Estate & Tax Considerations for Business Owners

Business owners have a lot of things on their plate day-to-day and it can be hard to take a step back and do some long-term planning. One area that probably doesn’t get enough attention is planning for the possibility the owner passes, either before selling/liquidating the business or before fully implementing a succession plan.

Although many businesses are sold by the owner as part of their retirement plan, some business owners maintain an investment holding company after their operating business has been sold; this can create estate and tax issues if proper planning has not been done. Also, some corporations are non-operational in nature, such as real estate holding companies or passive investment corporations, that provide retirement income and are still owned at date of passing.

Sound financial and legal advice allows business owners to prepare for the inevitable, most owners of large businesses ensure this is in place. This would normally include a well drafted will and possibly an estate freeze where some form of ownership has already been has already been transferred to the next generation of owners, whether that be family members or existing managers. Smaller businesses may not have as much estate planning work done and beneficiaries and the business could be more exposed on the owner’s passing.

Estate Planning is a complex subject area and there is no cookie cutter approach. Every situation is different and requires careful analysis and planning. Let’s consider three common scenarios and explore the risks to the business and the owner’s estate from several angles:

1. The business owner already has family working in the business, or members of the management team who are groomed to take over.
2. The business owner has no logical succession plan and knows the business will need to be liquidated on their passing.
3. The business owner has no family members or management team willing or able to take over the business on their passing and knows the business will need to be sold for the benefit of their estate.

Each of these scenarios are quite different and present various risks that could be detrimental to the business or the owner’s estate.

The first scenario, where the business owner already has family working in the business or members of the management team who are groomed to take over, is probably the best scenario. The owner may already have transferred some ownership to the next generation through an estate freeze which would mean that they’ve done extensive tax and legal planning. However, there may still be challenges for the estate from several areas. For example, if the owner had maintained voting control of the business, the family members or management team may face challenges running the business until the estate has gone through probate and full control can be passed to them. A well drafted will should give significant powers to the executor to deal with any management needs that arise. This could include things such as the ability of the company to borrow, the ability to distribute assets or the ability to make acquisitions.

The second scenario where the business needs to be liquidated but the owner has no succession plan in place presents a similar need for the executor to have extensive powers to be able to liquidate the business in an orderly fashion as well as to implement post-mortem tax planning. In this scenario the business owner/estate can face the possibility of double taxation without adequate tax planning. The risk of significantly higher tax in dollar terms would be most pronounced in situations where the business has significant value and untaxed capital appreciation. For example, a real estate holding corporation with significant equity, or an investment holding company with significant unrealized gains on investment securities such as stocks or bonds or other property. If the business owner has a surviving spouse, the shares can roll over to the spouse on a tax-free basis. Therefore, the tax risk arises in situations where there is no surviving spouse or when the surviving spouse passes. With no tax-free rollover there will be a deemed disposition at date of death and realized taxable capital gains calculated as the fair market value of shares at date of death minus their adjusted cost base. This will be taxed on the business owner’s terminal tax return. Once the executor starts liquidating assets of the Corporation there will be additional capital gains and possibly recaptured depreciation realized at the corporate level. When the assets of the Corporation have been liquidated the shares can be redeemed or the corporation wound up, resulting in taxable dividends to the estate/beneficiaries and a new layer of tax. The redemption/wind up of the Corporation will result in a capital loss for the estate/beneficiaries but in certain circumstances there is no ability to apply the capital loss against any capital gains, resulting in unutilized capital losses. Without the tax savings from utilizing the capital losses the total tax paid on the various layers of taxable income could be in the 60 -70 percent range.

There are several post-mortem tax planning solutions to avoid the high level of tax. Which one to use depends on the situation and how fast the estate can be liquidated. For example, if the business can be liquidated and wound up within a year then the capital loss, in most situations, on redemption/wind up can be carried back and applied against the capital gain on deemed disposition at date of death reported on the business owner’s terminal tax return. There are other techniques such as pipeline planning and bump planning which are a little too technical for this article, but the key point is to be aware of the risks as they pertain to each unique set of circumstances.

The third scenario where the business owner has no family members or management team willing or able to take over the business which will need to be sold for the benefit of the estate/beneficiaries is perhaps the trickiest. With the owner’s demise, the business will be significantly affected even if good staff are in place. The executor will need broad powers to be able to continue business operations with the least repercussions. The executor will also likely need to hire outside help such as consultants, accountants, or lawyers. The business will also need to be prepared for sale, and the sale process could take an extended period. The tax implications will depend on whether a share sale or asset sale occurs. An asset sale can result in the same risk of double tax as in scenario two, whereas a share sale could likely occur without capital gains tax as the deemed disposition at death would have triggered capital gains tax on the terminal return resulting in a bump to FMV of the shares now help by the estate. The lifetime capital gains exemption could be available for all of part of the capital gain on the business owner’s terminal tax return so then end result of a share sale could be quite favorable, whereas an asset sale could result in significant tax especially in a scenario of unutilized capital losses.

This article is not intended to be a technical paper nor the dispensing of tax or estate advice. Rather it is a siren call to business owners to be aware of the risks to their business and estate especially in the event of their untimely passing.

Every business owner’s situation is unique, and their circumstances need to be evaluated against estate issues and tax rules to assess risks and the level of planning needed. Give us a call if you have questions about your specific situation, we can help.