There may be a silver lining to the economic devastation wrought by the pandemic.
Through strategic estate planning, business owners who already have a succession plan can limit the amount of taxes their estate and heirs will have to pay.
This approach is very industry specific. It primarily benefits businesses that have been negatively affected because the business’s value is so much lower than it was before such drastic efforts were taken to stop the spread of the novel coronavirus.
William Tam (CPA, CA, CBV), Principal of Manning Elliott’s Valuations Practice, says that some owners of small- to medium-sized businesses in industries hit hard by the economic shut-down are well placed to reduce their estate’s tax burden and probate costs.
“It’s an opportunity given the business value declines that the pandemic has engendered,” he says.
Let’s say the business today is worth $5 million. The owner would exchange $5 million in common shares for $5 million in preferred shares. The preferred shares would be redeemable at the discretion of the existing owner. This means the owner still retains the full value of the business based on today’s value.
Then, new common shares would be created for the heirs to buy at a nominal amount — a dollar perhaps.
As the business recovers from the shutdown, the business’s value also grows. However, the dollar value of that growth is attributed only to the next generation’s common shares; the owner’s preferred share value remains the same.
So, if a business that’s valued at $5 million today finds its bearings again and, a year from now, is valued at $6 million, the owner’s share is still $5 million. That’s the amount on which business estate taxes and probate fees will be based on. Any growth in the business’s value from this year forward would be allocated to the next generation.
“In essence it’s a strategy in which business owners could effectively transfer the future growth in the business while paying less tax given today’s decline in the business’s value,” Tam says.
For this to work, the owner cannot simply pick a dollar amount for the business’s value out of thin air, hoping to artificially lower the future tax burden. The Canada Revenue Agency has systematic checks and a trained valuation team in place to identify and audit any assigned business values that appear to be unreasonably low.
The owner should engage a Chartered Business Valuator, such as Tam, to perform a valuation in order to provide a realistic picture of what the business is worth.
On a high level, there are three different approaches to determine the value of a business:
• Asset approach: this is typically used for real estate or investment holding companies. Most of this income is considered passive so the valuation looks at the balance sheet and makes certain adjustments for fair market value and taxes affecting certain assets.
• Income approach for an operating business: this focuses on reviewing the company’s cash flows, earnings, revenues and operating expenses. “We normalize it to what a third-party buyer would expect to earn from the business , factoring in the buyer’s required rate of return based on the risk of the business,” Tam says.
• Market approach for an operating business: this looks at the value of comparable companies. “It’s similar to what you’d do if you’re trying to sell your house; the first thing you do is get an idea of what your neighbours’ houses sold for,” Tam says. “Similarly, you’d look at comparable companies operating in the same industry, maybe in the same geography and see what these businesses sold for in the last few years..”
“When the business owner engages a third-party business valuator, they can be assured the valuator is independent and would have an objective view of all the financial details pertaining to the business,” Tam says. “They won’t add in an element of bias to either superficially lower or increase the value; it will be a neutral assessment.”
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