Selling an advisor’s book [1/8] – Why and how do we prepare

[Eight-part series, current to publication date only]
1 – Why and how do we prepare
2 – Finding the right buyer
3 – Getting the best price
4 – Tax issues overview
5 – Incorporation issues overview
6 – Caveats and limitations
7 – Selling when incorporated vs. unincorporated?
8 – Ways to get paid

1 – Why and how do we prepare

The average age of the financial advisory population is rising. At the same time, all advisors face increasing compliance requirements. Together, these demographic and regulatory trends may lead more advisors to sell their books.

Transferring a practice is often the largest business deal a financial advisor will oversee. And it’s often also the advisor’s largest personal financial transaction. On the buy side, it can be a monumental financial obligation and personal commitment; on the sell side, it is the culmination of many years of invested time, effort, resources and emotion.  

In the past, young advisors would be lining up with cheques in hand. The future may not be quite so predictable. When it comes to negotiations, while the top-line purchase price may be top of mind, it is the bottom-line figure that matters most: the after-tax take-home cash for the seller. 

Over the next year, we’ll present a series of articles aimed at assisting advisors in negotiating with those tax concerns in mind. We’ll start with a high-level look at the parties’ preparation, key evaluation criteria, valuation approaches, and how negotiations build toward a contract. We’ll then turn to tax considerations, determining what is being sold, how payments are structured, and what actions may be taken to mitigate tax concerns.

This article will discuss the timeline and preparations for selling.

Strategic planning

An advisor who has a clear vision of what her practice stands for and where it is headed — often called a career or practice plan — will be able to command a higher price than an advisor who doesn’t.  

To obtain anticipated value, a selling advisor will need to emphasize what is desirable about her practice, and may need to adapt the practice to meet the market’s requirements. 

The timeline for strategic planning varies, but to qualify as strategic, a plan should last a minimum of two to three years. Market cycles could affect potential buying and selling opportunities, extending the vision out to almost a decade. In practice, and to keep planning within measurable reach, a five-year outlook would be a manageable target, ideally with a rolling annual review. 

Due diligence

Due diligence is the process whereby contracting parties confirm their understanding of the transaction they may be entering. Initial impressions developed during informal interactions are confirmed or adjusted through more formal discussions, detailed disclosures and first-hand data and document reviews. Entering into a due diligence process has costs, since the process takes time and attention away from income-producing activities and management responsibilities. 

The more complex the transaction, the longer the due diligence usually takes. For an advisor with little or no experience looking at other advisors’ operations, it can take time to decide what to look at, and what to look for. Having an existing practice plan (both as a buyer and as a seller) can help focus in both respects.

For the seller, opening the books can be a sensitive matter. Without reasonable access, however, a potential buyer may be unwilling to proceed. Operationally, it can be disruptive to have another person reviewing papers and accessing digital files. Beyond that, the seller wants to be certain that the acquiring party will be able to complete the financial terms of the agreement, and that the seller’s reputation will be in good hands after closing. And whether or not the deal closes, privacy, confidentiality and the integrity of the practice must be protected. (Later in this series we will touch on non-disclosure agreements and other negotiating tools.)  

The depth and timeframe of due diligence may be minimal, whether by intention or simply due to lack of planning. In other cases, particularly where a mentor relationship has developed, informal talks may extend over years. As a transfer of client assets generally supports the value of a practice, the process should span at least one series of client review meetings. This could mean formal due diligence might run from a few months to a year or more.

Closing

The closing date is when the legal rights transfer between the parties. Sometimes, the entire practice is transferred on that date. In other cases, a selling advisor may decide to parcel out the practice over time, possibly in separate processes involving different buyers. 

Post-closing

The parties may intend a clean break at closing; but, formal or otherwise, there can be a continuing relationship for a number of years. For example, the buyer’s payments may be periodic following closing, whether or not the amount of payments relate to performance. Commonly, this will be a couple or a few years, but generally no more than five (in part for tax reasons, which we’ll discuss in a future instalment).

On the other hand, the buyer may want the seller to be present for client hand-offs. Usually, this takes one to two years.

Whatever the intentions, it’s critical that the parties document in their agreement if, how, and for how long they’ll continue to work together. 

