Many entrepreneurs don’t want to retire. “They love what they do. It’s their passion,” said Jason Safar, PricewaterhouseCoopers Canada’s Oakville, Ont.-based national private company services tax leader. But financial advisors should urge their small-and-medium-size business clients to address the subject of their retirement. “They need to think about when they will leave the business and what they want to do after that,” Safar said. “Their retirement date and retirement plans will determine how much money they need to put aside for the later part of their lives.”
Planning for retirement is something all clients need to do. “But the difference between business owners and your other clients,” Safar said, “is that the biggest asset – sometimes the only asset – of many business owners is their business.”
Retirement plans should be made far in advance of leaving the business, said Colin Montgomery, a financial advisor with Edward Jones in Regina. Ideally, they should begin at the start-up of the business when the owner decides how he will pay himself.
“In sole proprietorships and partnerships, the income from the business goes to the sole owner or the partners, who then invest in registered retirement savings plans to get a tax deduction on their annual contributions and allow their savings to grow tax-deferred,” said Wilmot George, director of tax and estate planning at Mackenzie Investments in Toronto. A salary will also make business owners eligible to receive Canada/Quebec Pension Plan benefits down the road.
Clients whose businesses are incorporated have another option. “We are seeing a significant amount of cash building up in Canadian-controlled private companies,” said Peter Bowen, Toronto-based vice-president, tax research and solutions, at Fidelity Investments Canada. “This can be the owner’s retirement savings vehicle.”
It may make sense for these clients to forego RRSPs, George said, and fund living expenses with dividends, and have surplus earnings retained and invested within the corporation. “Business income is subject to a significant tax deferral when assets are retained within the corporation, and capital gains and dividends earned outside an RRSP receive preferential tax treatment.”
Benefits and drawbacks
George summed up the benefits and drawbacks of saving for retirement in an RRSP in the following way:
Pros: Salary and bonuses are deductible to the company; and the RRSP contribution and growth within the plan are tax-deferred.
Cons: A salary (less the RRSP contribution) is full taxable; and RRSP withdrawals are fully taxable.
And he summed up the pros and cons of building retirement assets within the corporation:
Pros: Business income is subject to a significant tax deferral when it is retained within the corporation; when money is withdrawn from the company, the owner benefits from the preferred tax treatment of dividends and capital gains, compared with RRSP withdrawals that are fully taxable.
Cons: investment income is taxed annually; and dividend income is not eligible for CPP benefits or for income-splitting with a spouse.
Investing retained assets
Myron Knodel, director of tax and estate planning at Investors Group in Winnipeg, noted that an SME client with an incorporated business could also consider setting up an individual pension plan. “A defined-benefit plan funded by the client/corporation will provide your client and his spouse with a retirement income. The advantage of an IPP is that the maximum annual contribution limit is greater than what can be contributed to an RRSP each year. Contributions are tax-deductible to the company, and, as a registered pension plan, it is protected from creditors.”
The decision of how to create a retirement nest-egg depends on how much cash the business owner needs to spend each year, his personal tax rate, his need for CPP or QPP benefits down the road, and his need for income-splitting with a spouse, George said. “And his investment risk tolerance. He will need to sit down with his financial advisor and his accountant to determine which strategy is best for him.”
Financial advisors need to have a good team in place when helping SME clients plan for their retirement, and that team should include a lawyer and an accountant, Montgomery added. “Our job as financial advisors is to determine what the client’s financial picture is today and what he wants to happen down the road.”
“If the client’s lawyer and accountant are not tax specialists, bring in a tax specialist,” said Heather Clarke, Winnipeg-based vice president of IG Insurance Services Inc. “Tax rules are complex and subject to change. If a plan is done wrong, it can be costly to fix.”
What happens to the business?
Your SME client needs to ask himself whether his business will be sustainable in coming years, said Terry Zive, president and financial advisor at Zive Financial Inc. in Toronto. “Will it still be a vibrant entity 20 years from now?
