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.
This is the continuation of the list of the most important tax and estate issues most entrepreneurs may face. Here are the first five items addressed in the prior column, and the list continues below:
- Failure to incorporate – Slowing business growth
- Failure to incorporate – Losing tax-free capital gains value
- Failure to incorporate – Exposure to creditors
- Holding investment money in a small business corporation
- Paying personal expenses out of a corporation
Continuing on …
6. Not protecting wealth using one’s spouse
While a couple may consider themselves as one family unit, every person is a separate legal entity. This is particularly important when one considers exposure to creditors
Entrepreneurs can take the simple step of transferring assets into the name of a spouse in order to distance those assets from creditors. As long as this is not done in an attempt to defraud creditors or as they are otherwise standing at the door, the exercise will have its intended effect.
Should there be a later marriage breakdown, the fact of the assets being in one or the other spouse’s name does not affect one’s entitlement to the value of those assets, at least in principle. Not surprisingly those going through such a breakdown are not always so co-operative, meaning that these steps should only be taken with the benefit of informed professional guidance.
7. Failure to protect against the loss of a business to taxes at an owner’s death
The shares of a corporation are capital property to a shareholder, and at that shareholder’s death those shares will be deemed disposed for tax purposes. If the shareholder’s children are the beneficiaries of the shares, the tax liability may be sufficiently onerous that the business itself will have to be sold or mortgaged to pay the taxes.
Where there is a spouse, those shares can be rolled over to defer taxation. As a practical matter however, the spouse is often unable to continue the business, and therefore it may have to be sold anyway, then giving rise to the taxation. The problem is exacerbated where the spouse may need to sell quickly and therefore may not get the best price for the business.
The simplest strategy to assure that the tax liability does not either force sale or impose a heavy debt burden is for insurance to be carried on the life of the shareholder.
8. Having no exit strategy from a business
Few people build a business for the sake of the business itself – generally it is a means for building and holding wealth to benefit oneself and one’s family.
Where there are multiple owners of a corporation, the usual expectation is that when an owner departs or dies, one or more of the others will buyout that interest. To be assured that this will be carried out, the owners would be well advised to execute a buy-sell agreement detailing what is to occur
Beyond the execution of the agreement, it is critical that there be sufficient funding to carry out the commitments at the appropriate time, especially for the sake of the spouse & family of a deceased shareholder. In that respect, life insurance is the simplest and generally the most cost-effective means to put the funding in place in the exact amount and at the exact time when it is needed.
9. Paying for business needs insurance personally rather than corporately
Where insurance is needed to pay for taxes at a shareholder’s death and/or to fund the transfer of the shares of that deceased shareholder, such insurance may be held personally or corporately.
While there may be factors encouraging one to own insurance personally, for premium cost reasons the insurance is often held corporately.
A corporation cannot deduct the cost of insurance premiums so it is using its own after-tax dollars to pay premiums. Alternatively, shareholders could receive taxable dividends out of the corporation in order to pay the premiums personally. Thus no matter how small the dividend tax (which can be over 30%), less insurance would be able to purchased personally than corporately.
Of course the difference in cost would be for naught if the eventual insurance proceeds were worth different value. In fact there is a corporation mechanism called the capital dividend account which can be used to preserve the tax-free status of insurance proceeds to flow out to a spouse and other estate beneficiaries.
10. Double taxation of capital assets
The shares of a corporation are capital property to a shareholder. In turn, the corporation may itself own capital property, and the value of the shares held by the shareholder will in part relate to the value of those underlying assets. Tax will be payable on the capital gain on share value when the shareholder disposes of the shares or when there is a deemed disposition such as at death.
At death then, the shares will flow to the deceased shareholder’s estate. When the estate later causes the corporation to sell the underlying capital assets (to wind up the business and distribute the estate), the corporation will pay tax on those same capital gains that the deceased paid indirectly on the share value increase.
All is not lost here – Steps can be taken in advance to plan against this result, and estate elections may also be possible post-mortem to minimize the damage.
Along the lines of “a penny saved is a penny earned”, a guiding principle in estate planning is that “tax delayed is money earned”.