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Introduction
According to a 2012 CIBC World Markets Inc. report, within the next 10 years approximately half of the country’s current small business owners are expected to retire. A 2006 Canadian Federation of Independent Business survey found that small and medium sized enterprises are not adequately prepared for their business succession: only 10% of owners have a formal, written succession plan; 38% have an informal, unwritten plan; and the remaining 52% do not have any succession plan at all. The results are backed by the 2012 CIBC survey that suggests that succession planning is increasingly becoming a critical issue. In the coming five years, CIBC estimates that $1.9 trillion in business assets are poised to change hands.

It is important that the succession planning process is started early because it takes time. Some business owners delay the process because they think they are too busy or feel that it is too costly. Other business owners are unaware that there is even a problem. Succession planning may also be avoided or delayed because of the potential for emotional issues, such as facing retirement/mortality, dealing with family conflict and the feeling of losing control.

The purpose of this Tax Topic is to review the business succession planning process as well as analyze some of the different alternatives that are available when structuring a succession plan, including:

  • Structuring a succession plan when no successor is identified, through:
  • the sale of personally held shares to an outside party; or
  • the sale of corporate assets or corporately held shares to an outside party and dealing with the investment/holding corporation after the sale; and
  • Structuring a succession plan when a successor has been identified, through:
  • the transfer of the business to a successor during the business owner’s lifetime by way of a gift, a sale or a combination of the two;
  • the use of an estate freeze to transfer ownership to a successor during life; or
  • the transfer of the business to a successor at death by way of a gift, a sale or a combination of the two.

For each of the above alternatives the related tax issues and the life insurance opportunities will be reviewed as part of this Tax Topic.

Goals and Objectives
The first step is for the business owners to identify their personal and business goals and objectives. The following are some questions that the business owners and their advisors may consider when determining their goals and objectives:

  • What are the business owner’s plans for the future of the business? Has the business owner considered succession planning?
  • Has the business owner identified a successor or successors?
  • Is the successor a family member, a child, an employee or someone else?
  • When will the successor be ready to take on the task?
  • How should the active versus inactive children be treated? Equitably versus equally?
  • What is the timing for the succession plan?
  • What is the business owner’s current lifestyle and what are the business owner’s expectations for his or her lifestyle during retirement?
  • Are there any opportunities to reduce taxes?
  • Has the owner considered his or her tax liability at death and has any planning taken place?
  • What is the availability of liquid capital to fund the estimated tax liabilities at death?

The next step is analyzing the alternatives while bearing in mind the goals and objectives that were determined in the first step. While analyzing the alternatives, debt funding, tax liabilities, estate equalization and other estate costs should be taken into account. Some funding alternatives that may be considered include using other estate assets, borrowing money at the time funds are required, investing in a sinking fund to accumulate the amount required at a future date or purchasing a life insurance policy to provide funding at a future date. The following analysis of the alternatives includes a discussion of the life insurance opportunities that arise in the various succession scenarios.

No Successor Identified
The first alternative is really the non-succession, succession plan. With this alternative, the business owner does not have plans to pass on the business to a family member. There may not be an identified successor and/or the business owner plans to retire on the proceeds from the sale of the business to an outside party. Based on results from the 2005 CIBC survey, this approach seems quite common as approximately 40% of small business owners plan to sell their businesses to outside interests. The sale of the business could happen through an asset sale or share sale.

1. Sale of Personally Held Shares to an Outside Party
If the business owner sells the shares of the corporation, the disposition of shares results in a capital gain or loss. The amount by which the proceeds of disposition exceed the adjusted cost base of the shares is a capital gain; one-half of the capital gain is taxable to the business owner. If the shares are qualified small business corporation shares and the shares are held personally, the business owner may be able to use his/her lifetime capital gains exemption to offset all or part of the capital gain. (For a more detailed discussion of the capital gains exemption, refer to the Tax Topic entitled, "The Lifetime Capital Gains Exemption".) Note that if a holding company owns the shares and consequently sells them, the business owner will not be able to claim the capital gains exemption. For the consequences of selling shares owned by a holding company refer to the section below that discusses the sale of corporate assets.

Because of the preferential tax treatment of capital gains and the potential use of the capital gains exemption, a business owner usually prefers to sell personally held shares of the corporation rather than selling the assets of the corporation. However, with the introduction of the new eligible dividend rules and accompanying lower tax rates on eligible dividends, the sale of personally held shares may not always be preferred depending on the province of taxation. Following the share sale, the business owner will hold the after-tax proceeds personally to invest, fund his or her retirement and/or pass on to heirs at death.

