Table of Contents
- Why is Tax Planning Necessary for a Business Up for Succession?
- The Four Big Ds to Consider in Business Succession Tax Planning
- Succession Planning Tax Strategies
- Create a Trust and Divide the Income
- Mind the Offshore Assets
- Don’t Miss an Exemption.
- Use a Separate Will to Transfer Shares to The Heirs
- Buy-Sell Agreement
- Use The “Dividends Announced but Not Paid” Trick
- The Pipeline Method
- An Estate Freeze
- Keep the Experts on Board Keep the Experts on Board “
- Bottomline
On seeing a writing related to succession planning, a reader might wonder, should I be reading about such an unpleasant subject? It’s funny; everyone seems to relish discussing the topic of death–just as long as it’s not their own death.
It might be painful to consider the issues of estate and succession. Still, unfortunately, they are one of the most critical aspects of business and tax planning before and after death.
What is succession planning for a business?
It is about drawing up a strategy for passing down leadership roles from existing leaders to new ones. Such planning is crucial for ensuring a business’s smooth functioning amidst any eventuality.
Similarly, family business succession planning involves transferring such leadership roles to family members, or from a business owned by a family.
Why is Tax Planning Necessary for a Business Up for Succession?
Around 1.2 trillion dollars’ worth of fortune will be in the hands of the next generation in Canada, this year alone.
Canada does not have estate taxes. The taxation occurs via deemed disposition of capital assets, probate fees, and income tax on RRSPs, . Such taxes can cost a lot to the estate and can go up to and beyond 40%. Proper planning, however, can save a large portion of these taxes.
Moreover, tax laws continue to change. Businesses must stay alert to new regulations that can impact taxes on succession. Succession planning ensures that a business owner considers all related issues well before time.
The Four Big Ds to Consider in Business Succession Tax Planning:
- The four Ds
- Death: The Death of a business owner in Canada leads to "deemed disposition." The Canadian Revenue Agency (CRA) deems all their holdings to be disposed of immediately before their death at a fair market price. It can cause colossal taxation to a business, mainly if prior planning has not been implemented.
The death of a partner reinvigorates all the problems a company faces. It is Murphy’s law at its best (whatever can go wrong, will go wrong). Therefore, the sooner the planning takes place, the better.
- Divorce: Tax planning must consider such eventualities. A divorce before succession complicates the business manifold. There can be claims against the assets held by the heirs.
Mainly, when the ex-spouse of the deceased is a business partner, the business environment becomes heated and unproductive, with frequent arguments between the spouse and the deceased’s survivors becoming a norm.
To prevent undue hazards to your successors, make sure you have purchased life insurance, with which the successors can offset the undue losses. A buy-sell agreement is another option, which will be described later in this blog post.
- Disagreement: Another tax consideration for a business is who will inherit what. The tax implications of some assets are more significant, while those of others are smaller. For example, a successor inheriting preferred shares of a fixed value in a company may not see any deductions, while another inheriting a villa with capital gains tax may have to sell some assets to pay the taxes.
This question can harm the business badly. Any dispute between the beneficiaries can bring the company to a stalemate.
- Disability: It can happen to any one of us. A disability before correctly forming succession plans can lead to a tug-of-war between the potential beneficiaries. There will not be enough left to pay taxes.
So, make sure to prepare a medical power of attorney for someone to decide matters on your behalf.
Succession Planning Tax Strategies
- Create a Trust and Divide the Income
One effective strategy in family business succession planning is to create a trust.
This allows for the smooth transfer of the family business on a tax-deferral basis, ensuring the company remains in the family’s control.
It’s important to note that assets transferred into a trust may trigger a deemed disposition at the time of transfer, resulting in potential capital gains tax. While trusts can provide tax-deferral opportunities, there is generally no automatic avoidance of deemed disposition at death — instead, the assets remain in the trust and avoid probate, but capital gains may still be triggered depending on the circumstances.
Similarly, dividing the income will make the receipts by beneficiaries fall under lower tax brackets, thus minimizing the taxes.
Moreover, since the assets belong to a trust at your death and not to you, there will be no deemed disposition, and the assets go to the beneficiaries tax-free.
However, it is not always true. A trust can help defer tax, but it does not eliminate it entirely unless structured very carefully and with specific exemptions.
- Mind the Offshore Assets
If your business has assets in multiple countries, you must ensure that you do not have to pay double taxes and undergo probate in several places.
Canada has bilateral treaties with many countries to protect double taxation on offshore assets. Ensure you talk to your lawyer about this aspect while doing succession planning.
