Names like Weston, Desmarais and Thomson represent some of the most successful Canadian family-owned businesses. Said to be well run, organized and with a unified vision for the future, they are the exact opposites of most family businesses, only about one-third of which survive into the second generation.
Experts agree that the thorn in the side of family-owned businesses stems from a lack of preparation – on everything from succession planning to taxes and ensuring wills are up to date.
Here are some of the most common financial planning problems blamed on bad or even no preparation.
The business isn’t organized properly, says David Burnie, a partner in the Ottawa-based firm of Ryan Lamontagne Inc. Sometimes the company has been set up as a full proprietorship when it should be a corporation and even when it has been set up as a corporation, it’s not structured properly. “It doesn’t cost anything to make anybody a shareholder on the first day with different classes of shares…but it does cost more money if you want to change it later,” says Burnie.
The founding generation is almost totally concerned about sustaining the business by reinvesting profits and wealth into the company at the expense of not looking after their own needs, says Paul Coleman, a partner at Toronto-based Grant Thornton LLP. In the end that means the original owners have quite a bit of wealth, but then find it difficult to translate into a sustaining cash flow after they reach retirement.
The challenge comes to a head when the founders want to retire and hand over the reins to the second generation but discover they can’t monetize their investment. The owners could sell their stake to their adult children who are taking over the business, but chances are they don’t have the capital to buy it from them, says Coleman. Unless the founders are looking at a sale to a third party, there’s no monetization, and the business passes between generations in almost a cashless transaction.
Then there are some founders who don’t need to spend everything they make but they take it all out of the corporation via salary or dividend. The problem is that the owners then pay higher personal taxes on that money rather than leave it in the business and pay a much lower small business tax of 15.5%, says Burnie.
A benefit of leaving the money in the business is that you can pay a dividend to your children when they turn 18. In Canada, no income tax is paid on the first $40,000-or-so for anyone who has no other income, like a student, if that money comes from a dividend from a small company. “That’s one way a small business owner can fund a child’s education,” says Burnie. “Instead of using money that you have taken out of the corporation and paid 50% tax on, you use money that you have taken out of the corporation and only paid 15.5% tax on.”
Please note that Ottawa signalled in its March budget that that it will release a consultation paper in the next few months to look into tax rules dealing with private corporations. Among them is this strategy that allows Canadians, including family-owned business owners, to use private corporations to reduce their taxes payable, including “sprinkling” earnings to lower-earning family members.
The owners decide to borrow money from the corporation. There are many times in the growth of a company when the owners may need to borrow money, and some owners may think it’s to their benefit to borrow from within the corporation rather than go to the bank, says Burnie. “But there are a lot of rules about shareholder loans and they are abused,” he cautions. “And when they get caught the consequences are very onerous. You can’t simply take money from your corporation for a number of years and not pay it back. There are very specific rules.” For the most part, if you decide to take money out of your corporation you have to pay it back the year after you took it out.
No succession plans are in place and the goals and future plans of the company are not in sync when the next generation takes over. “Nine out of 10 business owners lack business continuity instructions for the family or the employees,” says Vancouver-based financial advisor Keith Brown of Financial Confidence Advisors Inc. “Who is going to make financial decisions or accounting decisions or how to change the directors if the owner becomes incapacitated or dies? Literally 8.5 out of 10 businesses have no plan,” says Brown whose clientele is made up strictly of business owners.
Succession planning is so important it should be addressed by founders a minimum of five years before they want to retire, says Coleman. That way they can present ideas to the next generation and address any competing needs. Waiting until the 11th hour will place founders in a reactive, rather than a proactive situation, he says.
The owners, whether first, second or even third generation, don’t have updated wills that deal with their business. Often business owners have one will for their personal wealth and a second will for their business, says Burnie. Most of the time, the shares of a privately held company can avoid probate, which can vary among provinces.
Bringing in family and friends who are not really capable of doing the job. It’s difficult to say no to a family member or the adult child of a close friend, says Brown. One of his clients hired a bookkeeper as the firm’s chief financial officer. The problem was that as the business grew, it really needed a professional, qualified accountant. When those kinds of transitions are required, difficult decisions have to be made.
The founders don’t address how to fund the taxes that will arise when they die. When the founders die and want to pass on the business to the next generation, the tax department considers those shares to be a deemed disposition, says Coleman. There are those who are proactive and have purchased life insurance to cover the cost of this inheritance tax, as long as they do so when they are young and healthy and don’t wait until they are well on in age. “We have clients with pregnant tax liabilities in the tens of millions of dollars,” he says. “Some bite the bullet and buy insurance but some don’t. The worst case scenario is that the business has to be liquidated to pay for the taxes.”
The families can’t adapt to constant change. There are many disruptors out there, whether they come from technology, government regulations, new competition or the inability of the company to keep fresh and in front of customers, says Brown in his e-book The Family Business Advisor: Providing Structured Transitions for Business and Wealth. Brown suggests parents provide the necessary education for the next generation, help them be productive and be a good role model. “You need to model, not just preach, core values in order to successfully pass them on to the next generations,” he says in the book.
The owners have worked hard to build their company and insist the next generation take over. Coleman says when he works with families actively pursuing options for succession, he encourages the founders to think of all possible options, including selling the business, especially if the next generation isn’t interested in taking over. An increasingly commonplace tactic is for a professional management company to take over the firm.