This article has been compiled from “You have a business plan. What’s your retirement plan?” and “Your business exit strategy,” both featured in Perspectives Volume 1, Issue 3, Spring 2012.
If you’re an owner of one of Canada’s 1.2 million employer businesses,1 you likely have a deep understanding of and appreciation for the significant time and resources that go into starting, growing and preserving a successful business, especially if you’ve built the company from the ground up. And regardless of whether you are in the earlier phases with your business or it’s well into maturity, you may also relate to the fact that many business owners devote the majority of their attention to the day-to-day operations and activities related to the company. At the same time, however, it’s also crucial to clearly define a long-term path, for yourself, for your family and for the business itself. This is especially true given the fact that in the coming years and decades, many Canadian businesses will see a shift in ownership, as almost two-thirds of small- and medium-sized enterprise (SME) owners are over age 50.2 With retirement and succession on the horizon for so many business owners, it’s important to recognize that it’s never too early to start thinking about and planning for retirement and an eventual exit from a business. By carving out appropriate plans in this regard as much in advance as possible, business owners can help ensure their intentions and visions for the future, both personal and business-related, are realized.
Making retirement plans as a business owner
It is common for many business owners to have much of their net worth tied up in their business. In situations where an owner’s business represents a large portion of the value of their estate, this often means they aren’t as well-diversified as those with a traditional retirement portfolio. And unlike a salaried employee with a pension, it’s up to them to fund their own retirement, so planning in this regard takes on a heightened significance for business owners. Some individuals may take the approach of relying on the business to fund their retirement income, but there are a number of reasons why this may not work out as anticipated. For example, someone wishing to sell their business may have trouble finding a suitable buyer, a successor may not have the financing available when they have been identified, or depending on the market or industry, the value of the business may be lower than expected at the time of the sale.
Note: Given the complexity of the following planning considerations, it is crucial to ensure your needs and circumstances have been appropriately addressed by consulting with a qualified tax and legal professional.
RBC Wealth Management myGPS™ for business owners
RBC Wealth Management’s myGPS™ offers a new, integrated approach for individuals, including business owners, to identify, plan, track and help realize their wealth goals. It is a tool that acts as an effective supplement to comprehensive planning, especially for business owners, who may often face more complex planning needs. Through answering a questionnaire specific to business owners, which addresses key aspects such as business structure, valuation, planning for unexpected tragedy or change, exit strategies, succession and wealth transfer, and retirement, myGPS™ then generates a customized selection of potential opportunities that may be beneficial for each particular need or goal.
For more information on myGPS™, please view RBC Wealth Management’s Fall 2016 issue of Perspectives magazine, “An integrated approach with myGPS™.”
Reducing risk through retirement savings
For business owners, holding some of their retirement savings outside of the business may decrease some risk. The early years or periods of growth within a company mark an ideal time to build retirement planning into decision-making, which may be accomplished by diversifying and directing surplus assets to Registered Retirement Savings Plans (RRSPs) or Individual Pension Plans (IPPs), for example.
|RRSP||A personal retirement savings plan registered with the federal government where contributions are tax deductible to the individual and can grow on a tax-deferred basis.|
|IPP||A defined benefit registered pension plan that a corporation can set up where contributions made are tax deductible to the corporation and can grow on a tax-deferred basis.|
While RRSPs are a common approach for retirement savings, some business owners may wish to consider the additional benefits offered by IPPs. An IPP is similar to a defined benefit registered pension plan offered by large organizations to their employees, but the main difference is that IPPs usually only have a single member, typically the business owner and their spouse or a key employee.
Ins and outs of IPPs
In comparison to RRSPs, a main benefit of IPPs is that they allow a business owner’s corporation to make higher tax-deductible contributions, which means they may offer greater retirement income in the future. Contributions grow in IPPs on a tax-deferred basis, in much the same way as RRSPs. With an IPP, annual contributions will vary depending on past earnings and length of service, but generally speaking, the older the business owner is, the more funds that can be contributed to the plan. When the plan is initially established, the business may also be able to make a larger contribution to cover the plan member’s years of service before the IPP was set up, retroactive to 1991.
Another area where IPPs may offer additional benefits over RRSPs is creditor protection. While RRSP assets are typically only protected from creditors in a personal bankruptcy situation, IPPs are a pension, protected under federal and provincial pension legislation, and thus may present less risk in this regard. Note: It is crucial to consult with a qualified tax or legal advisor to discuss asset protection options appropriate for your situation.
In considering IPPs, there are also a few potential drawbacks business owners should consider. First, there is less flexibility than with RRSPs regarding withdrawals. Since the IPP is a pension plan, the funds are locked-in during working years and in retirement (with exceptions in certain jurisdictions, which offer at least partial unlocking in certain circumstances). Second are the associated costs for administration, as IPPs are more expensive than RRSPs to administer. These costs include set-up, annual administration and mandatory actuarial valuations. Keep in mind, however, that these costs can be reduced because they are tax-deductible to the business.
