BookSale – Page 2 – Doug Carroll

Selling an advisor’s book [5/8] – Incorporation issues overview

[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

5 – Incorporation issues overview

Last time, we talked about the tax treatment of a business sale, depending on whether the parties are employees or self-employed. This article will discuss incorporation and how it affects a sale transaction.

TAX IMPACT OF INCORPORATION

A corporation is an artificial person, so it’s a separate taxpayer from the shareholders that own it. This means a corporation has specific tax characteristics, some of which can provide benefits not available to unincorporated taxpayers.

Tax rate on business income. Income received by an employed or self-employed person is taxed at his or her marginal rate. Depending on the province, that can range from the teens to more than 50% at top brackets. Comparatively, a Canadian-Controlled Private Corporation (CCPC) is entitled to make use of the small business tax rate, which ranges from about 11% to 19%, depending on the province. The small business rate applies to the first $500,000 of income for both federal and provincial purposes (though Manitoba uses $425,000 and Nova Scotia $350,000).

Integrated with personal. A corporation is an intermediary before distribution of income to the shareholder. The corporation takes a full deduction for wages paid to an employee, such that the employee pays the all associated income taxes. For amounts the corporation’s been taxed on, it pays out a dividend on which the shareholder tax is reduced to account for previously paid corporate taxes.

Reinvested earnings. If the shareholder does not need all corporate earnings for current personal needs, the excess can be invested within the corporation. This allows tax deferral at the personal level that will eventually apply on dividends. Bear in mind that complex rules apply to passive/investment income in a corporation, requiring careful management with the benefit of professional tax advice.

Retirement and health savings options. With the legal separation of corporation and employee (even if the shareholder is the employee), it becomes possible to use RRSPs or even an individual pension plan (IPP). An IPP is able to house even larger deposits than are allowed under RRSPs. Beyond registered savings, there is also the possibility of using a retirement compensation agreement (RCA). Corporations also open up more options for providing health care benefits.

Income splitting. It is possible to employ others, such as a spouse and family members, whether someone is self-employed or operating with a corporation. In either case, the amounts paid must be commensurate with services provided. Beyond that, the corporation also enables ownership sharing; though, for corporations governed by a professional body, the participation of non-professionals may be limited. Assuming others can be shareholders, dividends may be paid to them, which is particularly beneficial if they are in lower tax brackets.

Tax on disposition. A corporation can sell its client list, or the shareholder could choose to sell shares of the corporation. If the shares are sold, the shareholder will be subject to capital gains tax, with the potential to make use of the lifetime capital gains exemption.

NON-TAX FACTORS

While tax is often the driving force behind incorporation, there are many non-tax reasons for using a corporation.

Creditor protection. As a separate legal entity, the corporation is liable for its actions, but the liability of shareholders is generally limited to losing what they have invested in the corporation. On the other hand, if a creditor requires a shareholder to guarantee the corporation’s debts, then exposure to that creditor is no longer limited. Absent such guarantees, creditors will only be able to look to the corporation’s assets to satisfy their claims.

Ongoing professional liability. While creditor protection is available to professional corporations in general business dealings, there is no shield against malpractice claims. The professional remains personally responsible for professional services and advice given, for which appropriate liability insurance is required.

Continuity. As a separate legal entity, a corporation can survive past the departure or death of its shareholders. Where the business is distinct from those who operate it, this can support its independent value and facilitate its transfer.

Professional image. A business operating through a corporation may be seen as a more stable and durable operation.

Broadened and shared ownership options. It can be helpful to formally isolate business interests in a corporation from personal interests. As things grow, an additional corporate layer may be desired to separate operating assets from surplus assets held through a holding corporation. Where multiple business principals are involved, it may be necessary to create two or more lines of holding companies. And, as family are involved, trusts may be used to house and protect their interests, and to guard against their over-involvement in the business while preserving intended tax benefits.

Selling an advisor’s book [4/8] – Tax issues overview

4 – Tax issues overview

Last time we reviewed valuation and negotiation. This article will discuss issues that can affect the tax treatment of a book sale for one or both parties.

The legal nature of parties involved in the transfer of an advisory practice is one of the central determinants of the transaction’s tax outcome. It comes down to clarifying whether the parties are employees, self-employed or incorporated.

Employees

From the selling side, amounts received by an employee are taxed at the person’s marginal tax bracket. Those amounts are generally taxable in the year received, without the ability to defer recognition or to take a reserve or a portion into income in a future year. This applies to a payment received from a succeeding advisor/buyer for making a recommendation to clients to continue with the successor, including any portion received under a non-competition agreement (also known as a restrictive covenant).