Risks

Here are the main risks in a buy-sell transaction:  

  • Missed opportunity: The possibility that a high-potential buyer or seller does not come to a party’s attention, or that that potential is not recognized at the relevant time. A well-considered and documented strategic plan should minimize this risk.
  • Unrealized value: It’s important to understand the value of the practice from one’s own perspective and from the other side. Without this, a bad bargain may be struck (for at least one party, maybe both).
  • Imprudent venture: An ill-prepared advisor may enter into an unadvisable deal, possibly for the simple reason that a long-awaited counterparty has materialized. Having an understanding of oneself and one’s future plan can help protect against this pitfall. 
  • Practice disruption: Pursuing, evaluating and concluding the sale of a practice can be time-consuming, even if the deal does not close. Both parties need to guard against false starts, balance strategic activities against continuing obligations, and conduct negotiations efficiently.
  • Reputation/liability: Possibly the greatest proportion of a practice’s value lies in the advisor’s goodwill with clients, which in turn rests on reputation. If you’ve entered a deal with an advisor who later behaves badly, you may incur legal liability for his actions (though that’s unlikely). More likely is that you incur reputational liability by association. 
  • Return on investment: This is a business deal. Parties must apply their analytical skills dispassionately to arrive at a fair value, structure manageable payment terms, and conscientiously monitor and fulfill obligations at and after closing, all with taxes playing a central role in the result. 

Next instalment, we’ll discuss finding the right buyer for your book.

Mutual fund corporation tax changes – Federal Budget March 22, 2016

The federal budget tabled on March 22, 2016 announced changes to the tax treatment of fund switches within mutual fund corporations. Despite the change, this structure continues to offer investors significant tax efficiencies for non-registered portfolios and corporate accounts.

Background

Canadian mutual funds can take the legal form of a trust or a corporation. While most funds are structured as mutual fund trusts, some are structured as mutual fund corporations. The latter are also known as corporate class funds, as each fund is a distinct class of share of the corporation.

To rebalance holdings within a mutual fund corporation, investors are able to exchange shares of one class of the mutual fund corporation for shares of another class. 

By making use of an Income Tax Act (Canada) provision applicable to convertible corporate securities, this exchange is deemed not to be a disposition for income tax purposes.

The change

Budget 2016 proposes to amend the Income Tax Act so that an exchange of shares within a mutual fund corporation will be considered to be a disposition at fair market value for tax purposes. 

This measure will apply to dispositions of shares that occur after September 2016. 

The measure will not apply to switches between series of shares within the same class where the shares received in exchange differ only in respect of management fees or expenses to be borne.

While tax measures of this nature are usually made effective on Budget Day, it would appear that the government is content that investor-taxpayers would not be able to manipulate or circumvent the change. Accordingly, investors will have a few more months to rebalance before facing dispositions.

Continuing benefits

Apart from tax-deferred switching, mutual fund corporations have a number of tax-beneficial features that remain available.

Netting of gains and losses

Capital gains and capital losses are shared across all funds within a mutual fund corporation. This feature can lead to lower expected distributions compared with holding a series of mutual fund trusts.

  • Gains that would otherwise be distributed from a class fund can be offset by losses elsewhere within the mutual fund corporation
  • If a capital gain is distributed, the investor is subject to tax on that gain
  • If there is no distribution, there is instead an increased net asset value, being  as this is an unrealized capital gain 
  • That gain will be realized when the class fund is disposed, which now includes switches between funds within the mutual fund corporation

If a mutual fund corporation has more capital losses than gains in a year, the excess can be carried forward indefinitely to apply against capital gains in future years. As of March 31, 2015, Invesco Corporate Class Inc. had assets under administration of $7.01 billion, and a $1.46-billion capital loss carryforward.

The use of the loss carry forwards depends on activity within the corporate class funds.  There is no assurance that this level of loss carry forwards will be maintained, nor can a timeframe be predicted in which these losses may be exhausted.

Managing high-tax income within the corporation

For mutual fund trusts, interest and foreign income are distributed to investors (net of associated expenses), to be fully taxable at the investor’s marginal tax rate.

A mutual fund corporation is taxable on all income earned by its funds. Management and operational expenses are deductible for the corporation.

  • There is no distribution of interest or foreign income from mutual fund corporations 
  • Instead, the investor experiences an increased net asset value, roughly equal to the income earned, net of applied expenses 
  • That gain will be realized when a class fund is disposed, which now includes switches between funds within the mutual fund corporation

Flow-through of preferred income

Canadian dividends and realized capital gains are initially taxable to the mutual fund corporation. Special refunding mechanisms allow these two income types to be distributed to investors in their preferred form. 

