BV Benefit #10 - Executor / Trustee Protection

Executors of an estate with business interests should obtain an independent professional business valuation as support for the values used in the estate administration tax ("EAT") filing, particularly in light of recent changes to EAT legislation and the potential for personal liability facing executors.

At the time of probating the will, EAT (previously known as "probate fees") of 0.5% must be paid on the first $50,000 of estate assets and 1.5% on the value of the remaining assets. [1]  The estate representative (i.e. executor or trustee) has many responsibilities, including but not limited to:

1. Filing an affidavit as to the estimated value of the estate;


2. Remitting the EAT on the estimated value; and


3. Providing an undertaking to file, within six months, a sworn statement of the total value of the estate, and to pay the balance of any additional tax owing (if any).

In 2011, the Ontario government amended the legislation to enhance the EAT compliance regime.  Beginning January 1, 2013, the Ontario Minister of Revenue will be afforded significant audit and verification functions, including the right to conduct a review of the estate inventory and valuation provided by the executor.  If a greater estate value is determined, additional taxes can be assessed.  As a result, there will be much more pressure to verify the value of the assets disclosed in the EAT filing.

Penalties have been added to encourage compliance.  It will be an offence for an estate trustee to fail to make the required filing with the Minister of Revenue.  It will also be an offence for any person who makes, or assists in making, a false or misleading statement in connection with the estate trustee’s filing.  Offences are punishable by fine, by imprisonment or both.  The minimum fine will be $1,000.  The maximum fine will be twice the EAT payable.

An estate representative may be exposed to personal liability if the estate assets have been distributed before the Minister of Revenue issues a notice of assessment.  There is no ability to obtain a "clearance certificate" to protect the estate representative from personal liability.

In light of the responsibilities of the estate representative, the new audit measures, and the potential for personal liability, it will be critical for executors to be diligent in obtaining and documenting proper and accurate valuations of the deceased’s property for purposes of calculating the EAT.  Where the estate holds shares in privately held businesses, the benefits of obtaining an independent and professional business valuation will far outweigh the costs to the estate and the risk to the executor of not having one prepared.

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[1] source: www.attorneygeneral.jus.gov.on.ca

BV Benefit #9 - Matrimonial Separation

According to Statistics Canada, over 40% of marriages will end in divorce before the 50th year of marriage. [1]   Where there is a family business or where one spouse has an ownership interest in a privately held company, there may be a need for an independent business valuation in a matrimonial separation.

The division of property is a major issue in a divorce.  According to the Ontario Ministry of the Attorney General: [2]

"When a marriage ends, the equal contribution of each person to the marriage is recognized.  The law provides that the value of any kind of property that was acquired by a spouse during the marriage and still exists at separation must be divided equally between the spouses. Also, any increase in the value of property owned by a spouse at the date of marriage must be shared.  The payment that may be owed to one of the spouses in order to effect this sharing is called an equalization payment, or an equalization of net family property."

As such, upon separation, a net family property (NFP) statement is prepared setting out the value of the total assets and liabilities of each spouse as at the date of marriage and the separation date.  In order to assist in this regard, family law lawyers will often turn to financial professionals for assistance.  Privately held business interests (i.e. shares, stock options, restricted stock, etc.) constitute property, the value of which must be included in the NFP statement. The assistance of a Chartered Business Valuator will likely be needed where there are business interests and the parties cannot mutually agree on the value of the those interests as at the marriage date or the separation date.

Depending on many factors, including the chosen separation process (i.e. collaborative, mediation, litigation, etc.), the parties may agree to jointly retain one independent business valuator to value the business interests.  One party, however, may opt to individually retain an independent business valuator.  The other party will then retain a separate independent business valuator to review, critique and respond to the other expert’s report.  This, however, can be a costly process.

Where an established business exists at the time of marriage, the parties may elect to jointly obtain an independent business valuation at that time.  Full disclosure and agreement on value up front will eliminate the need for a retroactive marriage date valuation in the event of a future breakdown.

