One Way To A More Profitable Exit

Photograph by Arthur Mola

Many entrepreneurs—especially the founders of growth companies—will recall fondly the simplicity of the early days of their firms. But one simple vestige of the typical startup can unnecessarily expose the wealth that business creates to creditors and the taxman.

As Harry Chana, a senior tax manager at BDO Canada, explained during a workshop at the 2012 PROFIT 200 CEO Summit, most businesses are formed as operating companies owned or co-owned by founding shareholders. This structure is easy and inexpensive to set up. However, says Chana, "It doesn't maximize the owner's after-tax cash flow, and it doesn't take advantage of the exemption limit on capital gains, which can entitle business owners to up to $750,000 tax-free."

These considerations might be the least of your worries in the heat of launching a business, but they become magnified as your company grows, generates rising profits and starts to accumulate earnings.

For most entrepreneurs in this situation, Chana recommends an estate freeze, which typically involves the use of a holding company, a discretionary family trust and a multiple-class share structure in a specific way that can reduce taxes on personal income, maximize capital-gains exemptions and protect wealth from the operating company's creditors.

It sounds complicated and, yes, you'll need accounting and legal professionals to help you do it. But here, in a nutshell, is how it would work for a two-spouse, two-child family. All four family members are made beneficiaries of a discretionary family trust that owns, say, 100 common shares of the operating company (Opco) and, as such, receive commensurate dividends and proceeds from the eventual sale of the business. Since the trust is a discretionary one, those dollars can be distributed to the beneficiaries in amounts that will maximize the tax efficiency of income-splitting and lifetime capital-gains exemptions.

On the other side of the equation, the spouses would co-own the holding company, which in turn would own, say, 100 "special" shares in Opco. The value of those shares is fixed by way of an estate freeze—giving the spouses, via the holding company, first dibs on proceeds from the sale of Opco shares, up to the value of those shares. (Whereas the common shares held by the trust can grow in value.)

What does it cost? It varies, of course, but Chana says the reorganization costs to put a structure in place can start as low as $7,000 plus legal fees. There are ongoing compliance costs to maintain the structure that also must be considered.

Is it worth it? In one example Chana used, Opco is sold for $10 million, which yields $520,000 in combined tax savings for the famiily of Opco's founder.

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