Part 4. Tips, Tools and Taxes
In Part 3 we discussed the importance of assessing the dealer’s readiness for transition. In this entry we will look at some tips, tools and a simplified example of feasible tax planning strategies for dealers.
A valuation of the business will provide information on the current value of the business and the tax position of the shareholder group. A Chartered Business Valuator will take into consideration key industry benchmarks, valuation metrics and provide a report of the estimated business value. The valuation can provide a basis for assessing the owner’s perception of value to a market based valuation. This exercise may assist in identifying factors that depress the business value and could create a roadmap for increasing the value in the future.
A Review of key legal documents such as wills and powers of attorney to ensure they are up to date is important. Further, a review of the applicable shareholders’ agreements is an important exercise; we encounter many scenarios where the owners are not clear on the shareholders’ agreement terms and related implications. Further, the structure of life insurance or disability coverage is often not consistent with the shareholders’ agreement. A written plan should address the day to day management of the business in the event of an unplanned transition due to poor health, loss of capacity, or death. The key documents should be reviewed and updated on a regular basis and shared with the proper internal and external parties.
Every dealer should have a unique and personalized plan. To help illustrate some key principles, the following simplified example outlines a specific tax planning strategy. This example is for illustration purposes only and should not be considered advice or relied on by the reader to make decisions. Consult with your professional advisors to evaluate your options and the best course of action.
Simplified Scenario: The dealership has been successful over the past 10 years and the overall value of the business has grown from $2 MM to $10 MM. We have assumed that $2 MM represents the owners cost for his or her shares in the business.
If a transition were to occur without a tax strategy, there could be a tax liability in the $2 MM range- this is the estimated tax on an $8 MM capital gain if there is no Capital Gains Exemption (“CGE”). The exemption may not be available for an unplanned transition because the business may not meet the CGE criteria at the specific time. Stated another way – an incremental amount of tax may arise due to a lack of proactive planning. A qualified advisor can assist in evaluating and implementing the planning options. A key strategy, in our example, would have been to implement a freeze when the business had a $2 MM value. A freeze is such that the shares owned by the shareholder have a fixed value and this value does not increase notwithstanding that the business appreciates in value. A freeze can be implemented on a tax deferred basis and the owner can retain control of the business, notwithstanding that he or she does not own the growth shares of the business. A key issue in the context of a freeze is to decide who will own the new common shares issued as part of the freeze.
We often use a family trust as a key part of a freeze. Notably the family trust may be the entity that owns the newly issued common shares. As part of the exercise we may propose that the beneficiaries of the trust include the business owner, his or her spouse and children. The trust acts as a conduit such that dividend income or a capital gain realized by the trust can be allocated to one or more beneficiaries. Further, the family trust can accommodate a succession plan because the trust can distribute the common shares of the business to one or more beneficiaries of the trust. Based on proper planning the distribution of the common shares occurs at cost. Based on our numerical example, the trust could be distributing common shares worth $8 MM and without a capital gain realized.
In connection with a freeze we often advocate that a holding company be created, if one does not already exist, for the purpose of distributing surplus funds from the business. The distributions may occur in the form of tax-free dividends. Such a strategy can have the following benefits:
- A pool of retirement / nest egg type funds accumulate and such amounts are separate from the business;
- The funds accumulating in the holding company may be protected from a future creditor that has a claim against the business; and
- The distribution of surplus funds from the business may allow the business to meet the CGE criteria.
Our example is a simplified outline of proactive tax planning that can lead to significant tax savings. A key approach is to evaluate the status quo implications and to then review the merits of proactive planning. Talk to your professional advisor to determine the structures and strategies that will work best for your circumstances.
This discussion is based on the Welch LLP webinar “Succession Planning for Automotive Dealers” with Welch LLP Partner Jim McConnery CPA, CA, TEP and Sirius Financial Founder and President Susan St-Amand.