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What is a Section 86 Reorganization?

January 10, 2013

Tax Question:

What is a section 86 corporate reorganization?

Facts:

Many company owners have a dream of selling their company and using the proceeds to fund their retirement. Occasionally the sale may be to a third party, but often the sale is to family members or trusted employees who do not have the available cash to finance the purchase. One solution to assist in this transfer of ownership is to perform an estate freeze.

Discussion:

Section 86, often used in succession planning, is when the existing shareholder wants to pass the business onto other family members. The existing shareholder is freezing the value of the company at a date in time by exchanging all the current shares with redeemable shares of a fixed value. For example, if a company is worth $500,000, the common shares would be swapped for say 5,000 preference shares with a redemption value of $100 each. This allows new shareholders to acquire an interest in the future growth of the company for a nominal fee. As the value of the company has been frozen through the issuance of redeemable preference shares, the existing shareholders then take this frozen value out of the company over time by redeeming the exchanged shares.

Advantages:

  • The new shareholder does not have to find financing to buy into the company. However, they will only partake in any value generated subsequent to the freeze.
  • The old shareholder has frozen the value of the company and can withdraw this value over time in a tax-efficient manner making use of the personal tax brackets.
  • The old shareholder could still be issued new controlling shares to ensure they take an active role in the company so that the frozen value is preserved in the future.
 

Disadvantages:

  • As the existing shareholders would be redeeming their shares via dividends instead of a share sale, they may not benefit from the lifetime capital gains exemption.
  • The frozen value is susceptible to the ability of the company to pay it in the future.
  • A valuation has to be performed to support the exchange value of the old shares.

If you would like more information on this topic, please contact a member of the Empire CPA team by filling out the contact form below.

Canadian and foreign tax laws are complex and have a tendency to change on a frequent basis. As such, the content published above is believed to be accurate as of the date of this post. Before implementing any tax planning, please seek professional advice from a qualified tax professional. Empire, Chartered Professional Accountants will not accept any liability for any tax ramifications that may result from acting based on the information contained above.

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