James Kraft says he broaches the subject of estate planning with clients who are small-business owners by asking them about their contingency plans.
“‘God forbid, you’re stuck somewhere overseas – who’s running your business?'” asks Kraft, an estate and insurance advisor and vice president with Bank of Montreal’s enterprise wealth planning group in Toronto. “[That concept] is something they can grasp. They can see themselves tied up for a short period.”
Many business owners put off thinking about how, and to whom, their business will be passed on when they die. Failing to put an estate plan in place can jeopardize the future success – or, indeed, the survival – of a business and potentially unravel a lifetime’s work on the part of the owner.
“Some business owners don’t want to think about [estate planning], and others think they’re going to live forever,” says Jack Courtney, vice president of advanced financial planning at Investors Group Inc. in Winnipeg. “It’s just not something they’re interested in tackling.”
Adds Kraft: “The business is probably the largest asset on [a business owner’s] balance sheet, and they are not treating it with the same respect as they might an investment portfolio.”
A client’s comprehensive estate plan should address both personal and business situations, and typically includes a will and a succession plan, as well as insurance, tax, investment and retirement planning components.
Financial advisors have a critical dual role – both coach and quarterback – in estate planning. As a coach, you can alert a business owner to the need for an estate plan and help him or her navigate the often delicate considerations surrounding succession. As quarterback, you can work with estate planning professionals such as accountants and lawyers to ensure all the complex components fit together.
“Advisors can help with the insurance and the investment sides, certainly. But, most important, they should be raising the issue with the client as the trusted advisor, and then bringing in the experts to help,” says Jamie Golombek, managing director of tax and estate planning with Canadian Imperial Bank of Commerce’s financial planning and advice group in Toronto.
Says Abby Kassar, vice president of high net-worth planning services in Royal Bank of Canada’s wealth-management division in Toronto: “The advisor’s role is to make sure that all of the experts are at the table, and they’re all talking to each other.”
In addition, when a business owner has a proper estate plan – one that includes setting up an appropriate corporate structure for the business, for example – he or she is better prepared to field unsolicited purchase offers for the business.
“If an offer comes around the bend,” Courtney says, “even if I don’t want to sell, but the offer is too good to be true, would I get the optimal tax flow [out of the sale of the business]? Do I have the right [corporate] structure to do that?”
While putting an estate plan in place can take as little as six months to a year, Kassar says, ensuring that plan is operating as intended can take three to five years. That’s why business owners looking to exit a business must start planning well in advance.
“Generally, the earlier the better,” Kassar says. “But three to five years will really allow [business owners] to plan ahead and structure their affairs in a way to maximize the value of their business at the time of an exit and to minimize the taxes that they would have to pay upon a sale or upon a transition.”
While there’s no set stage in your relationship with a client to begin a conversation about estate planning, the question of who will succeed a business owner – a child, a business partner, a third party – is often the essential element that drives other considerations.
“Their estate plan is dependent on their succession plan,” Kassar says.
While every business owner’s estate plan is unique, the key areas of consideration include:
WILLS AND POWERS OF ATTORNEY
Everyone should have a will, of course, but having a will is particularly important in the case of a business owner. In the event of unexpected death, the will can provide the executor with instructions on how to deal with the business, and who will have the power to make decisions. A will also can be drawn up to put into effect certain tax-planning strategies – such as the use of capital gains exemptions, rollovers and trusts – that help minimize the tax liability for an estate. As part of the will-making process, the business owner also should consider naming individuals to hold power of attorney for financial affairs and for health in case of a sudden disability.
A business-owner client also needs to give careful thought to whom he or she will choose as executor. Among other qualifications, the executor must be competent and familiar with the business, and have time to take on the role. In some cases, a corporate executor, which can remain impartial, may be preferable.
Finally, a business owner can use a will to address the issue of equalizing bequests between children who are active in the business and those who are not. For example, a business-owner client could leave a controlling interest in the business to the child who is active in the company and give non-controlling shares or other assets to a child who is not active.