The amount of the non-competition payments and their timing (e.g., if extending past the year of closing) must be reasonable.

If the buyer is an employee, few tax deductions are available, and specifically, no deduction is allowed for payments made to acquire another advisor’s clientele. As well, for tax purposes, an employee cannot generally acquire capital property for which annual depreciation might otherwise be claimed. Similarly, acquiring a client list as goodwill does not qualify as eligible capital property, for which annual amortization charges might otherwise be claimed

Finally, if the buyer has borrowed funds to assist in the purchase, any interest charges will not be deductible.

Much of this summary reflects the Supreme Court of Canada’s 2004 ruling in Gifford (see “Relevant cases”).

Self-employed

A self-employed taxpayer is not subject to the same tax treatment as an employee. Payments made and amounts received will generally fall under the rules applicable to the earning of business or property income.

Advisory practices are capital in nature, so a self-employed buyer cannot claim a current deduction; nor must the seller/receiver generally record a current income inclusion. The payments are instead under the eligible capital property regime, allowing a buyer to claim amortization. A seller is entitled to “capital-gains-like” treatment in the year of sale. [New regime – The 2016 Federal Budget will replace the eligible capital property (ECP) tax regime with a capital cost allowance class. Draft legislation was released July 29, 2016, and the comment period closes September 27, 2016. There is a transition period, so we’ll still discuss the legacy ECP regime, but be aware that new rules are coming in 2017.]

Relevant cases

Gifford v. the Queen, 2004 SCC 15

Gifford and Bentley were financial advisors employed with Midland Walwyn in North Bay, Ont. In 1995, Bentley (who was departing the practice) agreed to provide a written endorsement of Gifford to his clients, supported by a 30-month restrictive covenant. Gifford borrowed the funds for the agreed price of $100,000. Gifford subsequently claimed deductions for depreciation and interest. Those deductions were denied, and the appeals eventually made their way to the Supreme Court. The court held that the payment for the accumulated goodwill and the agreement for Bentley not to compete were made to create an enduring benefit for Gifford. This amounted to a payment on account of capital, and the Income Tax Act (ITA) s. 8(1)(f)(v) prevents an employee deduction from being made for such an expense. Furthermore, interest payments therefore would be a payment on account of capital, and are expressly denied deductibility under s. 8(1)(f)(v).

Morrissette v. the Queen, 2006 TCC 284 (translated from French)

Morrissette was an advisor with Laurentian Bank Securities (LBS). In October 2002, LBS advised Morrissette that it was terminating his employment. A payment of $20,000 was made at that time, with a further $5,000 to be paid six months later as a “final payment—sale of clientele” if LBS had retained 75% of the assets under management. The court found that Morrissette was indeed an employee, and that the $20,000 was severance pay, not a capital gain as Morrissette had claimed. The court referred to Gifford in discussing the $5,000 payment, determining that this amount was “in respect of a certain right of [Morrissette] in his clientele.” Note that this case proceeded under the informal procedure, and is therefore not binding on any court.

Desmarais v. the Queen, 2006 TCC 417

Desmarais accepted a $350,000 payment from Valeurs mobilières Desjardins (VMD) to move from Nesbitt Burns. He took on the role of branch manager, overseeing 24 advisors. A colleague joined him, and was making ongoing payments as a commission split to acquire the clientele of Desmarais. Desmarais claimed the payment as a capital gain, was reassessed by CRA and appealed to the court. The court determined that the VMD payment was an incentive to sign the employment contract, and taxable as income pursuant to ITA s.6(3).

Bouchard v. The Queen, 2008 TCC 462

These were three appeals involving a couple, Danielle and Jacques Bouchard, and their daughter Jacinthe. The couple retired as advisors from National Bank Financial (NBF), receiving in part what was described as “retiring allowances.” The central issue was whether the payments were capital or employment income. The reasons are quite detailed, but the court arrived at the conclusion that all amounts at issue were employment income.

Selling an advisor’s book [3/8]– Getting the best price

3 – Getting the best price

So far, we’ve reviewed general tax and legal considerations when selling your book, as well as common questions buyers and sellers will ask. This article will discuss how to value your book, and how to negotiate with buyers to get the best price.

Both buyers and sellers often want to get to “the number” for a book sale [DASH] whether that refers to a multiple of commissions, percent of assets under administration or other simple calculations. While fundamentally there must be a book of assets to operate on, the makeup of the book and the efficiency of the practice currently housing it can vary widely. Just as an advisor would not recommend that a client purchase a stock or fund based solely on its current dividend yield, these single-criterion measures may be easy to derive, but simplistic in terms of arriving at the true value of a practice.

