Tax and Estate Planning for Business Owners
RETIREMENT PLANNING
Retirement planning is important for everyone, but it is especially important for business owners. That’s because business owners often invest significant time and money in their business with the hope that their business will become their retirement plan. Since many business owners expect their business assets and/ or operating and holding companies to provide for their retirement, it is critically important to plan ahead to
identify opportunities for growth, capital preservation and tax minimization.
SHOULD I INVEST CORPORATELY OR THROUGH AN RRSP?
If you are self-employed, or a partner in a partnership, investing for retirement continues to be efficiently achieved through Registered Retirement Savings Plans (RRSPs). As business income is earned and taxed personally, the income creates RRSP contribution room that you, as business owner, can take advantage of in the following calendar year. The resulting RRSP tax deduction and tax-sheltered growth provide an ideal opportunity to build wealth for retirement.
For owners of incorporated businesses, the question of building retirement assets in a corporation versus an RRSP (or other personal savings vehicle) is a complicated one that often depends on factors that include corporate and personal tax rates, cash flow needs and a desire for
Canada Pension Plan (CPP) benefits. In fact, investing for retirement in a corporation versus an RRSP often depends largely on whether you pay yourself a salary (which includes bonuses) or dividends in your working years.
Traditionally, owners of incorporated businesses typically pay out enough salary and/or bonuses to create maximum RRSP contribution room for the business owner to make annual RRSP contributions. RRSP contribution room is created by earned income from the previous calendar
year, which generally includes salaries and bonuses, but not dividends. For 2016, RRSP contribution room is limited to $25,370 which would require a 2015 earned income of $140,944. The payment of a salary/bonus also reduces the taxable income of a corporation, which reduces
exposure to general corporate tax rates that apply once business income exceeds $500,000 federally.
However, due to a significant tax deferral that is available when business income is retained in a corporation and the preferred tax treatment of capital gains and dividends earned outside of an RRSP, if a business owner does not need cash personally from the business, the business
owner may be better off forgoing the payment of salaries and bonuses, and instead accumulate retirement assets in their corporation. Business owners could end up with more after-tax money by investing in a corporation as opposed to an RRSP. Also, to the extent business owners need cash personally, they may prefer to fund their cash flow needs with dividends instead of paying a salary.
The following charts provide an illustration of the potential difference between paying a salary sufficient enough to maximize RRSP contributions versus investing in a corporation and funding personal needs with dividends. For this illustration, the charts are based on
Ontario tax rates for 2016 and assume top tax rates for comparison purposes.
Summarizing the previous charts, where an incorporated business (Ontario) earns income subject to the small business tax rate, where the income is paid to the business owner as a salary/bonus to allow for maximum RRSP contributions, net cash payable to the business owner
from his or her RRSP after a 15 year investment period is $28,273, assuming tax at top rates and a 6% annual rate of return. On the other hand, if the business owner forgoes the payment of a salary/bonus – and consequently contributions to an RRSP – and instead invests in his or her
corporation, net cash payable after a 15 year investment period and a 6% capital gains growth rate would be $34,334. Also, in the latter scenario, if the business owner has no other income, their net cash payable on receipt of their dividend may be greater due to the combined
effects of the basic personal amount and dividend tax credit. Where an individual has no other income, between $12,730 and $32,845 of dividends can be received tax-free depending on province and type of dividend received.
Of course, the effectiveness of this strategy can differ from business owner to business owner based on province, cash flow requirements and investment asset allocation, so working with an accountant and financial advisor is critical in determining the most suitable option
for corporate business owners. It should also be kept in mind that an excess amount of investment assets in a corporation can make the corporation ineligible for the $824,176 capital gains exemption on sale, and creditors of the corporation would normally have access to all assets of the corporation including investment assets (the use of a holding company can help prevent this – see the following section). On the other hand, the payment of a salary might yield Canada Pension Plan (CPP) retirement benefits, spousal RRSP income splitting opportunities
and the opportunity to set up an Individual Pension Plan (IPP) or Retirement Compensation Arrangement (RCA), both of which require the payment of a salary or bonus for eligibility.
CAN A HOLDING COMPANY HELP?
Many incorporated business owners consider establishing a separate holding company\ (Holdco) to hold shares of their operating company (Opco). Although the tax rate on investment income earned in a Holdco does not differ from the rate that would apply if the income was earned through an Opco, the use of a Holdco can provide other benefits.
