Supporting Valuations in Tax and Estate Planning

30% to 40% of business owners are planning to transfer their business internally to another shareholder, management, employees or family member. [1]  One option for those planning to transfer the business to the next generation over time is through an estate freeze.

In an estate freeze the business owner’s common shares are exchanged for preferred shares of equal value to the common shares.  New common shares are then issued by the company to the next generation family members.  This allows the business owner to “freeze” his/her unrealized gain in the corporation on a tax-deferred basis, with any future growth in value of the company accruing to the children.  As a result, the business owner can estimate and plan for the future tax liability, perhaps with life insurance.

Under an estate freeze the fair market value of the common shares must be established.  According to the CRA, the fair market value must be determined “by a fair and reasonable method”. [2]  If not, CRA will likely challenge the validity of the transaction alleging that a benefit had been received by a shareholder who acquired property from a corporation at less than fair market value.

In the event of a potential dispute with the CRA, price adjustment clauses (PACs) are sometimes used to retroactively adjust the fair market value to avoid the “conferral of benefit” problem.  Unfortunately, a PAC may not help if a fair and reasonable valuation attempt was not initially conducted.  

In Guilder News Co. (1963) Ltd. et. al. v. M.N.R., 73 DTC 5048 (FCA), the Court rejected the PAC as a basis for adjusting the price and eliminating the benefit on the grounds that the parties had not reasonably attempted in good faith to transact at fair market value.  Other recent case law involving PACs include St. Michael Trust Corp. v. Canada (2010 FCA 309, affirming Garron, 2009 TCC 450) and Krauss v. Canada (2010 FCA 284, affirming 2009 TCC 597).  Potential implications of not having a fair and reasonable valuation to the business owner include additional taxes, interest and penalties.

An independent valuation prepared by a qualified business valuator can provide a fair and reasonable basis for the fair market value used in an estate freeze, essentially acting as insurance for potential disputes with the CRA.  Inadequate fair market value assessments can give rise to unfortunate tax consequences as well as costly and time-consuming litigation, not only with the CRA but also with the advisors. 

Other tax and estate planning mechanisms involving the transfer of assets or shares to a related party could include business incorporations, corporate restructuring, share reorganizations or family trusts.  In order to take advantage of tax deferrals, these transfers typically must occur at fair market value.  You will be well served and protected by involving and retaining an independent business valuator to assist you with the fair market value determinations.

If you are considering an internal transfer, contact us at jason@vspltd.ca or www.vspltd.ca to assist with your business valuation needs.

1.  Sources: 2007 RBC Study - Quantitative Study of the Business Succession Market in Canada and CICA/RBC Business Monitor (Q1 2010).

2.  Source: CRA’s Interpretation Bulletin IT-169.

Business Valuation Helps Facilitate an Internal Transfer of a Business

According to recent studies on the business succession market in Canada, between approximately 30% and 40% of business owners surveyed are expecting to transfer their business internally to other shareholders, management, employees or a family member.

If you are planning to one day sell your business to an internal party, an independent business valuation can be very beneficial for managing value expectations and ultimately facilitating the transfer of the business at a fair and reasonable price.

It is extremely important for all parties involved in an internal transfer to agree on the current fair market value of the business, to ensure a smooth ownership transfer.  The current fair market value can be used to set the price for the transaction in situations where the purchaser acquires the departing shareholder’s shares or situations involving share redemptions by the company.

In his best-selling book on protecting family wealth, “Every Family’s Business”, Tom Deans suggests that all business owners should arrange for an updated annual valuation of the business.  One of the 12 steps in Tom’s annual checklist for family businesses (referred to as the Wealth Protection Blueprint) states that business owners should:

“… arrange for an updated valuation of the business and calculate whether there is appropriate insurance in place to ensure that estate taxes will not impair the ability of the company to function in the event of the owner’s death.”

Tom then discusses the implications of not obtaining a valuation prior to an internal transfer.  There can be serious repercussions to the business and to family members if the company is transferred to the next generation for an amount that is less than or greater than the actual fair market value of the business, particularly when the transaction was financed with debt.

An independent business valuation will help set a reasonable price, one that is fair to all parties, to facilitate the transfer of all or a portion of the equity to other shareholders, management, employees or a family member.  Having an independent expert business valuator explain the valuation process, approach and assumptions will help ensure that all parties are satisfied that a fair and reasonable deal was struck.

The business valuation can also be used for contingency planning to help protect the business and the business owner’s family in the event of an unplanned involuntary transfer due to death, disability, divorce, distress or disagreement.

If you are considering an internal transfer, contact us at jason@vspltd.ca or www.vspltd.ca to assist with your business valuation needs.

1.  Sources: 2007 RBC Study - Quantitative Study of the Business Succession Market in Canada and CICA/RBC Business Monitor (Q1 2010).