Franchise operators face succession issues

And don’t forget that franchisors reserve the right to veto a deal if they don’t believe your children can run the show.

The Globe and Mail
April 23, 1999

Franchise operators face succession issues
Owners who want to pass on the business to their children should address areas including payment, capital gains and taxes on the estate.
John Southerst

JeffHamiltonKwikKopy.jpg

The deal Jeff and Krista Hamilton, left, struck to buy his parents' Kwik Kopy Printing outlet allows Sandra, right, and her husband David to step back into the business if it is in danger. Brian Atkinson/The Globe and Mail

Passing a franchise on to your children may seem like the simplest of business transactions. After all, they know the business after years of working with you, your franchisor presumably has good relations with them and the store has a steady stream of long-standing customers.

But dangerous shoals lurk beneath the surface of these calm waters.

If your children plan to pay you out of cash flow over time and then the business turns sour, for instance, your retirement income is in danger. An ugly surprise awaits if you have to pay a couple of hundred thousand dollars in capital gains tax after the sale.

And your children may face selling the business to pay taxes on your estate when they expected to inherit it after your death.

Franchise owners with children who may someday take over the business should consider how to make sure they cover these issues. All it takes is a little willingness to plan for the worst at an awkward time.

Last summer, Jeff and Krista Hamilton bought their Kwik Kopy Printing franchise in Fredericton from Jeff’s parents, David and Sandra. Jeff and Krista agreed to pay a price “in the high six digits” for the franchise over eight years, and a lot can happen in that time.

So the sale agreement allows Jeff’s parents to step back into the business if the company is in danger. “If the economy goes into a tailspin and we can’t afford to pay David and Sandra, they don’t want us to close the doors,” Jeff says. “It’s not in their interest.”

The contract also stipulates that Sandra work in the business for a year after the sale and David for two years. “It’s a benefit to us to have their experience,” Jeff adds. “We also don’t have to hire two more people to replace them right away.”

Jeff and Krista take enough out of the business each year to pay themselves, their debt to Jeff’s parents – plus an amount to cover taxes. With David and Sandra’s retirement fund at stake, however, they are cautious`.

The younger couple took out insurance, for instance, so that if either one dies, the other will be able to pay most of their debt to David and Sandra and hire a manager to run the shop until the remaining spouse is prepared to return.

On their side, David and Sandra have also made sure Jeff and Krista are secure in their business. They took out universal life insurance that would approximately cover taxes on their estate if they both die.

Universal life policies can be valuable retirement and estate planning vehicles for small-business owners because they consist of both insurance and investment components. While you cannot deduct contributions to the investment component from your taxable income, it grows tax-free until you cash it in.

“It’s a good supplementary fund above [a registered retirement savings plan],” says John De Goey, a financial adviser at Equion Securities in Toronto, “plus it offers insurance on the lives of the spouses.”

Therefore, with a universal plan designated “joint and last-to-die,” a surviving spouse can keep the inheritance without paying taxes and probate fees when his or her partner dies, as long as they jointly owned non-registered assets and named each other as beneficiary on RRSPs and registered retirement income funds.

When the second spouse dies and the heirs must pay taxes and probate fees on the inheritance, the insurance kicks in and covers them. If this isn’t covered off, Mr. De Goey says, the children “either have to take a mortgage, sell other liquid assets or sell the franchise to pay Revenue Canada its pound of flesh.”

The other major hazard for owners of large franchises is capital gains tax on the sale of the business. A sole owner who sells a franchise could lose half of its value in excess of $500,000 to the government.

But there’s a way to avoid the tax bite without losing control of the franchise – and keep it in the family. It’s called an estate freeze.

When the value of the franchise has grown by $500,000 – get a professional business valuation to find out, Mr. De Goey says – you have reached the maximum that you can shelter from capital gains tax.

To effectively “freeze” capital gains at that level, the founder may then divide ownership of the company into two types of shares: preferred and common. The founder owns the preferred shares, which hold the full value of the company to date. They are the only voting shares and pay dividends, giving the founder control and providing income that is taxed at a low rate.

The common shares, with only nominal value of perhaps a dollar each, go to the children. “All additional growth is in the hands o the children,” Mr. De Goey says, “but the parent gets control and the tax-free capital gain.”

It’s important to note that estate and tax planning are just one side of the ticklish business of transferring franchises to the next generation. There are plenty of other considerations, especially such delicate questions as when the parents will bow out, what they will be paid and the role they will have after the sale.

And don’t forget that franchisors reserve the right to veto a deal if they don’t believe your children can run the show.


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