Life Insurance Opportunities
A portion of the proceeds from the sale of the business could be used to fund or over-fund a life insurance policy. The policy could be used to increase the funds available to heirs or a charity at death (Estate Bond). Alternatively, the policy could be used to provide tax-sheltered growth to fund future retirement income needs by leveraging the cash value of the policy (Insured Retirement Program) or by withdrawing funds from the policy. For more information on these insurance planning techniques, see the Tax Topics entitled, "Accumulating and Transferring Wealth Through the use of Life Insurance" and “Leveraged Life Insurance – Personal Ownership”.

Another strategy to consider is using some of the proceeds from the sale to purchase an Insured Annuity. In this strategy, a capital sum is invested in an annuity that provides a regular payment stream to the investor as long as the investor is alive. The investor also purchases a permanent life insurance policy with a death benefit equal to the capital invested in the annuity. A portion of the cash flow from the annuity is used to pay the life insurance premiums. At death, the annuity payments typically cease and the life insurance death benefit is paid to the estate (or the named beneficiary) to replace the capital originally invested. The net result is often a larger lifetime income flow as compared to other fixed-rate investments, while still leaving an estate for heirs. For more information on this insurance planning strategy see the Tax Topic entitled, "Insured Annuities".

2. Sale of Corporate Assets or Corporately Held Shares to an Outside Party
The alternative to selling personally held shares of the business is the sale of the business assets or the sale of shares owned by a holding company.

If the business owner sells the assets of the business or shares held by a holding company, the income from the sale is taxed inside the corporation. How the income is taxed depends on the type of assets sold and the income generated. For example, the sale of depreciable assets, such as equipment, results in recaptured depreciation if the sale proceeds exceed the undepreciated capital cost (“UCC”). Recaptured depreciation is included in taxable income and taxed as active business income. The sale of non-depreciable assets, such as land or shares of an operating company, result in a capital gain equal to the sale proceeds less adjusted cost base. One-half of capital gains are included in taxable income and taxed as investment income. Gains on the sale of intangibles and goodwill are also included in taxable income at a 50% inclusion rate; the taxable portion is taxed as active business income as opposed to investment income. The type of income (i.e., active business income versus investment income) and type of corporation (for example, a Canadian controlled private corporation (“CCPC”) versus a non-CCPC) determine the corporate tax rate. For more information on corporate taxation refer to the Tax Topic entitled, “Corporate Taxation”.

In many purchase and sale scenarios, the purchaser prefers to purchase the business assets. Purchasing assets provides a higher depreciable asset base resulting in a higher depreciation expense in the early years and thus lower taxable income. A purchaser may also prefer to purchase the assets for liability reasons. The purchase of shares could expose the purchaser to liability related to the activities of the corporation prior to the purchase, including guarantees, warrantees, taxes, etc. This risk can be mitigated by including the proper indemnities in the purchase and sale agreement. On the other hand, as mentioned above, the vendor may prefer a share sale since it may result in lower income taxes payable. Due to the conflicting interests of the vendor and the purchaser, the sale price for a share sale is not generally the same as the sale price for an asset sale. Typically, the vendor will offer a discounted purchase price if the purchaser purchases the shares of the corporation.

Once the assets or shares of the business are sold and the taxes are paid in the corporation, the business owner will be left with a corporation holding the after-tax proceeds. These corporations are commonly referred to as Investment Companies or Holding Companies. For tax purposes there is nothing “special” about such corporations; they are subject to the same income tax regime as all corporations. Note that, as discussed above, investment income in any corporation is taxed differently than active business income. (For more details refer to the “Corporate Taxation” Tax Topic.)

At this time, the former business owner has a choice: the corporation can be wound up and proceeds distributed to the shareholders or the corporation can invest the funds, pay corporate tax on the investment income and distribute funds from the corporation as needed.

a. Winding-Up the Corporation
If the shareholder decides to wind-up the corporation after the sale of the assets, the cash and/or investments will be distributed from the corporation to the shareholder(s) and will likely result in additional personal income taxes payable. Paid up capital, shareholder loans and capital dividends can be distributed from the corporation to the shareholders tax-free and are generally distributed first. The remaining capital in the corporation is generally distributed to the shareholders as taxable dividends. (Note that dividends, unlike salary, are not deductible to the corporation.) After all assets have been distributed from the corporation and all income tax filings have been completed, the corporation can be dissolved.

