Small business – Page 6

Trusts and small business corporations – Flexibility in family wealth management

The trust has existed under common law for centuries and can be devoted to a wide variety of purposes. In essence, a trust structure separates legal ownership of property from beneficial ownership. In the hands of a business owner, a trust may likewise be applied for many purposes, but the focus is often on tax results.

For that business owner, the property in question consists of shares of a business corporation, with the trust beneficiaries being a combination of spouse, children and possibly extended family members. The business owner would generally be cast in the role of trustee – often with one or more other trustees – having the ability to legally manage the shares on an ongoing basis.

Though not exhaustive, summarized below are a number of key benefits of this arrangement. Circumstances will dictate whether and to what extent this may impact a particular individual or business, and therefore, consultation with qualified tax and legal professionals is a must before acting upon any of this information.

From an income perspective:

Shares may be structured in such a way so dividends can be paid to the trust as a shareholder. In turn, the trustees will have the power to manage the distribution of dividends to the trust beneficiaries. As a flow-through from the trust, beneficiaries receiving dividends will generally be entitled to the dividend gross-up and tax credit.

The effective tax rate on Canadian dividends is less than it is for regular income (e.g., interest and registered plan income), and can even be lower than the rate for capital gains, particularly for those individuals not in the top income tax bracket. There is actually a level where a taxpayer will pay no tax on the dividends if that person has no other income. For ineligible dividends (where the prior corporate income benefited from the small business deduction), the ‘tax-free’ dividend level ranges from a low of $7,000 to about $35,000, depending on the province.

Note that an anti-avoidance measure (known colloquially as the “kiddie tax”) effectively negates the preferential tax treatment of such dividends paid to minors related to the business owner, whether directly or via a trust. This measure may also apply to capital gains if dividend payments have been withheld on the shares.

From an ownership perspective:

Generally, capital gains on business corporation shares will be realized on disposition at the business owner’s initiative, or possibly deemed so upon that person’s death. One or more trusts are often components of an estate-freezing exercise whereby eventual capital gains on these shares are sought to be pushed to younger generations. The freeze can be implemented by changes in beneficial ownership that may involve absolute transfers or may instead make use of intermediate vehicles, such as further corporations and/or trusts.

In addition to the capital-gains-freeze aspect, the concurrent purpose of this exercise is to multiply access to the lifetime capital gains exemption on qualifying small business corporation shares. The exemption (proposed to increase from $750,000 to $800,000 pursuant to the 2013 Federal Budget) is a per-person entitlement and can be structured using one or more trusts so the tax benefits can be achieved without the business owner losing control of the enterprise.

From a protection and control perspective:

Subject to share provisions and/or a shareholders’ agreement, direct share owners generally have full ownership rights. Even when in a minority position, securities legislation may entitle a shareholder to require a corporation to take actions contrary to the controlling majority’s wishes. By separating beneficial from legal ownership, a trust can help the business owner achieve wealth- and estate-planning ends while muting business complications that might otherwise arise.

In addition to being subject to attack from others, property owned directly by an individual is exposed to the individual’s own frailties. A trust can provide a greater degree of insulation against present and future risks and uncertainties, such as creditor claims, matrimonial disputes, mental incapacity or the death of that individual.

Tax talk on the dock – 5 planning points for an investing skeptic

I had the opportunity to catch up with an old friend by a dock earlier in the summer.

He is a true entrepreneur who took a calculated risk, established a successful business, sold to a multinational, had a brief retirement (at age 40) and a few years later is looking for the next challenge.

With those buyout funds in hand, he observed the recent economic turmoil with much skepticism about market investing. Actually he was a skeptic well back in time, and those funds never left the safety of his bank account. Even so, he knows he can’t remain on the sidelines forever.

So as summer comes to a close, here is what we threw about, apart from the horseshoes and mosquito swatter.

Run a business, if you are so inclined

My friend firmly believes that true wealth is built through active business management. And given his track record, I can’t disagree that a well-run enterprise can net impressive results – emphasizing the requirement to be well-run.

In actuality, he is something of a zealot when he extols the virtues of running a business, and more specifically the benefits of running a business through a small business corporation. He is living proof of the value of the small business rate, spousal income splitting and the lifetime capital gains exemption. Heck, he almost bubbles over in recalling the joys of a well orchestrated salary-dividend mix.

However, running a business is more than merely a financial decision, whether tax-driven or otherwise. In many ways, it’s a lifestyle choice, and has to be undertaken with that aspect clearly in focus.

Kill the mortgage

There is perhaps no more clearly predictable rate of return on applied money than to eliminate a big debt like a mortgage. Somewhat ironically, that kind of arithmetic certainty dovetails well with the more nebulously measured emotional comfort of being mortgage-free. Hey, it’s your home.

In his case, he had already achieved this prior to the business buyout.

