Please find below simple to follow ideas regarding three fundamental aspects of wealth planning: tax planning; estate maximization and retirement planning; and investment management.
Tax planning
As a growing small business owner when is the right time to incorporate? What are the benefits of incorporation? When should a business incorporate? Can a business owner split income with a spouse? Or how should an owner invest the money in the corporation? Incorporated businesses offer three major benefits, which include tax deferral, income splitting and sale of a business.
Tax Deferral
Using a corporation provides tremendous tax deferral opportunities as the tax rate on the first $400,000 of active business income in a corporation is just 13.5% (2010 – BC). It is precisely this smaller business rate that’s crucial to the viability of incorporation, especially when it is compared to the top personal rates in BC – 43.7%.
But tax deferral exists only as long as the owners are able to leave some money in the corporation. When they pay themselves a dividend, there’s a second layor of tax, which brings the total up to roughly the top marginal rate in each province. So if a business owner uses up all their cash flow for personal living expenses, the benefit of incorporation is reduced if not eliminated.
Income Splitting
Tax deferral is key, but not the only reason a business owner would benefit from incorporation. Another incorporation advantage is income splitting – one of the most effective ways of minimizing tax liability. But the correct circumstances need to be in place, because in certain instances it might be inappropriate to initially structure the share capital of a corporation that’s needed to accomplish an income split.
Take for example when a new business is started and its success is uncertain. Ideally, income splitting is done after the corporation has existed for some time, and is generating enough income to justify an income-splitting arrangement. The attribution rules are a hurdle that must be surmounted before a successful income-split arrangement is achieved. A properly structured corporation will allow spouses who are in a low tax bracket to receive dividend income, resulting in a lesser total tax liability as compared with what the owner/manager would pay had he or she earned all the income personally.
Sale of a business
The Lifetime Capital Gains exemption on the sale of a small business corporation (SBC) is currently $750,000. Strategies that business owners should consider in order to take advantage of their allowable remaining capital gains exemptions are:
- Consider crystallizing this exemption to preserve future potential tax benefits; and
- Plan to reduce the CNIL (cumulative net investment loss) balance before selling a capital asset in order to maximize the capital gains exemption.
Estate Maximization
For most business owners, the company is their largest asset, and they depend on it for retirement cash flow. One of the simplest forms of estate planning is a valid and up-to-date will.
Intestacy
Dying intestate, (without a will) means assets will be distributed according to a pre-defined intestacy schedule. Each province has statutory rules, which govern who gets what, and they are very inflexible. Rarely do the rules governing distribution of assets consider the needs of the deceased’s beneficiaries or how they would like the estate to be handled.
So if a business owner suddenly dies, the shares of his or her corporation will for part of the estate. And in the absence of a will, there’s no provision, to leave the company shares to a spouse, and benefit from the spousal rollover. The end result will likely be a massive capital gains tax will have to be shelled out.
Multiple Wills
The use of multiple wills was first recognized in Ontario by the Courts in Granovsky versus Ontario, a case in which Phillip Granovsky died leaving two wills. The primary will dealt with all of his property except for shares of certain private corporations. The assets excluded from the primary will totalled nearly 25 million, and were dealt with in a secondary will, which was not submitted to probate. Consequently no probate fees were paid on the value of the assets governed by that will.
This precedent made it non-necessary in Ontario (and certain other provinces) to obtain probate when dealing with shares or debt obligations of private corporations. The secondary will need not be submitted for probate, which means the directors of the company may transfer shares through the corporate resolution (the company directors deal with the transmission of the shares and are prepared to deal with the estate trustee or trustees).
Retirement Allowances
Incorporated business owners have the advantage of paying themselves a retirement allowance before they retire. If they have been incorporated since 1996, they should consider making a corporate resolution, which states that the company is going to pay out an allowance when the owners retire. Having this resolution already on file means it will be no problem to pay this out in the future.
Investment Management
Interest Income
There is no tax-deferral advantage to earning investment income inside a corporation. In fact, in most provinces, a tax cost results once tax is paid at the corporate level and also at shareholder level after a dividend is distributed. Investment income is subject to a refundable tax on interest and other investment income in a Canadian Controlled Private Corporation. These refundable taxes are paid back to the corporation only when it has paid out sufficient taxable dividends.
With the addition of this refundable tax on investment income, interest income is taxed at close to 50% in most provinces. Due to the higher tax rate associated with interest income, you the incorporated business owner should consider keeping interest income to a minimum, while concentrating on investing for capital gains, particularly deferred capital gains, such as corporate class mutual funds. Corporate class funds are an excellent investment option while business owners are in the accumulation phase of life.
Eligible Dividend Income
Eligible dividend income earned in a corporation retains its character and can be paid out to shareholders – the 33.3% Part IV tax that dividends are subject to is refunded entirely to the corporation when the dividend is subsequently paid out to shareholders.
This dividend income is taxed at the investor’s marginal tax rate (subject to preferred rates for eligible dividend income). For business owners who are at the stage where they’re living off the investment income in their corporations, investing to earn eligible dividend income is a great option.
Tax-Free Capital Dividends
The capital dividend account (CDA) is a notional account that accumulates the untaxed portion of net capital gains as well as any insurance proceeds paid to a corporation. A general recommendation would be for a corporation to pay out a tax-free dividend when the CDA has a positive balance. Even if a business owner does not need the funds, it makes sense to crystallize this account when the balance is positive, so that future capital losses won’t reduce or eliminate the CDA account. The business owner can then loan these funds back to the corporation as a shareholder loan. The shareholder loan account can be accessed if cash is needed at a future date – an advantage since such loans can be drawn down tax free to the shareholder.
Another advantage of shareholder loans is that debt outstanding at the time of death can be included in the secondary will, avoiding probate. Works Cited - Advisors Edge Magazine
