Transferring Your Business to the Next Generation: A Guide For Canadian Business Owners

Transferring Your Business to the Next Generation: A Guide For Canadian Business Owners

DISCLAIMER

This information is intended for business owners in Canada and serves as general guidance only. Always consult with a qualified advisor before making any legal decision. 

In this article, we’ll cover the following topics:

• How to transfer your business to the next generation

  • Estate freeze

  • Family trust

  • Section 85 rollover

  • Common shares

How to transfer your business to the next generation

A common mistake business owners make when transferring their business to non-arms-length individuals (e.g. their children, siblings, etc.) is setting the value of their business at a nominal amount – essentially gifting their business to the next generation. 

The problem with this is that the CRA will see the transaction and will measure it against the real market value of the shares. For example, if you report the sale as being $1, but the CRA finds that the real value of your business is $1 million, you’ll be hit with a hefty capital gains tax. 

Worse, the value of the purchaser’s newly acquired shares will remain at $1. They’ll have shares with an adjusted cost base of $1, which means that whenever they decide to sell those shares in the future, they will also be hit with a hefty capital gains tax. So, if by the time they decide to sell their shares the company has grown to be worth $2 million, they will pay a capital gains tax of just under $2 million. Combined, the seller and purchaser have now paid capital gains tax on $3 million – a significantly higher tax than should have been paid in the first place.

So, what’s the best way to transfer a business to the next generation? 

Estate Freeze

An estate freeze allows you to transfer your business to the next generation without incurring any capital gains taxes, all while retaining control of the business and maintaining a steady stream of income. 

Freezing an estate can be thought of as a reorganization that fixes the value of one taxpayer’s shares of a private company that they own. (This taxpayer is who initiates the estate freeze, hence why they’re referred to as the “freezor”). The owner of the company exchanges their common shares for fixed-value preference shares, equal to the market value at that time. This effectively fixes the value of the company at the preference shares held by the owner, and ensures that all future growth is rightfully passed to their beneficiaries. 

For more on estate freezes, read “Estate Freezes: What Every Canadian Business Owner Needs to Know.”

Family Trust

You’ll find a proper overview of family trusts in the article “What Are Family Trusts, and Why Are They Useful to Business Owners in Canada?,” but the gist is that family trusts are structures that facilitate the distribution of wealth to the beneficiaries that are named inside of a trust agreement (also known as a ‘deed’ or ‘indenture’). Beneficiaries are typically your children, grandchildren, spouse, and other close family members. Less common, but no less appropriate, are holding companies named as beneficiaries.

The main benefit of using a family share to transfer a business is that you can maintain control of your business’s assets. Rather than handing over the entire business all at once to your 19-year-old son, who might then go straight to a Lamborghini dealership, you can piecemeal the business, little by little, as the beneficiaries grow older and become more involved by retaining of the trust as trustee until you pass, or naming another individual who is not a beneficiary as trustee. However you must alert to the reversionary trust rules of 75(2) under the Income Tax Act which can result in income earned inside of the trust being allocated back to the settlor - consult with your tax advisor.

Section 85 Rollover

Once you’ve established a family trust, the next step is to cancel your existing common shares in the company and exchange them through the section 85 rollover for preferred shares. (For more on the section 85 rollover, read “Section 85 Rollover: How It Benefits Canadian Businesses”). 

These preferred shares will freeze the current value of your business so that you retain the full value of your business. Over time your operating company can redeem your preferred shares, paying you out slowly in a tax-efficient manner such that your estate is not hit with a huge capital gain on your death. In other words - if you have $1m of preferred shares post-freeze, it’s far more tax-efficient to ‘melt’ the preferred shares by redeeming 1/20th each year for 20 years than it is to incur a deemed disposition of the entire amount at death.

Common Shares

The last step to freezing an estate is issuing new common shares which will be subscribed for the family trust that you’ve just established. This will allow your family trust to receive dividends from the operating company, and then distribute those dividends to your named beneficiaries. 

Want to learn more about transferring your business to the next generation? We’re here to guide you, whether it’s help with drafting wills, drafting contracts, and more. Contact us today using the form below.