Note to readers: This is the first in a series of articles by Rosemary McCracken on how financial advisors can help their business owner clients. This series will be published over the next few months in The Insurance and Investment Journal.
Clients who intend to establish their own businesses have many considerations to make in the planning stages, and their financial advisors can make a big difference to the success of these ventures. Smaller businesses have unique financial planning needs.
According to Industry Canada, 98% of Canadian businesses are small- to medium-size enterprises (SMEs), with between one and 100 employees, and 48.3% of the Canadian workforce is employed by small businesses.
But not all SMEs make it. A recent BMO Wealth Institute Survey, Entrepreneurs: Definitely Not Your Ordinary Business Owner, says only 51% of small and medium-sized businesses survive to the five-year mark. The odds of survival fall each year after that.
“Entrepreneurs who make it plan ahead,” said Grant Black, BMO Bank of Montreal’s Halifax-based vice-president, commercial banking, for Nova Scotia.
Heather Clarke, Winnipeg-based vice president of IG Insurance Services Inc., suggested that financial advisors also invite their clients’ lawyers and accountants to the planning table. “And if the lawyer and accountant are not tax specialists, bring in a tax specialist,” she said. “Tax rules are complex and subject to change. If a plan is done wrong, it can be costly to fix.”
The business structure
Planning ahead starts with deciding on the structure the business will take. “Choosing the right structure is a huge decision that will have consequences for the business owner and the business, said Wilmot George, director of tax and estate planning at Mackenzie Investments in Toronto. “The most common business structures are sole proprietorships, partnerships and corporations.”
Sole proprietorships. Sole proprietorships are businesses that are essentially an extension of the business owner, who reports the business’s income on his personal tax return. “They are the choice of most new business owners,” said Black, “because they are easy to set up and cost-effective. The owner doesn’t have the expenses of incorporating.”
“It’s not uncommon for a business to see losses in the early years,” George added, “and those losses can be used to offset the proprietor’s other income, thereby reducing the taxes owed.”
The disadvantages, he said, are unlimited personal liability. “If somebody sues the business owner or creditors come after him, his personal assets may be exposed.”
A mistake that sole proprietors sometimes make, noted Aurele Courcelles, Investor Group’s Winnipeg-based director of tax and estate planning, is failing to distinguish between their personal expenses and their business expenses. “They need to set up separate bank accounts and separate credit cards for the business so that they can justify their business expenses to the Canada Revenue Agency.
“They can register a name for the business without incorporating,” he added, “but they will need to do their homework and find names that are not already registered.”
Partnerships. Businesses with two or more partners benefit from the pooling of financial resources and multiple skill sets, Black noted.
Like a sole proprietorship, the partners each report their share of the business’s income or loss on their personal tax returns, Courcelles said. “A partnership should also have its own bank account and credit cards.”
The partners share liability, George noted, “which can be an advantage. It can also be a disadvantage because they can be financially responsible for another partner’s mistakes.”
Differences of opinion among partners can pose problems. “The partners need to draw up a partnership agreement that sets out a decision-making process, what would happen if a partner should die or decide to leave the business, and what would happen if new partners are added,” Courcelles said.
Incorporation. Incorporating a business means setting up a separate legal entity. “The owner,” Black said, “becomes a shareholder, and the corporation files its own corporate tax return.”
There are several advantages to forming a corporation. “It limits personal liability. Creditors can typically only gain access to corporate assets,” George said, “unless the shareholders give personal guarantees – which some financial institutions may require for loans.”
Corporations also provide opportunities to defer tax on business income that remains in the business and for capital gains exemptions when the business sells it shares.
They also provide income-splitting opportunities, Courcelles noted. “A spouse and adult children can be added as shareholders, and they can be paid dividends.”
Corporations can ensure a business’s continued existence, he added. “A corporation does not cease to be after the death of its founder, whereas a sole proprietorship dies upon the proprietor’s death.”
The downside is the cost of incorporating, maintaining corporate records and preparing corporate tax returns. “But the advantages,” George said, “may make these costs worthwhile.”
One major advantage of incorporating a small business is the small business deduction, created to stimulate small business growth. Active business income – income from providing goods or services, not a business’s investment income – is taxed at preferential tax rate, up to an annual income limit. “Currently the federal tax rate on the first $500,000 of active business income is 11%, and the provinces and territories will apply their own provincial tax rates,” George noted. “On average, the combined federal and provincial tax rate on active business income is about 15%.”
Income from sole proprietorships, on the other hand, is taxed at the owner’s personal rate, which may put a business owner into a higher tax bracket.
George said business owners should ask themselves the following questions when choosing a business structure:
Are you concerned about personal liability? Do you have family members in the business? Do you need to spend everything you make or can you leave some money in the business?
Special considerations for family businesses
Family businesses are those in which multiple members of the same family are involved as major owners or managers. The Canadian Association of Family Enterprises estimates there are about 900,000 family businesses in Canada.
“They are a vital part of the Canadian economy,” said Paul MacDonald, CAFE’s Oakville, Ont.-based executive director. “Many families see their businesses as a legacy that they want to pass on to future generations. This makes them willing to put time and hard work into building them, and gives these businesses a competitive advantage in the marketplace.”
Sarah Adams, RBC’s Toronto-based vice-president, small business, provided the following suggestions on how to get the best out of a family business:
Separate family time and business time. Family-run businesses, in particular, need to keep that balance. “Everyone needs time away from the business to recharge,” Adams said.
Define the roles of different family members in the business. “Family relationships come with pre-defined roles that can carry into the business. Take each other’s strengths and weaknesses into account, and clearly define each member’s business role.”
Have a support network in place outside the family to which you can turn for advice. “Family members usually have similar backgrounds and similar thought processes. Sometimes you need outside, unbiased advice to work through a problem.”
Create a plan for conflict. “There will be times when family members disagree on a business decision. Anticipating this and having a plan for how you will work through it is half the battle. The worst thing you can do is let a disagreement blow up in front of staff, or at home with your family.”