Time for a Reorg?

Clients with their own businesses probably think they know all about corporate structures. After all, they chose the corporate structure when they set up their corporation. So once they have their business in a corporation, why would they want to undertake a reorganization? There are some very good reasons. ...
Time for a Reorg?
Clients with their own businesses probably think they know all about corporate structures. After all, they chose the corporate structure when they set up their corporation. So once they have their business in a corporation, why would they wan tto undertake a reorganization? There are some very good reasons.

> Income Splitting
When a corporation is initially set up, it will often have only one shareholder, usually the primary operator of the business. As the business becomes successful, the advantage of splitting income with a spouse becomes more attractive. Income splitting can be done by paying a salary, but there are restrictions. For example, a salary has to be for services rendered and has to be reasonable under the circumstances. Simply issuing new or additional shares to a spouse is also a problem. A successful business will have grown in value, and issuing shares for nominal consideration should not be done without a corporate reorganization that meets certain tax rules.

Income splitting can also be done with children. A corporate reorganization can be undertaken, often involving the use of a discretionary family trust that allows dividends to be paid to children via the family trust, for a more tax-effective method of splitting income.

> Capital Gains
Another reason for a corporate reorganization is to allow the corporation to qualify for the capital-gains deduction, particularly if a future sale is being considered. Current tax rules provide for a capital-gains deduction to an individual of up to $813,600 (2015 amount) on the sale of certain qualified assets, including the sale of shares of a qualified small-business corporation.

However, a corporation may have built up passive assets, such as investments, that would cause the shares to not qualify for the deduction. Sometimes the corporation will own its business premises, which may not necessarily be part of an eventual sale. Those are assets that need to be removed without incurring tax.

That is not as simple as it sounds. The rules for what qualifies for a tax-free reorganization are complex, and it can take years to ensure that the particular assets are removed without tax, and to arrange the ownership within the family to allow for other family members, such as a spouse and children, to be able to use the deduction on an eventual sale.

If your client uses their capital-gains deduction, the next generation has to pay for the purchase using after-tax dollars, with salaries or dividends from the company to cover the purchase. On the other hand, if they do not use the capital-gains deduction, they have to pay the taxes, and the next generation can use a structure to pay for the purchase using corporate funds.

> Succession Planning
When the principals are ready to retire and want to pass on the business, who will step in to take over? Will the business be retained in the family and passed on to the next generation? Will it be sold to employees or to an outside party? Or will it simply be closed down?

An alternative is to freeze your client’s shares in the company, by taking value in the form of preferred shares and having common shares issued for nominal consideration to the next generation. Your client’s preferred shares are then redeemed over time. This, however, will result in taxes paid  at dividend rates (up to 38 per cent) rather than at capital gains rates (up to 22.9 per cent). There are ways to mitigate the tax consequences of a non-arm’s-length transaction, but they must be arranged in advance.

These factors have to be considered and, depending on what is going to happen to the business, a corporate reorganization may often be necessary. For example, if the business is to stay in the family, the appropriate transition of ownership is one key consideration. If the business is to be sold, keeping taxes to a minimum will often require tax planning and reorganization.

Corporate tax reorganizations are complex, and planning is essential and should not be left to the last minute. There are ways to undertake a reorganization, but there are also traps in taxation that need to be carefully navigated. Because each business and family is different, seeking the advice of a tax specialist will ensure your clients’ plans are tailored to their needs.

In all cases, less tax owing means more money to finance their retirement
and that’s worth investing the time to structure the transition appropriately.

Alladin Versi, CPA, FCMA, CFP, is a partner in MNP’s taxation services group and the firm’s national leader for Aboriginal taxation services. He can be reached at [email protected].