  • Canadian dividends maintain their preferred character on distribution, allowing investors to claim the dividend tax credit, netting to a lower effective tax rate compared with other fully taxable income types
  • As with capital gains realized by investor actions (now including switches), only half of distributed capital gains are taxable

As stated above, assuming the budget is passed as tabled, the measure will only apply to dispositions of shares that occur after September 2016. 

Your tax refund pre-funding an RRSP tax bill

And nine more smart things you can do with your refund

Whether it arrives by mailbox or inbox, a tax refund can feel like “found money.” But alas, it’s not; it’s basically an overpayment of tax that the government eventually gives back to you – at a zero rate of return.

For many of us, it’s the result of payroll taxes being withheld during the year based on assumed annual income. The full picture only becomes clear once your tax return is filed and all credits and deductions are fully accounted for.

When the refund does arrive, what you do with it can have significant long-term implications. Contributing at least some of it to a registered retirement savings plan (RRSP) could be a way to systematically pre-pay future tax on the plan. Here are the numbers to illustrate that strategy and a few more tax-savvy options to consider.

1. Grossing-up your RRSP

The apparent simplicity of RRSP arithmetic can be deceptive. For a person at a 40% marginal tax rate, a $1,000 contribution will generate a $400 refund. But that is literally only half the story, as the eventual drawdown will be taxable, netting right back to $600 spendable. Some savers may be quite content with that, knowing that in the meanwhile growth will be enhanced by the tax-deferred nature of a registered account.

On the other hand, some of that future tax liability could be pre-funded by contributing the refund back into an RRSP. To give full effect to this, each successive refund ($400 + $160 + $64 + …) would have to be similarly applied. In truth, this is simply an increase to annual savings but with a specific purpose in mind. Leaving aside investment returns, this would build the principal towards $1,667 in this example, which nets to $1,000 spendable. 

Now obviously a person’s tax bracket can vary over time, with the key expectation of being in a lower bracket in retirement. Rather than being a drawback to a pre-funding strategy, it makes even greater use of tax breaks in high-bracket years to fund future low-bracket retirement-income years.

Given that tax refunds are themselves tax-free, there is no drain on future income, so the process can effectively be self-funding. It takes some discipline, but ideally a conscientious savings habit and a tax pre-funding strategy could operate in concert on an ongoing basis.

Reduced withholding at source

For some, a refund may instead be viewed as cash that had been needed for current expenses, but was trapped in the tax system. If that’s so, an alternative is to file Canada Revenue Agency Form T-1213 to reduce tax deductions at source. In our example, this would have released the $400 as cash flow during the year, though the net RRSP contribution is left at $1,000. 

Alternatively, if the household budget can bear it, the pre-funding strategy could be coordinated with Form T-1213. In our example, the RRSP contribution would need to be $1,667 presently, as opposed to building in that direction over the years. 

2. Spousal RRSP

A spousal RRSP builds on the use of an RRSP to arbitrage from high to low tax brackets across time by also doing so across taxpayers – to a spouse expected to be at a lower future tax bracket. 

3. Pay down discretionary non-deductible debt

Regardless why it’s there, this kind of debt can often compound against us faster than we can accumulate savings. Eliminate such costly commitments as soon as is manageable.

4. Retire RRSP loan in the current year 

An RRSP loan can help get money into an RRSP, but if not paid off in the current year, it puts a strain on future years’ living expenses and savings. As well, the interest is non-deductible.

5. Mortgage reduction

Importantly, a mortgage funds future housing, but principal and interest are non-deductible. Retiring a mortgage allows more of a monthly budget to be devoted to retirement savings. 

6. Tax-free savings account (TFSA)

Funded out of after-tax money, the TFSA allows tax-free growth and tax-free withdrawals. The annual allotment of TFSA room for 2016 is $5,500.

7. Registered educations savings plan (RESP)

An RESP boosts education saving through income splitting, tax sheltering and government grants of up to 20% federally, with some provinces offering further financial support.   

8. Registered disability savings plan (RDSP)

Families with disability issues can face large financial challenges. The RDSP enables income splitting, tax sheltering, free government bonds and up to 300% in matching grants.

9. Non-registered investments

Registered savings form the core of retirement savings. Projected spending patterns may show a need to supplement that, and investing a refund can get that part of a plan underway.

10. Live it up … a bit

After all, saving is just spending-in-waiting – but it’s a good idea to try to keep it in balance.