Successful Family Succession Planning: Ike Did It Right!

I’ve known franchisee Ike for several years, ever since his trusted public accountant Ronald introduced us. Ronald wanted me to implement some tax minimization and tax deferral solutions for Ike, focusing on executive compensation, pension and succession exiting strategies. Ike is a multi-unit franchisee with plenty of business sense but everyone can benefit from some outside advice.

In 2004 I learned that Ike’s tax strategies had helped him achieve yet another goal: transferring one of his franchised restaurants to his daughter, Patti.

I’ve always been fascinated about Ike’s story. I’ve read many studies about the desire of entrepreneurs to transfer their businesses to another family member, typically their children, when the time comes to retire. However most of those businesses end up sold to third parties. This is usually because younger family members lack the money to buy their older relatives out or simply have no interest in running the business. For franchisees, there is a third hurdle: the relative must also be approved for ownership by the franchisor.

Ike, by seeking professional advice from his trusted advisors in every stage of the process, avoided these pitfalls and made possible another generation of franchise success. This story begins back as 1992.

The long view

When asked to reflect on Patti’s achievements since 2004, Ike will tell you they owe much to sound financial preparation, supported by their franchisor’s system and its willingness to work with his family. Equally vital was the professional help they sought, especially from his public accountant, lawyer and financial planner.

Ike had always believed in a flexible business strategy that looks ahead five, even 10 years. Patti first expressed an interest in joining her family’s business as early as 1992. Ike’s planning prepared him for the day when Patti was finally ready to join the business and make franchising her career.

Part of being a mature business owner is considering your succession and exit strategy with every business decision you make; in other words, taking the ‘long view.’ In 1992 Ike told his public accountant of his desire to sell his franchises to his children. As their family accountant, Ronald’s role was to provide guidance and help him develop a business model and tax plan to facilitate this still far-off goal.

Setting up a trust

Ronald recommended that Ike reorganize his corporate structure to allow for an estate freeze on the future value of his business. An estate freeze limits the growth of capital property you hold during your lifetime; any future growth in the capital property is transferred to your heirs. Under this new arrangement, all Ike’s franchisor required of him was that Ike own 100 per cent of the voting shares and his children be recognized as non-voting shareholders. Ike shared ownership of the operating company with his children through a ‘family trust.’ The children would be the trust’s beneficiaries.

Remember: a trust is not a separate legal entity from the group or individuals who set it up. It is a device for holding property or assets for the benefit of a specific person, group or organization, known as the beneficiary (in this case, Patti and her sister Ellen). The person creating a trust (Ike) is called the grantor, donor or settlor. When a trust is established, an individual or corporate entity is designated to oversee or manage the assets in the trust. This individual or entity it called a trustee (again, Ike).

With Ike’s new business structure in place, it allowed for his business’ future profits and assets to accumulate in the family trust, with dividends to be paid through it to the children. This helped Patti and Ellen to accumulate funds in the most tax advantageous way, (a) because they were in a lower tax bracket than Ike, and (b) because he could maintain control of the assets and split the income with his children. The future trust also allowed Patti to meet the franchisor’s franchising fee by enabling her to accumulate her own funds in her own name to provide her the equity with which to buy her location from her father.

The individual pension plan

Ike’s trusted accountant also made two other recommendations that helped guarantee Ike’s own financial wellbeing once retirement approached. First, he recommended that Ike create an individual pension plan (IPP). Individual pension plans have become very popular with Canadian business owners because contributions made to them can legally exceed the maximum allowable contributions into a registered retirement savings plan (RRSP). Money placed in an IPP is deductible by the sponsoring company and is a non-taxable benefit for the individual. Increases in the total value of the assets held in an IPP are tax-deferred until withdrawn. This means a business owner can save a great deal more money for his or her retirement in a tax-efficient way.

Universal life insurance

Ronald’s second suggestion was for Ike to purchase (through his new corporate structure) a corporate-owned universal life insurance (UL) policy. Universal life insurance allows for tax-sheltered growth within the policy. A corporate-owned life insurance contract can tax shelter much of your retained earnings in the cash-value portion of the policy. You can access these funds for personal business use throughout your life by collateralizing the policy through loans from the policy. For example, as a retired business owner, you might borrow funds annually to increase your retirement cash flow.

Any related bank or policy loans will be repaid automatically upon death from a portion of the policy proceeds. A credit to the corporate capital dividend account (CDA) would be simultaneously created, equal to the full policy proceeds. Should Ike ever become disabled or critically ill, the corporate-owned UL insurance policy entitles him to the entire cash value without any requirement to repay the policy. Thus, a corporate-owned UL policy can provide the following benefits for a franchise owner who chooses to adopt it:

• Corporate deposits can be deductable;
• All personal deposits can be deductable over time;
• Large annual deductions provided each year against income for the rest of your life;
• Tax-free retirement (even tax-free death), with savings protected from your creditors; and
• The corporation or personal deduction creates an annual cash-on-cash return of approximately 60 per cent, in a plan on which taxes will never be paid.

The next generation

With Ike’s future secured, he turned his attention to the succession challenge itself. The challenge for franchisors like all businesses today, is finding candidates who will bring value to the brand. Today’s and tomorrow’s franchisee must be competent in business management, marketing, relationship management and resource management.

To protect its brand, the franchisor holds the final say over who will be granted franchise rights. The franchisor must simply ensure a proper fit between the next generation and its franchising system. Most well established franchising systems have created a set of step-by-step guidelines for current franchisees and their successors:

1. All parties (in this case, Ike as parent, Patti as would-be next-generation franchisee and the franchisor) must be involved in all steps of the succession planning and transfer-of-ownership process.

2. The new family member must show an interest in and commitment to owning the business and have already worked in the business in a senior management position. The child must demonstrate his or her capability to work successfully in the business. The franchisor will help by establishing a training program for the next generation franchisee candidate.

3. The franchisor will still hold final approval for any transfer of ownership. The next-generation candidate must complete an application (like any other franchisee applicant). He or she must also have the financing in place to purchase the franchise. Once the applicant’s training program is complete, the franchisor invites the next generation applicant to an interview. The panel determines the child’s suitability to take over the reins.

In 2004, Patti met and far exceeded the panel’s requirements. With the foresight of her father, the help of the franchisor’s next generation training program and Ike’s trusted financial advisors, Patti became a franchisee, just like her father before her. As one senior executive at the franchisor’s head office recounts about the entire process, “Ike must have had some incredible advisors because he did everything right in preparing his business and his daughter to take over his franchise.”

The value of this long-term planning is not limited to the quick-service industry. Business owners of all stripes must consider the future and prepare for the day when their life’s work must be passed along. A great place to start is to ask your business owner clients if they see their children taking over in five, 10 or even 20 years, the time to start planning for it is today.

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Peter J. Merrick, BA, FMA, CFP, FCSI, is President of MerrickWealth.com, a fee-for-services financial planning and executive benefit advisory firm in Toronto. He is a professor of financial planning at Ryerson University, author of “The Essential Individual Pension Plan Handbook” (Lexisnexis, 2007) and a presenter at the CICA 2007 National Conference on Income Taxes. Peter can be contacted at 416.854.1776 or peter@merrickwealth.com

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