That’s not to say that he was pursuing mortgage retirement to the exclusion of retirement savings. Rather, he placed more proportional emphasis on the mortgage than any raw calculus might explain.

Now being free of that debt burden, he is committed to becoming more knowledgeable and effective in fashioning his retirement income plan.

Getting 20% upfront on your RESPs

As people within the financial service sector, sometimes we forget that those outside the field have things on their mind other than the nuances we see much more regularly.

For instance, my friend was not even aware of the 20% Canada Education Savings Grant he was receiving on his RESP contributions. Thus, he was only contributing paltry amounts well below the $2,500 limit upon which the current year’s entitlement would be maxed out.

On the positive side, now that it is possible to pick up past years’ unused room, he will be able to get up to $1,000 CESG annually by putting in $5,000 for each of the kids until he catches up. Yes, he’s the same skeptic about market investments, but that’s a whopping tax/support benefit left on the table if that CESG is not unclaimed.

It remains to be seen whether he is inclined to make any further use of the RESP tax sheltering room beyond the CESG entitlement thresholds.

We differ on life insurance

While we are roughly on the same page that life insurance is a top priority matter for income replacement purposes, beyond that we diverge a bit.

He waffles on what to do with current life insurance, given the lack of an income replacement need. In not so many words, he defines that need in terms of whether his family would suffer a drop in lifestyle should he be removed from the equation. In that context, I agree that he does not need to replace income.

That said, terminal taxes and final debts loom, distant though they may be in the future. A tax-free death benefit may make sense to service that eventuality. Past premium payments are water under the bridge, and future premiums continue to be priced based on an earlier age.

A consideration of the internal rate of return of continuing premium payments may prove fruitful. That’s the kind of analysis an entrepreneurial business mind can appreciate.

Do the Wills

Actually they have done their Wills, but that was well before the business came to together and was later harvested.

The tax benefits of testamentary trusts may have been a passing topic in those earlier estate planning discussions, but now the benefits are very real – for the couple, the kids, and who knows who or what may come up in summers ahead.

Family business succession

The succession of a business is often the last thing on an owner’s mind, or at least the last thing that the owner wants to deal with.

Unfortunately, as with death and taxes, the transfer of a business is an inevitability that cannot be escaped – and it’s those same two former issues that make the transfer so critical to plan effectively.

Of even more immediate and personal impact, unless an owner intends to travel to the great beyond directly from the shop floor, a well considered succession plan is essential to enable the owner to ease into a stress-free and financially secure retirement.

Ultimately the goal is to provide certainty – either at retirement or death – about who will succeed to the business, and how and when that process will be carried out. The key is to be prepared.

Preparing the successors

Selecting a successor involves a combination of commercial and emotional considerations.

Particularly for a family business, the succession plan is intimately tied to the owner’s estate plan. The owner must not only decide on the appropriate successor(s) but also be prepared to deal with those who are not chosen, and the possibility that the business will have to be transferred to management or sold outright to strangers.

Some issues to consider:

How should family and management be involved in the succession decision?
How and when should the decision be communicated?
How will the estate be equalized for the non-successor(s)?

Once the decision has been made and communicated, the job of preparing the successors begins. Depending on the nature of the industry and on the style of the existing owner, the transition can take weeks, months … and often years.

Clearly, leaving the succession to chance exposes the business to a level of risk that could result in unintended results, and possibly a total loss of the enterprise.

Preparing the business

The most effective succession plans flow naturally from the existing business. A seamless ownership transition can be facilitated by conscientious record-keeping, people-independent management systems & policies, and general good organization.

An acid test for the owner is to consider what would happen if that owner were to take an extended vacation for 3 to 6 months,

If the business’ operations are significantly impaired or would grind to a halt (or if the owner gets no sleep while away), it is likely that the only thing to be transferred is a job obligation
If the business remains pretty much intact, there is a true business opportunity to be passed along

To the extent then that the business preparation fundamentals are in place, the time required to transition the business to successors will be minimized, and the chances for success will be maximized.

Preparing the transaction

Essentially the agreement of purchase and sale is a formal legal record of the business decisions that will have already been made during the foregoing preparation stages.

For many owners, there is a certain amount of comfort gained by knowing the general content of such a document. It covers things such as:

Identifying parties, relationships among them and relationship to the business
Statement of the transaction subject matter, price determination and payment method
Parties’ representations about themselves and commitments to one another
The closing agenda, including conditions, time, place and documents to be delivered
General legal provisions to give effect to the agreement

Finally, as with many matters in life and in business, the best laid plans can go for naught without the financial wherewithal to see them through to conclusion. Whether it is by sinking fund, insurance or a combination of the two, the job of preparing a business for succession is not complete until succession funding is arranged.

The bottom line

Planning a succession can be the most challenging business task an owner can face, but it need not be a daunting one. Knowing these fundamental steps can allow an owner to maintain business as usual for now, for retirement, for life and beyond.