What is a section 86 corporate reorganization?

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Grant-GilmourFacts:

Many company owners have a dream of selling their company and using the proceeds to fund their retirement. Occasionally the sale maybe 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 for 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 (see FAQ #15).

•   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.

Recommendation:

If  you  have  questions  concerning  reorganizations,  please  contact  us  at  Gilmour  Knotts  Chartered

Accountants for our help on this issue.