Participants:
Sal Albano, Vice President & Market Leader
Noel Perera, Director, Tax Planning, BMO Private Wealth, Ontario
Sarah King, Estate and Insurance Advisor, BMO Private Wealth, Alberta
On May 18, BMO Private Wealth held the second of a three-part series for automotive owners. The insightful session—on tax and insurance considerations—was hosted by Sal Albano, Vice President and Market Leader. After a brief introduction, the mic was handed over to BMO Private Wealth experts, Noel Perera, Director of Tax Planning and Sarah King, Estate and Insurance Advisor (Financial Security Advisor in Quebec).
The 5 “W”s of Insurance
King began her presentation by outlining different types of insurance and the suitability of each. Term insurance, for example, is an inexpensive option designed to be temporary, covering short-term needs like outstanding debt, loss of income or death. It’s particularly useful in various stages of an ownership or partnership situation where buy-sell agreements may be at play, explained King.
Long-term disability insurance replaces income in the event of disability and also works to support the cost of bringing someone else into the business.
Critical illness insurance is a one-time lump sum payout in the event of an illness. With the understanding that health care can be very pricey, critical illness insurance ensures you don’t have to worry about cash flow and alleviates the financial burden when dealing with an illness.
Long-term-care insurance isn’t all that common among automotive business owners. But there is an option to structure policies with the insurance built-in to ensure there isn’t any additional expense for that coverage.
Permanent life insurance is ongoing and more expensive than term insurance. King explained that term insurance is akin to renting an apartment, where you don’t own anything, whereas with permanent insurance you own the asset which becomes very valuable with a cash or investment value built into the policy. It also allows the holder to accumulate assets on a tax-sheltered basis, useful when working with business owners in the automotive industry because those type of holdings are often subject to sizeable taxes at high rates.
Business Transition and Equalization
To better explain tax and insurance implications, Perera offered a case example of an owner of an auto business who has three children. One is very interested and involved in the business and looking to ultimately take over the business. A second child is unsure of their interest level;, while the third child is definitively not interested in entering the family business. Any business transition structure necessitates flexibility to bring in the second child if needed, and to consider the impact on the third. “You’re looking at equalization,” he shared, adding there are many factors to consider to make sure the business enterprise is structured optimally from a tax and continuity perspective.
In a well-structured scenario, the operating business and real estate is split into separate corporations. An estate freeze and family trust are often employed so that the beneficiaries of the family trust can benefit from a multiplication of the capital gains exemption upon eventual sale of the business. One beneficiary, moreover, can be a corporation, which allows the extra cash in one dealership to flow into a trust which then flows to the corporate beneficiary. That structure allows for credit protection and purification for the purpose of capital gains exemption.
Insurance can be a very useful tool to help with transition and equalization, added King. In that same scenario, the parents have a decision to make: Does the child who’s interested in the business receive the whole business upon transition? If so, what do the other two children receive? The situation is perfectly suited for permanent insurance which would create liquidity as a trade-off for fixed assets.
If, for a simplified example, the business is valued at $20 million, a permanent insurance policy is set up in that amount. Upon the parents’ death, the first child will receive the business, while the other two would get $10 million in value. Equalization has been achieved.
Assessing the Business: Tax Readiness for Sale
Perera explained the Lifetime Capital Gains Exemption in greater detail. Basically, you avoid tax on $913 thousand of capital gains on the sale of shares of an active Canadian business operation. For the exemption to apply, you must: own the shares for 24 months, 90 percent of the business assets have to be active business assets (vs. passive or redundant assets) at the time of sale, and over a two-year period preceding the sale, 50 percent of the business assets have to be active business assets.
Perera then focused on certain factors to consider in preparing a business for sale. It’s important to get financial statements and tax returns in order, he said, adding that your books must always be ready. Depending on what’s being sold, different factors come into play. If selling fixed assets, ask yourself: Is it capital gains? Is it income? What assets won’t be sold? What are the redundant assets?
For many reasons, buyers typically prefer to buy assets vs. shares. If the buyer pays a fair amount for a building, for instance, the buyer he can offset a higher depreciation tax write-off against the income generated in the future in an asset purchase. A seller’s preference, however, is to sell shares in order to benefit from the capital gains exemption.
With two divergent wants, sometimes a hybrid sale—combination of an asset and share sale—is a better approach. Effectively, the seller bifurcates the corporation into two, selling the assets of one and the shares of the other. That way the seller can still benefit from the capital gains exemption, and the buyer can also benefit from the ‘stepped up’ cost base for assets purchased.
Death of a Shareholder
If you die, there’s a deemed disposition of all your assets at fair market value at the time of death, leaving a tax liability with respect to corporate assets and real estate. Insurance providing the necessary liquidity to cover tax liabilities is a common strategy employed by business owners in conjunction with tax restructuring, an estate freeze for example.
Business Partners
Be mindful of buy-sell agreements, added King. If two people own 50 percent of a business and one dies, the surviving co-owner can offer to buy out the deceased partner’s spouse who assumed ownership of the shares at the time of death. But if the spouse wants to maintain their piece of the pie, a buy-sell agreement can be structured to ensure there’s an insurance payout for the spouse. But it needs to be papered in advance to be useful. And remember, if the partner was sick and the company had disability insurance, it could also prove beneficial.
Read Part 1 of the series: Economic Trends Affecting Automotive Business Value
Read Part 3 of the series: Transition Planning Considerations, the Transaction Process and the Value of your Automotive Business
BMO Private Wealth provides this publication for informational purposes only and it is not and should not be construed as professional advice to any individual. The information contained in this publication is based on material believed to be reliable at the time of publication, but BMO Private Wealth cannot guarantee the information is accurate or complete. Individuals should contact their BMO financial professional for advice regarding their personal circumstances and/or financial position. The comments included in this publication are not intended to be a definitive analysis of tax applicability or trust and estates law. The comments are general in nature and professional advice regarding an individual’s particular tax position should be obtained in respect of any person’s specific circumstances.
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