In matrimonial disputes there is often an immediate need for a business valuation. However, shareholders may find that obtaining annual valuation updates for purposes of the shareholder agreement can also be very useful in the event of a marital breakdown.

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[1]  Source: www5.statcan.gc.ca, CANSIM Table 101-6511
[2]  Source: www.attorneygeneral.jus.gov.on.ca

BV Benefit #8 - Shareholder Disputes

Business owners typically do not require an independent business valuation every year.  Or do they?

In shareholder disputes there is often an immediate need for a business valuation.  However, being proactive and obtaining an annual valuation can help to avoid a potential shareholder dispute.

Business ownership can be complicated, particularly when there are a number of shareholders.  The odds of disagreement, conflict and dispute in these situations can be very high.  When shareholder relationships break down there should be a mechanism in place for dealing with the dispute or for enabling one or more of the shareholders to exit the business in a pre-determined manner.

Shareholder disputes are often grueling and devastating.  They can be costly and very time consuming.  The shareholders become distracted and ultimately exhausted from preparing for and attending discoveries, meetings with lawyers and experts, settlement negotiations and arbitration or court proceedings.  Relationships are destroyed and ultimately the business suffers because the shareholders are no longer devoting sufficient time and attention to managing the company’s operations.

The importance of a unanimous shareholder agreement ("USA") to privately held businesses cannot be over emphasized. An effective USA should address the following areas: i) compensation; ii) decision making; iii) entrance; iv) exit; and v) return on investment.

Having a business valuation is critical for new shareholders to buy-in and for existing shareholders to measure their return on investment or to exit the business.  Privately held company shares are illiquid assets.  The USA should provide a shareholder, under certain situations or triggering events, with the means to liquidate an otherwise illiquid asset.  For example, a buy-sell provision (or "shotgun" clause) allows for one shareholder to offer to buy the shares of another shareholder subject to the right of the other shareholder either: i) accepting that offer; or ii) buying the shares of the offering shareholder at the same price offered by that shareholder.

With respect to valuation, the USA should provide the definition of value (e.g. fair market value or fair value) and set out the process and timing for obtaining a valuation.  Many USAs stipulate that an annual or biennial valuation of the business should be prepared by an independent Chartered Business Valuator.

Committing to this process allows the shareholders to discuss and agree to the current value of the business before any potential disagreements arise.  In the event of a dispute, the valuation issue will have already been dealt with.  The return on investment of an independent and annual valuation can be tremendous if it means avoiding a costly, time-consuming and perhaps devastating shareholder dispute down the road.

BV Benefit #7 - Life Insurance Coverage

Many business owners utilize life insurance as an integral part of their exit and contingency planning.  Without life insurance the overall family wealth management plan may be incomplete.

Life insurance is often used for income replacement or to alleviate the burden of estate and probate taxes upon death.  However, when business owners use life insurance to fund a buyout or redemption of the shares of a deceased shareholder it is important to ensure that the death benefit will be adequate to:

1. Fund the buyout or redemption of the deceased shareholder’s shares (Buy/Sell Insurance); and


2. Ensure the continued survival of the business upon the loss of a key person in the business (Key Person Insurance).

As a result, the life insurance coverage should at least cover the current value of the business.  Privately held business owners spend significant time managing and building their businesses.  When asked, however, many grossly overestimate or underestimate the value of their business.

An independent business valuation provides business owners with third party evidence for ensuring adequate life insurance coverage.  This in turn provides the shareholders with peace of mind and comfort that they and their businesses are sufficiently protected.

Not only is an independent business valuation useful to the insured, it can also be beneficial to the insurance advisor.  An independent valuation will help the advisor:

1. Manage and control the process in creating the application file - insurance companies are increasingly requiring support for the amount of coverage requested; and
 
2. Solidify trust and cultivate the relationship with the client - providing the insured with third party evidence regarding the value of their business eliminates any pre-conceived notions the client may have with respect to being over sold or under estimated as far as coverage. 