The advantages of winding up the corporation shortly after the sale of assets include reduced compliance costs and simplification of the former business owner’s estate. The disadvantage is that the shareholder will have to pay personal tax on the wind-up dividend. If instead, the shareholder keeps the corporation, the personal tax can be deferred until the assets are distributed (which may not be until after death). Another option is distributing the funds over a number of years (a gradual wind-up) which may take advantage of the personal graduated tax rates and thereby decrease the total tax payable on the wind-up.

Life Insurance Opportunities
After winding up the corporation, the former business owner will hold the after-tax proceeds personally which may be spent or invested. In this scenario, the life insurance planning opportunities are the same as discussed earlier under the heading, “Sale of Personally Held Shares to an Outside Party” (for example, the proceeds could be used to fund an Estate Bond, Insured Annuity or Insured Retirement Plan concept).

b. Keeping the Investment Corporation
If the shareholder keeps the corporation, the after-tax proceeds from the asset sale can be invested inside the corporation. There may be an advantage in maintaining the corporation where there is a deferral of personal tax on the eventual distribution of income earned in the corporation and the sale proceeds and an overall tax savings on the income earned in the corporation versus personally. However, this advantage is dependent on the tax rates on each type of investment income earned in the particular province. Prior to distributing income to the shareholder, it is essential to compare the cost of distributing the income versus retaining the income in the corporation.

Currently, CCPCs are subject to tax at a rate of approximately 49% on investment income. A high rate of tax is imposed on investment income earned in a CCPC to prevent individuals from deferring tax on investments by incorporating investment portfolios. It is not the intent to tax investment income disproportionately on an integrated basis; therefore, the Income Tax Act (the “Act”) utilizes a refundable tax system (for a more detailed discussion on the mechanics of integration, please see the Tax Topic entitled, “Corporate Taxation”). In basic terms, the corporation receives a refund for a portion of the corporate tax paid when the corporation pays taxable dividends to individual shareholders.

Under this tax regime, it may be tax efficient to distribute the investment income earned by a CCPC to its shareholders on a regular basis as a dividend. This is because the refundable tax recovered can exceed the personal dividend tax paid. If this is true, the capital (arising from the sale of the business) will likely remain in the corporation until it is needed. . The growth is often distributed in order to recover the corporate refundable tax. For more information on the taxation of investment income in a corporation see the Tax Topic entitled, “Corporate Taxation”.

If the shareholder continues to hold onto the corporation until his or her death, he/she will have a deemed disposition at death equal to the fair market value of the shares of the investment corporation. The Tax Topic, “Dealing with Private Company Shares at Death – Post Mortem and Insurance Planning” deals with the tax issues and life insurance planning opportunities for an individual owning an investment corporation at his or her death.

Life Insurance Opportunities
The life insurance opportunities for a corporation holding the proceeds from a sale of a business are similar to those available to an individual. The main difference is that the life insurance would be held corporately instead of personally. In order to avoid a taxable benefit, the corporation must also be the beneficiary of the policy. A portion of the proceeds from the sale of the business could be used to fund or over-fund a life insurance policy. Deposits in excess of what is needed to fund the insurance charges can grow sheltered from corporate tax. The cash value can be used to enhance the funds available at death (Corporate Estate Bond) or can be used to fund future retirement income needs by leveraging the cash value of the policy (Corporate Insured Retirement Program) or by withdrawing funds from the policy. Another advantage of corporate owned life insurance is that upon the death of the life insured, the corporation receives a credit to its capital dividend account (“CDA”) equal to the death benefit proceeds received less the policy’s adjusted cost basis (“ACB”). For more information on these corporate insurance planning techniques see the Tax Topics entitled, “Accumulating and Transferring Wealth Through the use of Life Insurance – Corporate Ownership” and “Leveraged Life Insurance – Corporate Ownership”.

A Corporate Insured Annuity is another strategy to consider. In the corporate context this strategy works essentially the same as a Personal Insured Annuity except that both the annuity and the life insurance policy are held in the corporation. The corporation could use some of the proceeds from the sale of the business to invest in a life annuity. The corporation also purchases a permanent life insurance policy with a death benefit equal to the capital invested in the annuity. A portion of the cash flow from the annuity is used to pay the life insurance premiums. At death, the annuity payments typically cease and the life insurance death benefit is paid to the corporation to replace the capital originally invested. The net result is often a larger lifetime income flow to the corporation as compared to other fixed-rate investments, while still leaving an estate for heirs. At death, the corporation receives a CDA credit for any death benefit it receives to the extent that the death benefit exceeds the ACB of the life insurance policy. As a result, on the death of the life insured, the death benefit can be flowed out to the shareholders (estate or heirs) tax free to the extent of the CDA. For more information on this insurance planning strategy see the Tax Topic entitled, “Insured Annuities”.