- Don’t Miss an Exemption.
You can effectively manage your taxes during business succession if you have in mind the exemptions for which you are eligible. You can claim the lifetime capital gains exemption to reduce succession tax along with the personal exemptions.
Lifetime capital gains exemption
A share in a business fulfilling specific requirements is eligible for a lifetime exemption on gains tax for a maximum increase of $1,016,836 (in 2024).
The requirements for being eligible for such an exemption are the following
The same person has owned the share for the last 24 months.
Holding Period Asset Test (50% Rule):
Throughout the 24 months immediately before the sale, more than 50% of the fair market value of the corporation’s assets must have been used in an active business in Canada (or invested in other eligible small business corporations).
Canadian-Controlled Private Corporation (CCPC):
The corporation must be a Canadian-Controlled Private Corporation (CCPC) at the time of sale.
- Use a Separate Will to Transfer Shares to The Heirs
If you own a company, your family members may also be shareholders. There will be a will you use to tate about assets liable for probate.
However, you will transfer the shares mentioned above using a separate will, that will shall not go into probate. In this way, the shares get inherited while saving probate fees.
- Buy-Sell Agreement
If a marriage breaks down, the unfortunate divorce can cost half the fortune.
It would help if you were a guide for your children before they inherit your business.
Inform your children to sign a buy-sell agreement with their spouse to rule out share-in-business claims. Such issues should be settled by a one-time agreed-upon payment.
It is essential to do so because it can cost the business in terms of taxes and render it dysfunctional after the court cuts it in half.
- Use The "Dividends Announced but Not Paid" Trick
It is a trick in which you make your company announce a dividend for you every year but never actually pay it.
In your final return, such dividends finding their place in separate returns (under receivables, “rights or things”) can save your business a lot of taxes as you’ll be eligible for certain tax credits.
Explanation:
If a corporation declares a dividend before a shareholder’s death but the dividend is unpaid at the time of death, it may qualify as a “right or thing” under the Income Tax Act. These amounts can be reported on a separate return, potentially lowering the overall tax burden of the estate. However, this must be done in compliance with CRA guidelines and not used as a recurring strategy to defer tax indefinitely.
You can’t just “declare” dividends every year and never pay them indefinitely. That may draw CRA scrutiny and be considered tax avoidance or even abusive tax planning.
A dividend must be properly declared by resolution and recorded as a liability in the books. It creates a legal obligation to pay that amount. Not paying it over a long time can raise legal and accounting issues.
- The Pipeline Method
In this method, the successors create a new company which buys shares of the company previously owned by the deceased. The new company entrusts a promissory note to the parent estate. The estate then redeems that promissory note, and in this way, the estate moves from one generation to the next, saving a lot of tax.
The postmortem pipeline strategy is a tax planning method used to avoid double or triple taxation when a private corporation owner dies. Instead of paying dividend tax to extract corporate value, the estate reorganizes the shares into a new corporation and receives a promissory note equal to the fair market value of the shares at death.
After that, the private company repays the note tax-free, allowing the estate to extract funds without triggering dividend tax rate.
- An Estate Freeze
An estate freeze is a comprehensive solution that addresses many of a business’s tax concerns. It provides a business owner with fixed-value Preferred company shares in exchange for common shares, effectively ‘freezing’ the shares at that price.
Then new common shares are issued to a trust or the next generation at nominal value. It’s not a direct exchange with the next generation.
The next generation then acquires the company’s common shares at a nominal value through a trust. Any increase in the share value from the point of freeze will accrue to the second generation, thus saving your loved one’s capital gains tax on your business when you die.
Moreover, the second generation inherits the preferred shares as an ordinary inheritance.
In this way, the business holding family gets the following benefits:
- Minimizing post-mortem taxes
- Retaining control over business
- Better retirement planning
- Redeemability of preferred shares
However, it is not typically true in most estate freezes. Preferred shares are retained by the original owner (or their estate) to preserve value and control.
- Keep the Experts on Board
You should have the following professionals advising you when you do succession planning:
- An estate lawyer – to draft and review wills, trusts, and legal agreements.
- An accountant – to manage tax implications and ensure compliance with evolving tax laws.
- A financial advisor –to guide investment, retirement, and estate funding strategies.
- A life insurance expert –to help fund tax liabilities and protect your beneficiaries.
Moreover, run an annual tax health checkup on your business to prevent unwanted events for your successors.
Bottomline
Taxes are a significant consideration for family succession planning. You end up leaving a larger-than-expected tax bill for want of appropriate succession planning. Make sure you consult the experts today before the unavoidable happens.