Creating an exit strategy and comprehensive succession plan
For many business owners, creating an exit strategy often goes hand in hand with retirement planning. Regardless of whether you want to sell to a third party, transfer to family members or structure a management buyout, for example, advance planning for an exit may specifically aid in increasing funds you will be able to withdraw for retirement. Advance planning of an exit strategy may also make management transitions easier and provide a wider range of options going forward. With succession planning, it is crucial to engage with qualified advisors (including tax, legal, financial, estate) to help develop a comprehensive plan which balances personal and business needs, while assuring both retirement and succession intentions and goals are effectively aligned.
Succession is an area that many business owners understandably struggle with, especially if the owner has been there since the company’s inception. To help make the planning process as smooth as possible, two key areas of focus should be to plan as early as possible and to ensure family members, business partners and management know your wishes and intentions and that you in turn know theirs. Being proactive with planning and discussions around succession often identifies a clearer path as to whether younger family members or management are interested and capable in taking over the business. From there, it often becomes easier to then come to an agreement on the most suitable option and to put specific plans into motion to achieve that outcome.
Once the “big picture” decision has been made, it’s important to then take the appropriate steps to map out and formalize how that process will unfold. For a sale, this should include a valuation, assessing viability and saleability, setting a timeline and ensuring the business stays strong right up until the point of sale. For a transition to the next generation, this may include grooming the successor, hiring an additional management team as a supplement, managing the transition and considering a variety of wealth planning strategies such as an estate freeze. Please view RBC Wealth Management’s Spring 2017 issue of Perspectives magazine for additional information on “The complexities of business succession and how to promote success.”
Exit options at a glance
In thinking about a business exit and succession, there are four main options available to private business owners.
|Option||Potential advantages||Potential disadvantages|
|Keeping it in the family||
|Management buyout (MBO)||
|Sale to third party||
Note: Because each business situation is unique, it is important to consult with a qualified business planning professional to factor in specific circumstances when assessing the options available and to determine the most appropriate planning approaches.
Charitable giving quick tip
For business owners planning to sell their business, giving back to communities by using some of the sale proceeds to make a charitable donation in the year of sale could be an option for consideration. This type of strategy generates a donation tax credit which may help to minimize the tax on any capital gains realized on the sale. If your donation is expected to be at least $25,000, business owners may want to consider the benefits of setting up their own charitable foundation in the year of sale through the RBC Charitable Gift Program.
Examining the true potential of a management buyout (MBO)
Generally, many business owners gravitate towards one of two routes: transitioning to family or selling to a third party. Depending on circumstances, however, an MBO can offer some additional perks that may make it a more attractive option. The following are some of the additional advantages that an MBO has the potential to offer a business owner planning to exit their business.
- Key employees who are part of the management team are often crucial to the effective operation of the business and hold invaluable knowledge and experience, which makes them competent and qualified to help ensure the company’s continued success.
- The management team and owner usually have a strong sense of familiarity and comfort with one another, which can increase the likelihood that the transaction will be successful.
- In most circumstances, management teams will have fundamental insight into the business — whether that’s accounting, business, legal or otherwise — which can therefore make the succession process much smoother than with a third-party buyer, for example.
- If the management team has a proven, long-standing record of operating the business, debt financing of the purchase price should be easier.
- The transition will be less prone to hiccups and disruptions among customers, suppliers and employees if the management team remains familiar.
A closer look at the disadvantage of an MBO
A central aspect business owners need to consider for this exit strategy is the fact that internal buyers like a management team will generally not have significant amounts of personal cash to purchase the business. What this commonly means for small- and medium-sized companies is that the owner may need to offer a favourable purchase price and provide a vendor note on favourable terms in order to make the purchase feasible for the management team. In other words, an MBO may be ideal for a seller who is not adamant about maximizing all components of the sale, including value, cash proceeds on closing and deal terms. The management team should come up with some portion of the purchase price up front, even a small amount, to ensure all parties involved have some personal investment and vested interest in the business.
For mid- to large-sized organizations, securing a higher purchase price may be less difficult, as management teams will often partner with private equity firms that can contribute a substantial part of the equity component. The main potential downside to this, however, is that the management team will only receive a small portion of the ownership, given their minimal contribution of total equity. Here it becomes crucial for owners and the management team to discuss and clarify their goals and risk tolerances well in advance, as some individuals may be willing to risk personal assets or have limited control or ownership, for example, while others may not. Through understanding and examining all of the components of an MBO, as well as the potential advantages and drawbacks, business owners will be able to better determine if it’s a viable option for their circumstances.
In Quebec, financial planning services are provided by RBC Wealth Management Financial Services Inc. which is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RBC Dominion Securities Inc.