That said, common rules can constrain parties’ negotiations. Simply put, if a suggested price significantly departs from street wisdom, it may be rejected out of hand. Conversely, a figure that directly mimics one of those quick calculations may be accorded an undeserved air of legitimacy.

It will benefit both parties to establish a negotiating range that reflects the true business proposition. To do that, the usual starting point is to look at free cash flow.

Free cash flow analysis

Free cash flow analysis begins by using the real data of a business to determine its historic gross cash flow. The focus is on the recurring flow, minus the cost to collect it. “Free” cash flow is the net amount in hand that is not required to go back into operations. Armed with this history, you can project the expected future cash flow, as modified by a subjective review of its quality and feasibility.

Having established the expected stream, the next step is to determine current value. This is done by applying an appropriate discount rate (a percentage) in order to commute the stream into a current figure. The discount rate is essentially what a given buyer requires as compensation for using current money to buy a future (and uncertain) payment stream.

When examining an advisor’s practice, a buyer should distinguish between one-time charges and recurring revenue. The buyer will pay for the latter, again based on an expectation of its continuation. Relevant quality criteria might include the consistency and reliability of particular sources, whether receipts have been smooth or lumpy year-to-year, and any observed trends.

Where there’s been growth, the source of that growth is important. Organic growth may be considered as more of a built-in feature as compared to client expansion or turnover.

Lastly, a buyer should expect some attrition, as an ownership change may cause clients to go elsewhere.

Buyer’s capacity

Even with a thorough cash flow analysis, the buyer must still be able to put resources toward making that cash flow happen.

To see if that’s possible, the buyer should gauge the operational capacity of her current practice, including her own time and attention. Can the seller’s book be brought in without having to add resources? And if additional resources will be required, what are they, what will they cost and when can they be put in place? This brings attention back to free cash flow, since it factors into the buyer’s cost of realization, influencing the amount the buyer would be willing to pay.

Negotiation

Getting initial guidance from an experienced lawyer can help an advisor get started on the right foot; greater involvement under a formal retainer can follow. Here are some considerations:

Non-disclosure agreement

Once discussions with a potential buyer have begun in earnest, it’s advisable to have a non-disclosure agreement (NDA). The idea is to preserve confidentiality of any disclosure, and restrict the current and future use of it. Importantly, the agreement should also cover the fact that negotiations are underway, as leaks could unsettle clients and employees. While this obviously serves to protect the seller’s interests, it also benefits the buyer in that it preserves the value the buyer seeks to acquire.

Recitations and terms

It’s common for negotiations to span many months. During the course of those discussions, parties will make statements that may or may not be intended to be relied upon.

A good practice is to jointly build a memorandum of understanding to serves as a continuing check that the parties are seeing eye-to-eye. This document can feed into the formal contract eventually prepared by a lawyer. Once in that form, the respective and mutual premises can be laid out as recitations that form the foundation for what the parties commit to do under the contract terms.

Restrictive covenant

Just as a seller wishes to preserve the practice’s integrity with an NDA during due diligence, a buyer needs to protect the purchased product post-close. This can be achieved through a restrictive covenant in the contract, also known as a non-competition agreement.

A restrictive covenant has four components: who, what, when and where: e.g., the seller will not provide retail investment advice for two years from closing within the province of Manitoba. This example is illustrative only; careful and detailed drafting is required to assure that it clearly records intentions, and that it is enforceable. The Shafron case provides an example of a poorly drafted covenant (see “Shafron v. KRG Insurance Brokers,” below).

Anticipating disputes

Differences of interpretation can arise in even the most amicable situations, and taking a dispute to court can be costly. So, include dispute resolution terms in a contract.

At the same time, parties should understand that finely drafted contract terms may have little effect on an unscrupulous person; if you do not trust your buyer’s commitment, think carefully before committing yourself by executing the contract.

Shafron v. KRG Insurance Brokers, 2009 SCC 6

Shafron sold his property/casualty insurance practice to KRG, after being an employee of KRG and predecessors for 14 years. He executed a restrictive covenant not to compete within the “Metropolitan City of Vancouver.” There was no such legal place. KRG invoked the covenant when Shafron accepted work in Richmond, a municipality bordering the City of Vancouver.

The Supreme Court of Canada ruled that term was unreasonably ambiguous. Courts are not there to read down such provisions, as this could invite parties (particularly employers) to draft overly broad provisions, expecting the court to trim them to what is reasonable.

Note that a higher level of scrutiny is applied where the restrictive covenant is a term within an employment contract, as employers usually have more negotiation power.