How to effectively and efficiently transition your business to your kids
The next generation may be prepared to take over, but making the change is often more complex than anticipated
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At PwC Canada, it’s called “the great wealth transfer.” As the huge cohort of baby boomers ages out of the workforce, those who have founded or inherited private businesses are also aging out of their companies – and many are planning to transition their companies to the next generation. Yet today, setting up your kids to run the family business may not be as simple as it used to be.
“What we’re seeing today is a significant transition of companies not only from the first generation that founded the company to the second generation, but also from the second generation to the third generation,” says Trevor Toombs, Partner, Private Company Services Tax, at PwC. “And that third generation often has multiple children, some in the business, some not, as well as cousins and grandchildren, so the level of complexity within the family business is miles away from where it started.”
In this increasingly complex environment, how do business owners prepare for a transition that is effective, equitable and tax-efficient? According to Toombs and colleague Christine Pouliot, Partner and Deals Private Lender at PwC Canada, the answer begins with ensuring that transitioning the business to the next generation really is the right decision – for the family and for the company – rather than simply selling it. Once that decision is made, Pouliot and Toombs say there are concrete steps business owners can take to create a path for a smooth transition.
- Consider tax-efficient share structures
There is no one-size-fits-all tax solution for business transitions, but Toombs says that one of the most common strategies is to execute an estate freeze. This estate planning strategy aims to transfer the future increase in the value of the business to the next generation, typically by assigning preferred shares to the current owner and common shares to the children. In some cases, the current owner retains control of the business, while the children get the benefit of the company’s future growth while participating in ownership. “As profits are generated, you can slowly redeem the preferred shares owned by Mom and Dad to provide them with funds to live on, paying off the value they’ve created to date,” notes Toombs. As well, the estate freeze places a cap on taxable capital gains accrued to the original owners when they die.
- Explore the benefits of a family trust
Often set up in conjunction with an estate freeze, a family trust is, at the most basic level, a relationship created when a person transfers property (a “settlor”) to another individual or individuals (the “trustees”) to hold for the benefit of another (the “beneficiary” or “beneficiaries”). Assuming certain conditions are met, Trusts allow for the tax-deferred transfer of assets to its beneficiaries, which often include adult children, and they can smooth the transition of ownership from one generation to the next. Toombs notes that they also allow for a lot of flexibility in how the assets are shared or disbursed. For instance, if a business owner has several children but some are involved in the company while others are not, “you can use the flexibility inherent in the trust to give shares to one family member over another and perhaps equalize through other channels,” Toombs explains. “Or you can give shares proportionately to all of the children, but designate that control sits only with active family members.” A trust can also be beneficial if plans change and the owner decides to sell the company outright. And there may be a softer, psychological benefit: “A trust can be a great way to introduce children into the business as actual shareholders,” Toombs says.
- Recognize that there are options for monetizing equity
Pouliot says that entrepreneurs often have a good chunk of their wealth tied up in the business, and many fear that passing the company on to the next generation will make it difficult for them to monetize their equity. Those fears are often unfounded, Pouliot says. For example, an owner could bring in a financial partner “to either become a shareholder for a defined period of time or to invest through subordinated debt, monetizing some of the value of the company,” she explains. “There’s a myth that it’s hard for the owner to get the liquidity they need through a transfer to the next generation, but there are ways to do it.”
- Make expectations clear
Establishing firm but realistic expectations for the next generation is key to a smooth transition of ownership and control, Pouliot and Toombs say. Increasingly, many families are putting structure around their expectations through a family constitution or family council. “If the founders write down their wishes and everyone signs on to that, it can be a great guide for the entire family going forward,” Toombs notes. Whether written or informal, however, the point is the same: to make expectations clear. “Many families I work with take the position that any family member who wants to work in the business will be given the opportunity, but only if they’re qualified,” he adds. “That’s in part because those active family members have a fiduciary responsibility to non-active members to ensure the right people are making decisions. You can’t just install somebody because of a last name.”
- Set the next generation up for success
Children might have an interest in taking over the family business, but that does not mean they are qualified to do so. Simply handing over ownership and control when they lack the skills or experience to manage the company effectively is a recipe for disaster. To prevent that, Pouliot says, “a lot of families have a rule that if you want to work with the company, you’ve got to work somewhere else first.” Working with an outside organization can be beneficial not only for the children, giving them valuable real-world experience beyond the family circle, but also for the family business itself. “Very often, they come back with new ideas that they’ve learned somewhere else,” Pouliot explains. “.It can be quite beneficial to the company” Another success factor: ensuring that the management team that will work with the next generation is committed to supporting them in their new role.
- Be prepared to let go
“You always need to think about control,” Toombs says. “A lot of business owners really don’t want to give it up until they have to.” An estate freeze and family trust strategy can bifurcate ownership and control by assigning growth to the next generation but keeping control with the prior generation until a later date. Yet the transition of power can only be deferred for so long. “At a certain point, you have to let the next generation be at least a part of the decision-making process, and that’s often the most difficult part of the transition,” Pouliot says. “You have to be prepared to let the next generation make mistakes, take on risks and maybe do things differently. You have to let go.”
Owners also need to recognize that the next generation’s ideas about the company might not always align with theirs – for instance, PwC research suggests that the next generation of Canadian business leaders are deeply concerned with environmental and social responsibility. So, throughout the journey of transitioning the company, clear and frequent communication between the generations is key. “There should be long conversations around the next generation’s vision for the company and their priorities as to where it should be going, as well as your own views,” Pouliot says. “You don’t want any misunderstandings.”
This story was created by Content Works, Postmedia’s commercial content division, on behalf of PwC Canada, which is a member and content provider of this publication.