Tag: Succession

Ten lost tax and estate planning opportunities for entrepreneurs – Part ONE

Entrepreneurs are often so focused on their expertise and wares that they fail to adequately plan how to structure the business itself.  In particular, a failure to make use of a corporation and to careful monitor its operation can lead to significant forgone benefits and potential liabilities.

Though not exhaustive, this list covers the bulk of the most important tax and estate issues most entrepreneurs may face.  Five items are presented below, with a further five in next month’s column.

1. Failure to incorporate – Slowing business growth

If a business is run as a sole proprietorship, the owner of the business will be personally taxed on the income, ranging from 39% to over 50% at top bracket depending on province.  After-tax, this means that the amount available for reinvestment in the business annually is almost half or less than what was originally earned. 

By comparison, a small business corporation is entitled to a flat rate of tax below 20% on its first $500,000 of active business income. (The provincial tax threshold is only $400,000 in Manitoba and Nova Scotia.)  When the accumulated income (the retained earnings) is reinvested in the business, each dollar the business earns will generate in excess of 80 cents in useable capital.

2. Failure to incorporate – Losing tax-free capital gains value

A business earns income from year to year, and it also grows in value itself to the extent that earnings are retained within it.  If the business is run as a sole proprietorship, upon sale the owner will have to pay tax on the growth in the business’s value, which is the capital gain.

By comparison, every person is entitled to a $750,000 exemption from tax on the capital gains associated with small business corporation shares. (Heading up to $800,000 in 2014, and indexed annually thereafter.)  Accordingly, if the same business is run as a qualifying small business corporation, the owner can save in the area of $150,000 or more in tax on the disposition/sale, including a deemed disposition on death.

3. Failure to incorporate – Exposure to creditors

Launching a business is often a risky endeavour in at least two respects: 

  • Exposure to banking and trade creditors who have provided financial backing to the enterprise
  • Exposure to liability claims under contract and tort (eg., negligence) in the normal course of business operations

If a person runs a business as a sole proprietor, both of these liabilities will be imposed directly upon that person, and his/her assets will be subject to claim by such creditors. 

A corporation is a separate legal entity from the shareholders who own it, and therefore liabilities that arise within the corporation do not flow up to the owners of the corporation, with some fairly rare exceptions.  Unless the shareholder has executed personal guarantees on behalf of the corporation or has otherwise personally acted in a way to attract liability, the only personal asset at risk for the shareholder will be the investment in the corporation itself. 

4. Holding investment money in a small business corporation

The small business tax rate is only available on a corporation’s active business income, being earnings generated from its actual commercial activities.  By contrast, passive income arises out of excess corporate cash being placed in portfolio investments, including bank interest, GICs or marketable securities.  

Passive income is taxed at the regular corporate rate, and it is also charged an additional refundable tax that results in a total immediate tax payment close to 50%.  Rather than face these complications, a shareholder may be content to dividend that excess cash, pay the tax on the dividend, and invest the net funds personally.  

Alternatively if the owner would prefer to defer making those dividends, careful attention should be paid to the type of returns generated on those continuing corporate-held investments.  Generally this means an inclination toward tax-deferred returns such as unrealized capital gains, or making use of the sheltering capacity of exempt life insurance in qualified circumstances.

5. Paying personal expenses out of a corporation

A corporation is a separate legal entity from the shareholders who own it.

A small business owner who ignores this fact and pays expenses with corporate money is in for a rude awakening.  Such payments will likely be deemed as shareholder benefits, and be taxed at the shareholder’s marginal tax rate.

The proper procedure would be to dividend the money from the corporation to the individual.  The net effect of the gross-up and tax credit procedure is an effective tax rate about a third less at top bracket, and significantly lower at more modest bracket levels.

Here is what is coming in Part TWO:

6. Not protecting wealth using one’s spouse

7. Failure to protect against the loss of a business to taxes at an owner’s death

8. Having no exit strategy from a business

9. Paying for business needs insurance personally rather than corporately

10. Double taxation of capital assets

Battle over book succession – Brokerage and advisor’s estate face-off

About a decade back, part of my business role included acting as a kind of matchmaker and consultant with financial advisors looking to acquire or transfer a book of business.  The individuals and situations ran the gamut of readiness from systematically prepared down through wishful thinking, with two circumstances that have stuck in my mind ever since.

In the first case, a blueprint was in place a decade ahead of planned departure.  Two costly and time-consuming failed mentorships later, the exasperated advisor stood at the precipice of retirement, ready to jump at almost any expression of interest that might materialize. 

In the other case, the advisor was begrudgingly considering selling, having observed a stream of her contemporaries leave the business.  Not convinced of the economics of selling versus maintaining licensing and a minimal staff, she went on vacation to contemplate the options.  She died on vacation, and by the time the estate was ready and able to address it a few months on, the book had plummeted to a fraction of its previous going concern value.

Somewhere in the intersection of these two predicaments lies the reported – and as yet unresolved – case of the estate of investment advisor Allen Eisen.

Planned succession frustrated

Allen Eisen joined Union Securities in 2009, executing an employment contract that included a transition payment for migrating clients over from his previous employer.  The contract included a provision that “[a]ll accounts opened by you will be owned by you and may be sold within the company at the time of your choosing, subject to current policies and procedures.”

A supplementary letter a month later allowed Mr. Eisen to employ his son as his assistant.  The son was in the midst of obtaining required licensing, with the apparent intention for son to follow in his father’s footsteps and eventually take over the practice.

Allen Eisen died in early 2010. 

Lawsuit over book valuation and compensation 

Pursuant to its regulatory obligations Union appointed another advisor to supervise the book.  The son continued to be employed as assistant, with Union’s commitment that he could take over the book upon obtaining appropriate qualification.  He never obtained the licensing and left his employment a few months later.

The supervising advisor also left the firm a few months later, taking at least one of those legacy clients with him.  Union itself was sold to a new firm, and eventually the Eisen Estate filed a lawsuit against Union and the succeeding advisor for an accounting and compensation for the property value of the book.

Motion for dismissal dismissed

The Defendants took the position that as an estate could not be licensed, Union must be the owner after the advisor’s death in order to comply with its regulatory oversight obligations.  It was however conceded that Eisen had the ability to deal with the accounts while living.

A generic Union employment policy document found among Eisen’s personal papers similarly stated that all accounts of a deceased advisor belong to Union.  It was not clear how Union applied this policy generally, nor if, when and how it may have been incorporated into the Eisen-Union relationship.  Even so, this emboldened the Defendants’ claim to sole ownership without requirement for compensation, unfair though that may appear.  

The Estate countered that the specific employment contract terms in the 2009 letters superseded the generic policy.  Concurrently, the Estate contended that the Defendants’ reliance on the generic policy would entail an inherent contradiction in that the policy asserts Union as sole owner of the accounts at all times, despite the explicit statements in the 2009 letters and the Defendants acknowledgement of Eisen’s lifetime right to sell.

On a Defendant motion for summary judgment brought in February 2013, the judge found that “[a]s a matter of legal logic, neither side has a legal argument that trumps the other.”  On one hand, the Defendants are right that an estate cannot be licensed.  On the other hand, the Plaintiff Estate is correct that trading authority is distinct from property rights and that there is something nonsensical about such property rights evaporating on death.  

The judge ruled that full discoveries and a trial would be required to obtain a full appreciation of the evidence sufficient to dispose of the issues. Notably, it cost the Defendants about $15,000 in costs for the failed motion.  Whether the litigation progresses to full trial now goes back into the hands of the parties.

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.