“If it looks like it will be,” he said, “it is never too early to put the components for succession in place. The owner needs to identify the skill sets required to drive the business forward. And not only the skills but also the chemistry – the attitude and passion – that is right for this kind of business. For example, an individual can learn the technical side of the insurance business but if he doesn’t like people, he’ll never succeed in the industry.”
After identifying the skills and the chemistry that are needed to run the business, Zive said the owner will need to determine if there are people in the family that have them. “Or will he have to look outside the family?”
Some business owners opt to stay on as managers when they can no longer do the physical work some businesses require, Montgomery said. “They get younger legs to do the work, but even these owners will probably want to leave at some point. Some expect their children to take over, and they may not realize that the kids aren’t interested in the business.” He said SME clients should consult with everyone who is involved in the business, especially those they would like to run the business.
If an adult child is interested in taking over the business, the client can gift it to this individual, Knodel said. “But if the client needs money from the business, he will have to sell it to the child.”
An estate freeze is one way to handle the transition of an incorporated business to a younger generation. “Say the patriarch wants to retire from a business that is valued at $10 million and there are adult children who want to run it,” Zive said. “He exchanges his common shares for preferred shares, which are frozen at the fair market value of $10 million, and these are used to fund his retirement. New shares are issued to the adult children, and new growth in the business will accrue in their hands.
“The timing of the freeze is important,” he added. “If it takes place too early and the kids turn the business into a huge success, the business could be worth $100 million, while the patriarch is left sitting on the side with this $10 million in preferred shares.”
Selling outside the family
If your client decides to sell the business to a third party, Safar said he may have put a management team in place, “and preferably a team made up of younger people. The business may run fine when your client is there but it may unravel when he leaves.”
Tax-planning is the key component in selling a business, he said. “You want your client’s gross to be as close to his net as possible. If he sells the business for $5 million, you’d like to see him pocketing $5 million. So you need to create a structure that will allow as tax-efficient a sale as possible.”
Plans will have to be set in motion well in advance to ensure that the business is eligible for the $800,000 lifetime capital gains exemption to which Canadian taxpayers are entitled on the sale of qualifying small business corporations. And the exemption which will be indexed for inflation starting in 2015. “This can go a long way in funding your client’s retirement,” George said.
To be eligible for the exemption, at least 90% of the business’s assets must be used for carrying out active business in Canada. “Planning may be required to ‘purify’ the business by removing assets that are not used actively in the business, perhaps putting them into a holding company,” Montgomery said. “This is where the services of a tax accountant come in.”
And to qualify for the exemption, shares in the company cannot be owned by anyone other than your client or a member of his family during the 24-month period prior to the sale. “The $800,000 capital gains exemption can also be applied to other family members who hold shares in the business,” Safar said, and an estate freeze, through which they are issued new shares, will allow them to take advantage of the exemption. Again, the timing of the freeze is important. “It has to be done well in advance of the sale to build value in the hands of the relatives. And to allow them to hold the shares for at least 24 months.”
A family trust is established at the time of the freeze, and sometimes also a holding company. Members of the family and the holding company are the beneficiaries of the trust. “The operating company can pay dividends to the trust,” Knodel said, “and the trust can allocate and pay these to any of the beneficiaries including children over 17 years of age. The dividends are then taxed in the hands of the family members.”
A family trust, he noted, can be a tax-efficient way to fund children’s education. “Children who receive dividends from the trust will pay little or no tax because they have little other income.”
Dividends that are allocated to the holding company flow into it tax-free, he added. “The holding company can invest this money or pay dividends to shareholders who are usually the parents of the child beneficiaries.”
If the client has placed assets that are not actively used in the business into the holding company, he can draw upon them in retirement in the form of dividends. “The client can keep the holding company when the business is sold,” Safar said.
Note to readers: This is an article in a series by Rosemary McCracken on how financial advisors can help their business owner clients.