A tax-efficient exit: time invested now pays off later
Many private company owners are focused on their present reality, and rightly so. Growing a business and succeeding in the current pandemic-impacted market is more than a full-time job. Structuring for a sale or transition to the next generation often seems like a distant consideration. However, when the right offer comes along, or when a sudden illness, disability or life circumstance occurs, that once distant consideration is brought into immediate focus.
It is human nature to defer devoting precious time and resources to decisions we perceive to be out of our immediate view, somewhere on the distant horizon. However, experience shows that business owners who implement a plan well in advance of an exit achieve much better outcomes than those who only implement plans at the time of a sale. This is particularly true in respect of tax matters, as implementing a plan now for an exit at some point in the future ensures that your personal and business affairs are appropriately structured from a tax perspective, giving you more access to tax planning opportunities, maximizing your after-tax capital and minimizing diligence concerns of potential buyers, that may result from an independent review of the company’s tax exposure.
The effective tax rate on a capital gain realized in a sale transaction can range from 24% to 27% depending on province of residence. For many owners entering into an exit transaction, there is often a mistaken assumption that little can be done about the tax liability and they simply let the ‘after-tax chips’ fall where they may. Others defer tax planning until an exit becomes a reality, and the result is often disappointment when they discover the available options are limited without planning in advance. For example, multiplication of the capital gains exemption through a family trust or otherwise to family members, on a qualifying share sale may result in an ability to shelter proceeds from tax - but such a structure generally needs to be implemented years in advance.
Some business owners believe they have a structure in place to reduce tax on an exit but have not reviewed or re-visited the structure in many years. When an exit opportunity arises, they are surprised to learn their structure is tainted or less than optimal based on the current tax legislation.
While the COVID-19 pandemic resulted in a temporary halt in middle market private company transactions, a resurgence in deal activity is resuming at a furious pace. Emerging deal structures to address buyer uncertainty with respect to business valuations due to COVID-19 may carry significant tax consequences if not appropriately addressed. This, coupled with the numerous changes to the taxation of private companies and their shareholders over the past few years, means there is perhaps no better time than now to understand how these changes could impact previous planning.
Begin with the end in mind
The first step is to consider some of the following questions and discuss them with your advisor:
- How do the recent changes to the taxation of private companies and their shareholders impact transition and sale planning under the current business structure?
- How has the business landscape changed due to COVID-19?
- Can I take advantage of the lifetime capital gains exemption under my current structure to reduce or eliminate tax?
- Are there any opportunities to multiply the lifetime capital gains exemption under my current structure?
- Do my operating companies currently hold any ‘bad assets’ that may restrict the ability to qualify for the lifetime capital gains exemptions?
- Do I have different business ventures co-mingled in one operating entity and are these businesses separately saleable?
Who would be most likely to purchase my business?
- A current employee or group of employees, through a management buyout? Does this need to occur at fair market value or is there an opportunity to have them gradually ‘earn-in’ to the established value of the company?
- An arm’s-length unrelated purchaser? –Will the purchaser be looking for me and key employees to stay involved in the business for a stated period of time? Will this impact the total purchase price or will this be based on the business remaining successful over a period of time?
- A strategic buyer such as a peer or competitor? Will there be a desire to fold the business operations into the buyer’s? Will there be commitments related to current employee retention – or conversely, will the buyer shut the business down to reduce competition, leaving current employees unemployed?
- Do I have a suitable family member that has an interest in taking over the enterprise? How can he or she be introduced into the structure on a tax-efficient basis while preserving my current value? How will family members that are not involved in the business be equalized?
- Will I need all the cash from an exit immediately for personal expenses? What is the plan for the proceeds? Will proceeds be used to invest in other opportunities?
- Have I appropriately considered key employee rewards, retention, equity compensation plans and the associated outcomes on a transaction event?
- Have material compliance and tax exposures been addressed and remediated in advance of a transaction?
Developing your tax plan
The questions above can lead to a meaningful discussion about what tax planning alternatives are available to you and your business on an exit. A good tax advisor will be able to implement a tax plan that provides you with the most flexibility to cover a variety of exit scenarios and also take advantage of immediate planning options. Some of the advantages of a comprehensive tax plan include:
- Ability to defer tax on profits not immediately required for personal expenses while consistently purifying the operating company of passive assets in order to maintain access to the capital gains exemption on a share sale;
- Structure to allow for multiplication of the lifetime capital gains exemption;
- Appropriately structure foreign operations to provide access to Canadian tax treaty benefits;
- Reduce the immediate tax on proceeds when the proceeds are to be reinvested, donated or deployed into other operating businesses rather than used for immediate personal expenses;
- Allow for deferral of tax payments where cash proceeds are not paid up front (i.e., earn-outs or stock based proceeds).
Know your objectives
A suitable plan depends very much on the personal circumstances and objectives of the business owner, the profile of the business, the transaction structure, and many other factors. Consequently, a successful tax plan often requires a tailored approach that continually evolves as the business changes.
A successful exit from your business involves taking steps to implement the appropriate structure well in advance of a contemplated exit so that you have access to a full range of planning opportunities when you decide to sell. If you already have a structure in place, consider revisiting it to ensure that it still meets your needs in light of any recent legislative changes and the economic effects of COVID-19.