Successor in Mind
If the business owner has identified a successor, the succession planning process will be somewhat different. As part of the planning process, the business owner needs to decide when he or she is going to transfer ownership: the business owner could transfer ownership during life, at death or a combination of both. The business owner also has to determine how he or she is going to transfer ownership: ownership could be transferred via a gift, a fair market value sale or an estate freeze.

1. Transfer to Successor During Life
The business owner may transfer ownership of the corporation during his/her lifetime. The business owner may wish to retire and not be involved in the day-to-day operations or may wish to stay involved in some limited capacity. The transfer of shares could take place via a gift, sale of the shares at fair market value or a combination. As part of the transfer, the business owner needs to consider the requirement for continuing income from the business in order to provide for retirement and this need for continuing income will likely impact how the shares are transferred to the successor.

Gift to Successor During Life
If the business owner decides to gift the business to the successor during his or her lifetime, it is unlikely that the business owner and the successor are dealing at arm’s length. As a result, for tax purposes, the business owner will be deemed to dispose of the shares of the corporation at fair market value and likewise, the successor’s ACB will be deemed to be fair market value.

The business owner will have a capital gain at the time of gifting the shares equal to the amount by which the fair market value exceeds the ACB of the shares. The disadvantage of gifting the shares during the business owner’s lifetime is that the business owner will have income tax payable on the taxable capital gain at the time of the gift but will not have any proceeds to fund the taxes payable.

On the other hand, a gift is simple and does not require the successor to be burdened with paying for the shares. In addition, the successor’s cost base of the shares is high since it is deemed to be the fair market value at the time of the gift.

Another advantage of gifting the shares is that the gift may be protected from claims by the spouse of the successor. Note that the gifting provisions are different for each province. For example, in Ontario, pursuant to the Family Law Act, a gift and any income derived therefrom may be excluded from net family property in a marriage breakdown situation. Similarly, in Quebec, for individuals married or in a civil union under the matrimonial regime of partnership of acquests, a gift and the income derived from it, if the donor has so provided, remain the private property of the recipient. A sale of shares, on the other hand, may be exposed to an equalization claim in the absence of a marriage contract which provides otherwise. If the applicable province has a gifting provision that is being relied upon, the gift of shares should be legally documented.

Estate equalization must also be considered if the company shares are being gifted to children who are both active and inactive in the business. If the company forms the majority of the business owner’s assets, the non-active children may be disappointed if the shares of the company are gifted to the active children. To equalize, the business owner may decide to gift the shares equally amongst all of his/her children. However, this may also create problems where the active children have different priorities than the inactive children. For example, the active children may want to invest earnings into the business, where the inactive children may want earnings paid out as dividends. The inactive shareholders may prefer to convert their share value into cash by selling the shares to the active shareholders or the company (i.e., a share redemption) putting a strain on the cash flows of the company and/or active shareholders.

Life Insurance Opportunities
Life insurance on the business owner with the inactive children as beneficiaries may be a solution for possible estate equalization issues. This strategy provides funds to inactive family members on the death of the business owner. The disadvantage with this structure is that the business owner must fund not only his or her tax liability on the gift of the shares, but also the life insurance premiums.

a. Sale to Successor During Life
Instead of gifting the shares, the business owner may choose to sell the shares of the business to the successor during his or her lifetime and use the proceeds from the sale as his or her retirement income. In addition, the proceeds from the sale of the shares can be used to fund the business owner’s tax liability and make it easier to equalize the estate amongst the heirs.

It should be noted that if the shares are sold to a non-arm’s length successor at an amount less than fair market value, there is a potential double tax issue. If the sale price is less than fair market value, the business owner is still deemed to dispose of the shares at fair market value and will realize a capital gain equal to the difference between the fair market value of the shares and the cost base. However, the successor’s cost base will be equal to the amount paid, not the fair market value that the business owner was taxed on thus creating the double tax problem. If the business owner wants to sell the shares at a discounted price, a better solution is to sell a portion of the shares at fair market value and gift the remaining shares.