Preservation of Capital Gains Exemption (CGE)
One of the key benefits of operating a business through a corporation is the ability to shelter up to $824,176 of capital gains from tax on sale of the corporation’s shares, or deemed sale at death. To qualify for this exemption, under the Income Tax Act (ITA), the corporation must
be a “qualified small business corporation” (QSBC). This means, at the time the shares are sold (or at death), at least 90% of the corporation’s assets must be used to earn active business income and not passive income such as investment or rental income. In addition, in the two years prior to sale, at least 50% of the corporation’s assets must have been used to earn business income (for more information on the CGE, see the section “Lifetime capital gains exemption” on page 9). Where an Opco has accumulated significant assets that are not being used to earn active business income, the Opco runs the risk of not being eligible for the capital gains exemption.
To preserve the exemption, non-qualifying passive assets can be transferred from the Opco to a Holdco. The transfer would typically occur on a tax-free basis (inter-corporate dividend) while allowing the business owner to defer the payment of taxable dividends to him or herself as shareholder.
What should happen to my business when I retire?
A key question for many business owners is, “What should happen to my business when I retire?”. The answer to this question usually depends on your specific situation. Common succession planning strategies generally include the following, each of which has advantages and disadvantages that can impact retirement and the future status of your business.
1. Transfer the business to family members
Transferring a business to family members (e.g. children) is an obvious succession plan for many business owners, but it is not always straightforward. Sometimes children have views that differ greatly from their parents, and in some cases children have no interest in taking over the family business. It is important to assess the interest of children in advance as well as their ability to succeed you in running your business. Consideration should also be given to when and how the business should be divided amongst multiple children. It might make sense to give the business to children who are actively involved while leaving other assets to children who are not involved.
2. Sell the business to non-family members
A sale to non-family members or even employees can be an effective retirement and estate planning strategy, particularly if family members are not interested or capable of continuing the business, or if the value of the business is required for retirement funding. A third
party sale usually allows business owners to maximize the return on their business and can be an effective way to make use of the $824,176 capital gains exemption available on sale of qualifying corporate shares.
3. Split the Business
Businesses that are involved in several different activities can result in simpler succession planning when transferring to multiple children. By dividing the business into separate divisions, business owners can deal with the issue of choosing between children by transferring to
each child the division that is best suited to them.
4. Name an interim leader
Where family members (e.g. children) are not ready to succeed a retiring business owner, it might make sense to name an interim leader until the family member is prepared. An interim leader can serve as a mentor and keep the business going as your successor prepares. Ideally, interim leaders should have strong leadership abilities and a willingness to step aside when the time comes. They would likely need to be well compensated for their efforts, particularly if they will not have an ownership stake in the business.
5. Take the business public
Taking a business public is an option for many larger companies. It can increase the market for the company which can increase the value of the company’s shares once the company goes public. Public offerings can also increase flexibility with respect to tax and estate planning
as shares can be sold in smaller blocks over time. However, taking a company public can also be legally and administratively costly, so the benefits would have to be weighed against the costs.
CAN I PAY MYSELF A RETIRING ALLOWANCE
At retirement, incorporated business owners can receive a retiring allowance from their corporation provided their employment relationship with the company ceases and the payment is “reasonable” (their relationship as a shareholder can remain). Reasonableness is generally
determined based on the business owner’s length of service with the company, the amount of remuneration received over the years and the value of pension and other retirement benefits to which the owner is entitled.
Retiring allowance payments are particularly beneficial where business owners have been active in their business before 1996. Where this is the case, providedthe business owner is age 71 or younger, up to $2,000 per year of service prior to 1996 can be transferred to the business owner’s RRSP without requiring RRSP contribution room. In addition, if the business owner is not entitled to company-funded pension or DPSP benefits, an additional $1,500 per year of service prior to 1989 can also be transferred. The transferable portion of a retiring allowance payment (i.e. the amount that can be transferred to an RRSP without requiring RRSP contribution room) is referred to as the “eligible” portion of the payment. Amounts in excess of the eligible portion are referred to as “non-eligible” payments.
Retiring allowance payments are tax-deductible to the business and, unless transferred or contributed to an RRSP, taxable to the recipient. Retiring allowance payments can also be paid in installments which can help the cash flow position of the corporation and defer taxation to the business owner.
OTHER RETIREMENT CASH FLOW OPTIONS
Business owners do not always have to sell their business to receive cash flow in retirement. Those who wish to remain engaged in some capacity (e.g. while a child is transitioning to a new leadership role) can continue to receive a salary/business income from their business provided the payments are reasonable for work performed. Also, incorporated business owners can remain shareholders in the company and receive taxable dividends during retirement.
Other options include the payment of tax-free capital dividends where corporations have a positive capital dividend account (CDA), and the payment of tax-free return of capital where business owners have personally invested in incorporated businesses. An arrangement can also be made to have a corporation buy back a business owner’s shares over time, an option that would normally be taxed as a dividend.