SURVIVOR’S BUSINESS PLAN
Business-owner clients should consider drawing up a business plan that outlines what steps family members or associates should take to keep the business operating smoothly in the case of death or disability of the owner, Golombek says. “[That plan] is not a legal document,” he says, “but it’s a sort of blueprint for going forward.”
Life and disability insurance can be used to meet the immediate income needs of the business owner’s family members in the event of the business owner’s death or disability. In addition, proceeds from insurance can be used to pay for a tax liability associated with any deemed disposition of the business upon death. Without the proceeds from insurance, a large tax liability could force the sale of assets or even endanger the business.
“Insurance pushes a bunch of liquidity into your estate at a time when it’s needed,” Kraft says.
A business-owner client also might consider acquiring “key person” insurance to cover the death or departure of an important person in the business, says Golombek: “It can produce enough money to be able to pay for things like an executive search or hiring the services of an interim manager, etc., if the key person dies. [Without that insurance], you risk getting pressure from creditors, suppliers and shareholders.”
A client who is in a business partnership or who owns shares of a business with other individuals should consider drawing up a shareholder or partnership agreement with the other individuals. Such an agreement could set out what would happen in case one of the partners dies, experiences a disability or retires. A buy/sell provision included in the agreement may set out details about how the remaining partners will buy out the partner, or his or her estate, and include how a sale price will be determined. In many cases, life insurance is used to fund the buyout.
“[Shareholder agreements] help people avoid fighting later on,” Golombek says.
An estate freeze allows a business-owner client to take steps to minimize the tax liability to his or her estate on death by transferring future growth in the business to the next generation.
The accrued capital gain on the growth of the business is “frozen” at the time of the estate freeze, while future capital gains are transferred to children. When the business is sold or if there is a deemed disposition at the time of the business owner’s death, the tax liability of the “frozen” amount of the capital gain falls to the business owner or his or her estate. The tax liability on the future capital gain accrued after the estate freeze falls to the children when realized by them.
A common method of achieving this objective is for the business owner to convert his or her common shares to preferred shares, then issue common shares to a successor or successors. When properly executed, an estate freeze may allow both the business owner and family-member shareholders to access their lifetime capital gains exemption (LCGE) with respect to the sale of the business.
Recent legislative changes affecting the taxation of small businesses, however, have restricted the opportunities associated with using an estate freeze to achieve income-splitting with family-member shareholders through the distribution of dividends. In addition, if the capital gains of the successor generation are not eligible for the LCGE, they could be subject to taxation at the highest marginal tax rate unless the successors are active in the business.
If a business-owner client is uncertain about which of his or her children will be a successor, the client could set up a discretionary trust to be in force until the owner is ready to transfer business ownership to a child. In addition, a trustee can be given discretionary authority to allocate business or non-business assets from the trust to children according to wishes outlined by the business owner in the trust documents.
Also, a spousal trust can be set up in a business owner’s will to provide his or her spouse an income, generated from the business, during the surviving spouse’s lifetime. After the surviving spouse’s death, the capital in the trust can be transferred to the children.
DIVERSIFICATION OF ASSETS
Often, most of a business owner’s wealth is tied up in the business, which represents significant risk to family wealth. Business-owner clients should be encouraged to build up pools of investment and retirement assets to make them separate from the business. This can be done via RRSPs, TFSAs and other investment accounts. A business owner also could establish a holding company for the purpose of holding assets separate from the business and offering a degree of protection from creditors. However, business owners should consult with a tax expert before establishing a holding company for this purpose.
Of course, you can be especially useful in helping business-owner clients when offering investment, retirement and decumulation advice. Business owners may have developed great entrepreneurial skills, yet have little experience regarding investing or retirement planning, says Courtney: “We really have to guide them through that and give them confidence about the decisions they’re going to make.”