One disadvantage of selling the shares to the successor is that the successor may not have the funds available to purchase the shares of the company. The successor could finance the purchase with a bank loan or a loan from the former business owner. The former business owner could fund the purchase by taking a promissory note in exchange for the shares with the promissory note being repaid over a number of years. This would also allow the former business owner to spread the taxable capital gain over five years using the capital gains reserve (and up to 10 years for the transfer of eligible farming/fishing property to a child or grandchild).

Another alternative is for the business owner to sell the shares to the successor and take back a promissory note that does not have any set repayment terms during the business owner’s life. The promissory note could be forgiven on the business owner’s death. Similar to the gift, the successor has not paid anything for the shares; however, if the former business owner does require additional cash for his or her retirement, he or she can request payments on the loan. The promissory note will also provide some protection if the successor decides that he/she does not want to be involved in the business, leaves the business or if family law issues arise. The successor’s fair market value of his or her shares is reduced by the note payable to the business owner. As a result, the fair market value of the successor’s shares will only be equal to the increase in value since purchasing the shares from the former business owner.

Note that the promissory note should not be forgiven during the business owner’s lifetime as doing so could result in an income inclusion to the successor and potentially, a double tax issue.

Another option is for the sale of shares to take place over a number of years. For example, the successor may purchase 10% of the outstanding shares each year, for 10 years. One disadvantage of this structure is that the fair market value of the shares being purchased will have to be determined each year.

Life Insurance Opportunities - Investment
There may be life insurance opportunities where the business owner sells the shares of the company during his/her lifetime to a successor and the business owner receives the proceeds on the sale. If the business owner has funds from the sale of the shares that are not needed for lifestyle purposes, he or she could use the surplus cash to fund or overfund a life insurance policy. The policy could be used to increase the estate funds available to heirs or to provide a gift to a charity (Estate Bond). Alternatively, the policy could be used to provide tax-sheltered growth to fund future retirement income needs by leveraging the cash value of the policy (Insured Retirement Program) or by withdrawing funds from the policy. For more information on these insurance planning techniques, see the Tax Topics entitled, “Accumulating and Transferring Wealth Through the Use of Life Insurance” and “Leveraged Life Insurance – Personal Ownership”.

Another strategy to consider is using some of the proceeds from the share sale to purchase an Insured Annuity. As mentioned earlier, this strategy involves the pairing of a life insurance policy with a life annuity to provide a guaranteed fixed income while preserving capital. For more information on this insurance planning strategy see the Tax Topic entitled, “Insured Annuities”.

Life Insurance Opportunities – Fund Purchase of Shares
If the shares are sold during the business owner’s lifetime and a portion or all of the proceeds are satisfied with a promissory note, life insurance could be used to repay the promissory note. The successor could be the owner and beneficiary of a life insurance policy on the former business owner’s life. When the former business owner dies, the successor receives the death benefit proceeds tax free and can repay the promissory note owing to the business owner’s estate.

Alternatively, the corporation could be the owner and beneficiary of a life insurance policy on the business owner’s life. The advantage of the corporation owning the policy is that the premiums can be paid with cheaper corporate dollars. (Corporate dollars are cheaper because corporate tax rates are generally lower than personal tax rates.) When the business owner dies, the corporation receives the death benefit tax-free as well as an addition to its CDA for the amount by which the death benefit exceeds the policy’s ACB. The corporation could then pay a tax-free capital dividend on the shares owned by the successor. The successor could use the funds to repay the promissory note owing to the business owner’s estate. The loan repayment received by the estate could then be distributed, on a tax-free basis, to the beneficiaries of the estate.

b. Estate Freeze
Another way to transfer ownership to a successor (or successors) during the business owner’s lifetime is to use a tax planning strategy called an estate freeze. An estate freeze can be beneficial when used with an established business that has experienced growth and is expected to continue to grow. An estate freeze allows the business owner to lock in the value of his or her shares today and thus “freeze” the tax liability at that point in time. An estate freeze also allows a successor to come into the business with minimal capital contribution and participate in the future growth of the business. The business owner can maintain control of the corporation if he or she wishes by assigning the appropriate voting attributes to the shares received as part of the freeze.

An estate freeze is accomplished by having the business owner exchange his or her common shares of the operating company for fixed value preference shares either in the operating company or in a holding company that owns the operating company. The transfer can happen on a tax deferred basis. The relevant provisions of the Income Tax Act used to accomplish the share exchange include section 86 of the Act (for a straight share for share exchange) and subsection 85(1) of the Act (for a more complicated share for share exchange with a holding company).