The business valuation can be updated annually or semi-annually and can also be used as a benchmark for a value enhancement initiative, among many other possible uses and benefits.   The adequacy of the life insurance coverage should be reviewed annually in light of any growth or other changes to the business over the prior year.  Ideally, this process should be agreed to and formalized in the company’s shareholders agreement, which for many business owners, may not exist or may not have been updated for many years.

The importance of a shareholders agreement can not be overemphasized.   Next week we turn our attention to the need for an independent business valuation in shareholder disputes.

BV Benefit #6 - Tax and Estate Planning

With many business owners planning to transfer the business internally to the next generation over time, one option 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 [1], the fair market value must be determined "by a fair and reasonable method".  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 to the business owner of not having a fair and reasonable valuation include additional taxes, interest and penalties.

As such, an independent valuation prepared by a professional 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 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 with the fair market value determinations for these tax planning purposes.

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1.  Source: CRA's Interpretation Bulletin IT-169.

BV Benefit #5 - 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 the business internally to other shareholders, management, employees or a family member. [1] 

A valuation prepared by an independent business valuator (perhaps annually in accordance with a shareholder agreement) is highly recommended and very beneficial for purposes of transferring business ownership internally.

In order to ensure a smooth internal ownership transfer, it is extremely important for all parties involved to agree on the current fair market value of the business.   The current fair market value can be used to set the price for the transaction in situations where the purchaser (i.e. shareholder, management, employee or family member) acquires the departing shareholder’s shares or in 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.   In fact, one of Tom’s 12 steps in his 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.

Not only can a business valuation be used to set the price for an internal transfer or buyout of a departing shareholder’s shares but it is clearly a prudent tool for contingency planning to help protect the business and the business owner’s family in the event of the owner’s untimely death.

Next week we turn our attention to the benefits of a business share valuation for purposes of tax and estate planning.

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1.   Source: "Quantitative Study of the Business Succession Market in Canada, RBC and CICA/RBC Business Monitor (Q1 2010).

BV Benefit #4 - Sale of a Business to a Third Party

According to recent studies on the business succession market in Canada, more than one third of those surveyed are expecting to sell the business externally to a third party. [1]

"We should remember that good fortune often happens when opportunity meets with preparation."

- Thomas. A. Edison

This quote is aptly applied to situations involving the sale of a business to a third party, the fourth benefit of obtaining a professional business valuation.   For business owners today, the opportunity represents the short window of time before the aging baby boomers begin to flood the market with businesses for sale. The preparation begins with a business valuation.  The good fortune comes with a sale of the business for the maximum possible price.

For many business owners the sale of their business is a once in a lifetime event.   Once a business owner has committed to selling the business the question becomes - for how much?   Many business owners, for various reasons, grossly overestimate or underestimate the value of their business.  Investing in an independent business valuation is an investment that will pay for itself.   Here are 6 reasons why:

1. An independent valuation helps to manage the business owner’s pricing expectations which increases the likelihood of getting a deal closed;
2. A professional valuation can help justify the asking price and provide support for negotiating price with a potential purchaser;
3. Having an independent valuation prepares the business owner for any unsolicited offers received from competitors or other industry participants;
4. The valuation process can help identify potential purchasers or purchaser categories;
5. The valuation process educates the business owner regarding "stand-alone value" and "synergistic value" and the notion that value is different to different purchasers; and
6. A valuation ultimately helps the business owner maximize the sale price, ensuring no money is left on the table.

Many business owners looking to sell their businesses will not take advantage of opportunities in the current marketplace with proper planning, including a professional business valuation.   On the other hand, those that are prepared with a professional valuation and keen sense of market timing will vastly increase the odds of having good fortune bestowed upon them.

Stay tuned for our next discussion on how a business valuation can also be used for internal transfers of a business to existing shareholders, management or employees.

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1.  Source: "Quantitative Study of the Business Succession Market in Canada, RBC and CICA/RBC Business Monitor (Q1 2010).