Answer: This is an increasingly common situation.  Many people who are approaching retirement have built up their own companies and invested all their spare cash into it. They are now at the stage where they wish to retire and live off the proceeds of the company as this is their only significant asset.

There are a lot of risks with this strategy, and it is important to talk to a financial professional who understands the myriad issues and potential dangers involved in setting up succession plans for your business.

Things to consider include:

Donations tax

As you’ll be giving your son 50% of the shares in the business, this will trigger donations tax, which is 20% of the donation.

If your company was worth R10-million, the donation to your son would be valued at R5-million. The donations tax payable would be 20% of R5-million, which is R1-million.

Is there enough liquid cash to pay this?

Capital gains tax

You will need to liquidate 50% of your shares to give them to your son. This will trigger a capital gains tax (CGT) event.

If your marginal tax rate is 41% and you started the business from scratch, then the CGT will be calculated as follows:

Capital gain x inclusion rate x marginal tax rate:

R5,000,000 x 40% x 41% = R820,000

Do you have the necessary cash to pay this bill?

Business difficulties

If the business runs into difficulties in the future, there is often a reluctance to pay the founder the monthly pension as there is no obvious value add. The many years of hard work it took to build the business to where it was when you passed over the baton are forgotten. The pension is seen as a cost rather than a reward for creating the entity.

I have come across several instances where family members have disregarded verbal and written agreements, just to see the parent left with no income or means to contest this. There is often very little recourse if the original agreement does not completely protect the various parties.  

Possible solution

There is a possible solution that could avoid these taxes and provide you with an ongoing income: you set up a new company that runs the operations of your current company.

The assets of your current company remain in your hands so no donations tax or CGT are triggered. In the previous example, this would save you around R1.8-million.

The new company, which runs the operations of your current company, is owned by your son. A service level agreement is put in place for the operations company to pay your company a fee (your pension) for the use of their assets, brand and goodwill.

This way, your cash flow is assured and the need to pay expensive taxes is not triggered.  There are many variants of this and it can be tailor-made to suit your particular situation.  

What I like about this solution is that you do not have the cash flow issues that are caused by donations tax and CGT. You also get to keep control of your assets so there is a measure of protection for you.

Over time, the value of your original company will decrease as assets are depreciated and written off.  The value of the new company will increase as new assets are purchased by it. This is a tax-efficient way of transferring a business and ensuring that you receive a pension from it.

Creating a succession plan for a business is one of the most important financial decisions you will ever make. It is vital that you speak to a financial planner who understands the tax laws for business transitions and can put the best structure in place for you. DM168

This story first appeared in our weekly Daily Maverick 168 newspaper which is available for R25 at Pick n Pay, Exclusive Books and airport bookstores. For your nearest stockist, please click here.