The preference shares have a fixed redemption value equal to the value of the existing common shares at the date of the exchange. Because the redemption value is fixed or “frozen”, the new shares do not participate in any of the future growth of the company; they will not increase in value. Assuming all the common shares are exchanged and no other shares are outstanding, the preferences shares will have a value equal to the value of the corporation at the time of the freeze.

In conjunction with a section 85(1) freeze, the business owner may choose to crystallize his or her unused capital gains exemption. (To qualify for the exemption the shares must be “qualified small business corporation shares” or “qualified farm or fishing property” as defined in the Income Tax Act. For more details refer to the Tax Topic, “The Lifetime Capital Gains Exemption”.) This will have the effect of increasing the ACB of the former business owner’s preference shares. The increased ACB reduces capital gains tax in the future when the shares are sold on an arm’s length basis or on a deemed disposition of the shares at death.

After the share exchange, the successor can subscribe for new common shares for a nominal amount because all the value of the corporation is held in the new preference shares owned by the existing shareholder. This allows the successor to benefit from the future growth of the company. The preference shares received by the business owner can be voting or non-voting shares depending on the business owner’s wishes. For example, the business owner may wish to maintain control of the company until his or her preference shares are redeemed. On the other hand, the business owner may not care if he or she retains control and the preference shares may be non-voting.

There are many variations of estate freezes. Some of the options include: a partial freeze, a wasting freeze, use of a trust etc. These variations are discussed briefly below.

One of the issues with an estate freeze is that the business owner has essentially given away all future growth in the business. If the business owner is not comfortable giving away all of the future value, a partial freeze can be used. A partial freeze allows the business owner to bring in a successor to participate in the growth of the business, while still retaining some benefit from future growth of the business for him or herself as well. As with a full freeze, the business owner exchanges his or her common shares of the company for fixed value preference shares equal to the fair market value of the corporation. However, in a partial freeze the successor and the business owner both subscribe for new common shares for a nominal amount. As a result, both the successor and business owner will participate in the future growth of the corporation.

A wasting freeze is structured in the same way as the general freeze described above, except that in a wasting freeze the preference shares owned by the business owner are redeemed over time. A wasting freeze might be implemented if the business owner requires funds from the business for his or her retirement and the successor does not have the capital to fund a purchase of the shares. A wasting freeze allows the redemption of shares to be funded by the corporation over time. On the redemption, the business owner will have a deemed dividend equal to the amount by which the proceeds received exceed the paid up capital of the shares. The gradual redemption of shares may be advantageous from a personal tax perspective because the deemed dividends will be spread over a number of years taking advantage of the personal graduated rates. Life insurance strategies that produce cash flows such as the Corporate Insured Retirement Program or the Corporate Insured Annuity could be used to redeem the preference shares and provide life insurance proceeds to complete the redemption of any outstanding shares at death.

If the business owner is unsure of whom the successor of the business is going to be, the new common shares could be issued to a discretionary trust. If the business owner has more than one child, the business owner could include all the children as discretionary beneficiaries. The business owner could be a trustee of the trust. As the trustee, at some point in the future, the business owner could determine how the shares of the business should be distributed based on each child’s involvement in the business. The use of a discretionary family trust can also provide income splitting opportunities with adult children through the payment of dividends to the trust which are then allocated amongst the beneficiaries. The trust also provides an opportunity to split the income in the event of a sale of shares by dividing a capital gain amongst the beneficiaries. The use of a trust also provides an opportunity for multiplying the capital gains exemptions on a qualifying sale of shares by the trust. Generally, the trust allocates the qualifying capital gain to the beneficiaries of the trust and the individual beneficiaries use their capital gains exemption to reduce tax payable on the capital gain. For more information on the use of a trust in succession planning see the Tax Topics entitled, “Trusts – Just the Basics” and “Trusts as a Planning Tool”.

If the shareholder continues to hold onto the “freeze” shares until his or her death, he or she will have a deemed disposition at death equal to the redemption value of the preference shares. The Tax Topic, “Dealing with Private Company Shares at Death – Post Mortem and Insurance Planning” deals with the tax issues and life insurance planning opportunities for an individual owning fixed value preference shares at his or her death.

