not, do you have to consider selling the cottage in your later years to avoid creating a divisive issue amongst your children?

Another important factor to consider is whether the children interested in keeping the cottage have the financial wherewithal to pay their share of the cottages expenses on a yearly basis? If not, how do you overcome this potential issue, especially if one child has the financial resources and another does not?

Also, where there is a large inherent gain on the cottage, you have to determine whether your estate will be able to pay the income taxes without forcing a sale of the cottage and causing the estate to unwind your original intention to keep the cottage in the family? In this case, you may be able to use life insurance to cover off this issue.

The Will

A will may be construed as a document that reflects a parent’s opinion of their children and confirms the children’s opinion of themselves. If you infer one child is more responsible than the others (by selecting a certain child(ren) as an executor and excluding others), you risk igniting the fire of past resentments amongst the children and potentially causing resentment of you even in death.

Assuming you can navigate the determination of the executor(s) amongst your children without creating jealousy or animosity (if not, a corporate executor may be required), how do you distribute your assets upon death in a manner that mitigates any damage that can occur to your children’s relationships?

The distribution of material items is fraught with danger. How does one ever balance sentimentality and value? If you provide one child a sentimental heirloom, you risk that child complaining the other children got more value, while the other children complain they were not left sentimental heirlooms. What if you have art? How do you balance the value of art that has significant value differentials?

What about the situation where one child has been financially successful and another has not. If your will provides for a greater distribution to the child with less money, how do you ensure you do not create resentment with the financially well-off child? The less well-off child, who should be ecstatic, may actually be insulted, as they interpret the larger inheritance as their parents saying they were "financial losers" as opposed to being grateful for the larger inheritance. In these cases, one must tread carefully, but an unequal allocation may be more readily accepted where you explain your reasoning to your children before your death.

Another issue is grandchildren. Where the number of grandchildren is different in each family or one child does not have any family, do you give equal amounts to each family or equal amounts per child? How about where one of your children may be incapable of providing for a grandchild’s education and you feel a trust would be appropriate? Will any consideration other than equal consideration be construed as favouritism by your children?

Finally, many parents have provided loans to their children to assist with university, purchasing a house or what have you. How do you deal with prior gifts or loans? If you forgive the loans, you may have an unequal distribution and cause an issue amongst your children? Thus, you may want to consider a reduction of any distributions in the will for any outstanding loans.

This whole blog may be construed as ludicrous on a certain level. Some may say this blog is evidence as to why they will not leave anything to their children. Others may say I will leave my children whatever I feel like and if the distribution is unequal, so be it. However, it has been my experience that the majority of parents truly do not want to create any dissension amongst their children and aim to provide for an equal distribution. Even though they will have passed on, many parents still don’t want to alienate any of their children or cause resentment upon their death.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.