2. Transfer to Successor at Death
The business owner could decide to transfer ownership of the business to the successor(s) at death due to a desire to control the company during his or her lifetime. The business owner may wish to continue to be involved in the day-to-day operations and may not need the proceeds from the sale of the business as a source of retirement income. If the business owner decides to keep the business, he or she can continue to take a salary and/or dividend income from the business to fund personal expenses. At death, the business could be gifted or sold to the successor, both options are discussed below.

a. Gift to Successor at Death
Gifting the shares to a successor on the death of the business owner does not change the tax treatment at death. The death of the business owner still results in a deemed disposition of the business owner’s shares at the fair market value immediately before his or her death. The amount by which the fair market value exceeds the ACB of the shares will be a capital gain reported on the business owner’s terminal return. One disadvantage of gifting the shares is that the business owner’s estate has not received any proceeds for the shares; however, the estate is still obligated to pay the tax on the deemed disposition. As noted below, a life insurance policy on the business owner could be used to address the need for cash to pay the tax liabilities or equalize the estate. A gift is simple and does not require the successor to pay for the shares. In addition, the successor has a high cost base since the ACB is deemed to be equal to the fair market value on the deemed disposition at death.

As mentioned above, a gift may also have the advantage of being protected from claims by the spouse of the successor. The gifting provisions are different for each province and should be reviewed for the applicable province. For example, in Ontario, pursuant to the Family Law Act, a gift, and any income derived therefrom, may be excluded from net family property in a marriage breakdown situation. In Quebec, for individuals married or in a civil union under the matrimonial regime of partnership of acquests, a gift and the income derived from it, if the donor has so provided, remains the private property of the recipient. A sale of shares on the other hand, may be exposed to an equalization claim in the absence of a domestic contract which provides otherwise. If the applicable province has a gifting provision that is being relied upon, the gift of shares should be legally documented.

If at the time of the business owner’s death, the business owner has a spouse, the tax on the deemed disposition can be deferred until the spouse’s death if the business owner rolls the shares of the company to his or her spouse (or a qualifying spousal trust) pursuant to subsection 70(6) of the Act. The succession plan could be structured so that the shares are gifted to the successor on the second death of the business owner and spouse. This option only defers taxes payable. Funding the tax liability will still be an issue on the second death since there will be a deemed disposition equal to fair market value at that time.

Succession planning may be more complicated where some of the children are active in the business and others are not. In this case, estate equalization must also be considered. For example, the non-active children may be disappointed if the business was a major asset of the estate and it was gifted to a sibling and the remaining siblings were left with only the residual assets and/or a large tax liability. There may also be an issue if the business owner decides to gift the shares equally amongst all his or her children at death. This may create conflict between the active and inactive shareholders; the active shareholder may want to invest earnings into the business, while the inactive shareholders may want the earnings paid as dividends. The inactive shareholders may prefer to convert their share value into cash by selling the shares to the active shareholders or the company (i.e. a share redemption). This could put a strain on the cash flows of the company and/or the active shareholders.

Life Insurance Opportunities – Tax Liability on Death
Life insurance can be used to fund the tax liability arising on the deemed disposition at death of the business owner or the last to die of the business owner and his/her spouse. The business owner could be the owner, the life insured and the beneficiary of the policy. On the death of the business owner, the death benefit would be paid tax-free to the business owner’s estate and available to fund the tax liability. A disadvantage of having the estate as beneficiary of the life insurance policy is that the death benefit will be subject to probate fees and estate creditors’ claims.

Another option is for the corporation to be the owner and beneficiary of the life insurance policy. It may be beneficial for the corporation to be the owner of the policy because corporations generally have a lower income tax rate. Therefore, the after-tax cost of the insurance premiums is generally less than personally held insurance. When the business owner dies, the corporation will receive the life insurance proceeds and an addition to its CDA equal to the excess of the death benefit over the ACB of the policy. The corporation can then pay a tax-free capital dividend to the estate to fund the tax liability. If the corporation holds the insurance, it is important that the gift of the shares to the successor doesn’t occur until after the capital dividend is paid; otherwise, there will be no way to ensure the money flows to the estate to pay the tax liability.

If the shares of the company are to be transferred to the spouse or a spousal trust on the death of the business owner (i.e. a spousal rollover), the life insurance policy could be structured with a death benefit that pays out on the last death of the business owner and his or her spouse (joint last-to-die). Accordingly, the life insurance proceeds could provide the necessary funds to cover the tax liability when it arises on the second death. Again, the life insurance could be owned personally or by the corporation.

Another alternative when a spousal rollover is planned is a policy on the business owner’s life with his or her spouse as the beneficiary. If the business owner predeceases his or her spouse, the shares of the company would be rolled to the spouse (or spousal trust) at cost and the spouse (or spousal trust) would receive the life insurance proceeds. The life insurance could provide the spouse with a source of income during his or her lifetime. On his or her death, he/she is deemed to dispose of the shares and gift the shares to the successor. If the spouse did not encroach on the death benefit capital during his/her lifetime, the remaining funds could be used to fund the tax liability on the deemed disposition at the spouse’s death. Similarly, the corporation could be the owner and beneficiary of the life insurance policy in this scenario.

Life Insurance Opportunities – Estate Equalization
Life insurance may be an option to provide funds to inactive family members to ensure an equitable distribution of assets. The business owner can own life insurance with the inactive children as beneficiaries. When the business owner dies, the shares of the company could be gifted to the active child; the inactive child would receive the tax–free death benefit proceeds from the life insurance policy.

As an alternative, the corporation could be the owner and beneficiary of the policy. On the business owner’s death, the shares of the corporation could be gifted equally to all of his or her children. The corporation will receive the life insurance proceeds and an addition to the CDA equal to the death benefit proceeds less the ACB of the policy. The corporation could redeem the shares owned by the inactive children resulting in a deemed dividend equal to the redemption amount less the paid up capital of the shares. The deemed dividend could be designated as a tax-free capital dividend thus allowing the insurance proceeds to flow to the inactive children tax-free. The active children would remain as shareholders of the corporation. (Note also that the business owner will still have a deemed disposition at death of his or her shares and the redemption of the shares using CDA may have an impact on the taxation of this gain.)

A similar life insurance planning option with the corporation as the owner and beneficiary of the policy involves the successor purchasing the shares of the company from the inactive shareholders. As above, the business owner gifts the shares equally between all of his or her children on his or her death. The successor purchases the shares from the inactive shareholders for fair market value. Instead of purchasing the shares with cash, the successor could purchase the shares with a promissory note. There shouldn’t be a gain or loss on the disposition of the shares by the inactive children since the ACB of the shares will equal fair market value. A tax-free capital dividend could then be paid to the shareholders (i.e., the children who are active in the business). The shareholders can then use the dividend proceeds to repay the promissory notes owed to the inactive children. The end result is that the children who are active in the business are shareholders of the company and the children who are not active in the business have received tax-free proceeds for their share of the company’s value.

To avoid problems after the business owner’s death, whatever option is chosen, the business owner’s intentions and planning should be well documented and discussed with all parties involved.

b. Sale to Successor at Death
Instead of gifting the shares to the successor, the business owner could sell the shares to the successor at his or her death. The benefit of selling the shares, as opposed to gifting the shares, is that the proceeds from the sale of the shares will provide the estate with cash to fund the tax liability on the disposition of the shares and/or provide the estate with additional funds to distribute to beneficiaries of the estate.

If the successor is a child or family member, the business owner may think about selling the shares of the business at an amount less than fair market value. This is not advisable because it creates a double tax problem. A better alternative is to sell a portion of the shares to the successor at fair market value and gift the remaining shares. (For more detail refer to the section called, “Sale to Successor During Life”)

As with the sale during life, the main disadvantage of selling the shares is that the successor may not have the cash to purchase the shares from the business owner. The successor could borrow from a financial institution to purchase the shares and the interest on the loan may be deductible.

Another option is an agreement that allows the estate to take back a promissory note from the successor with the shares being paid for over a number of years. The estate may charge interest on the note. Interest received by the estate could be taxed in the estate at the graduated marginal rates (assuming the estate is a testamentary trust) or allocated to the beneficiaries of the estate and taxed at their personal tax rates. As the principal portion of the note is repaid, it can be distributed from the estate as a tax-free capital distribution.

Life Insurance Options
Life insurance could be used to assist the successor in purchasing the shares of the corporation on the business owner’s death. The life insurance could be owned by the business owner or the successor, depending on who is funding the policy premiums, and the successor could be the beneficiary. On the business owner’s death, the successor would receive the life insurance proceeds tax free and use the proceeds to purchase the shares of the corporation from the business owner’s estate. The proceeds received in the estate could fund the tax liability on the disposition of the shares and/or be distributed to the beneficiaries of the estate.

Conclusion
The key to successful succession planning includes involving experienced professional advisors, carefully choosing executors, trustees and company management and openly communicating with family members and advisors. The planning process will be more efficient if a logical approach is used to incorporate various alternatives, the business owners’ objectives and a review of the financial impact of the alternatives. An important part of the analysis of the succession planning alternatives is the funding of debts, tax liabilities, estate equalization and other estate costs; life insurance is a key tool in this area. Once a succession plan has been implemented it should be reviewed regularly and updated as needed.