Succession Planning: Taming your tax liability

Further to my previous entries on succession planning, family trust, estate freeze here is a great article written by Alexandra Lopez-Pacheco from the Financial Post.

As usual, If you have any questions, please do not hesitate to contact me.

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Taming your tax liability

To ensure the best possible conditions when a business owner is ready to pass the helm to the next generation, succession planning can maximize the company's value from the start. That's why it's never too early to begin the process, although typically many wait until three to five years before they plan to retire - and even more wait until it's too late. Developing a long-term strategy that will ensure a company's sustainability, independent of the owner, and over years enrich the skills, abilities and experience of those chosen to be the next leaders makes the company more valuable, as well as provide more retirement funds for the owner.

Part of this process is a solid tax strategy. The longer a company engages in astute tax planning to minimize its tax bill, the more money will stay in the business, as well as in the owner and his family's pockets, leaving more funds available for the next generation to buyout the owner.
According to tax specialist Paul Woolford, partner with KPMG's enterprise services, most small businesses are doing a pretty good job with accounting, but a large percentage of them are not taking advantage of all the tax-minimizing strategies available to them. And no wonder, every time there's a new federal or provincial government budget, the rules seem to change. This is where, of course, a good tax accountant comes in. They not only know the current tax rules but also keep up with new ones. "There are ways to achieve what you want in minimizing the tax bill, but you also have to be very careful to abide by the appropriate rules, and that's something that comes into play when you're looking at estate planning and succession planning," Mr. Woolford says.

When putting together a business tax plan, keep in mind it is necessary to review all possible variations and combinations available to tailor a strategy that will meet the specific needs of the company, its owners and often, his or her family. Many accountants contend business owners should put together their succession plan before the tax plan. What's more, small businesses are often about close interconnections between the owner, his family and the company. From effective use of tax exemptions and deductions, including the $750,000 capital gains allowance, to income-splitting and family trusts - there are many options available to considerably shave down the tax bill if an accountant can see all the pieces of the puzzle.

"I look at the corporation and the shareholders, and look to minimize and defer tax on both levels, and that's often one way of keeping the tax liability down or keeping more money in the company or in the individual's bank account," Mr. Woolford says.

As profit increases and the business becomes more complex, so too can the tax planning. "There are always levels of planning, from the basic planning to the complex planning to the high net-worth situation," Mr. Woolford says. "The idea is to put in a structure. It could be a family trust with beneficiaries that may include your spouse and adult children, for example. There are ways you can pay dividends to that family trust and have that trust allocate those dividends to individuals who may be in a lower tax bracket."

A good plan will cut the tax bill and, if incorporated into the succession planning process, it will also address specific needs related to ownership transfer. For example, if an owner knows he wants to sell the company to his adult child, he might prefer to keep the company's value down to lower the tax liability at the time of transfer. On the other hand, if he is planning to sell to a third party, achieving the highest possible valuation might be a better strategy.

When Bill and Bev Wostradowski were ready to turn over the company they established in in 1978 - Lake Country Building Centre, a building supply business in Lake Country, B.C. - to their son and daughter, they solicited help from their lawyer and their accountant, Bill Corbett, tax and succession planning partner at KPMG in Kelowna, B.C. "We had very good advice from Bill and our lawyer, and we put faith in them that they were going to steer us in the right direction," says Mr. Wostradowski, who is a member of the Canadian Association of Family Enterprise. He used the organization's resources and links to educate himself on the process.

The Wostradowskis chose an estate freeze - literally freezing the value of the shares the couple owned, and issuing common shares to the two adult children who had chosen to carry on with the business, Sherri Williams and Kevin Wostradowski. "That way, the growth and value accrues to the next generation," Mr. Corbett says. It also reduced the senior Wostradowskis' tax liability. Step two was to set up voting shares for the retiring couple.

"My wife and I sold our equity shares in the building supply business to our children and they were to pay us over a period of time, but we still retained voting shares. Then over five years, we gave out a few of the voting shares each year to the point that the children now own them all," Mr. Wostradowski notes. This ensured the couple had enough control should any conflict arise between their son and daughter during the transition.

They also set up holding companies for each of their successors names. By making the holding companies the shareholders, the main business can pay Sherri and Kevin through lower-taxed dividends to their holding companies rather than to them individually. And, in an example of how tax and succession planning can be integrated, this structure also allowed Sherri and Kevin to manage their own share of the profits as they wished. "One could be a saver, the other a spender, and since each had their own holding company, there would be no conflict," Mr. Corbett says.

Another component of succession planning is estate planning, which involves strategies to minimize or defer tax. Not very many people think of consulting their accountant before writing their will - but that's exactly what they should be doing. "An area that sometimes is overlooked is having two wills: a separate will that would hold the shares of your private corporation and then a normal will that contains everything other than your private shares," Mr. Woolford says. "If they only have a single will, then the shares of the private corporation could be subject to probate fees."

Another way of minimizing probate fees is to name beneficiaries wherever possible - for everything from RRSPs to life insurance - or make the intended beneficiary a joint tenant, which would simply mean that upon the death of the owner, the assets would immediately become theirs.

"It is pretty good idea to name your company as a life insurance policy beneficiary," Mr. Woolford says. That ensures there will be tax-free money available to protect a business's sustainability in the case of the owner's untimely death.

These days, the senior Wostradowskis are enjoying the fruit of their five-year-long investment in their succession planning. "The kids are all in a position that they can look out for their families and have their turn at the business, and my wife and I have enough money to travel and enjoy our life. That's all we were interested in," Mr. Wostradowski says.

Commercial Lease: Did you know?

Did you know?

Your Commercial Lease could state the Landlord can move your business or make changes to your Leased Premises whenever he chooses and without compensating you:

Excerpt from a clients Lease before I negotiate a substantial change in this clause:

"Landlord shall have the right, at its sole discretion, and without any obligation whatsoever to Tenant, to make any changes with respect to the Shopping Centre, including the right to relocate the Leased Premises or any portion thereof to another area of the Shopping Centre, and to the extent found necessary or desirable by Landlord at any such time during the term hereof, provided that the Leased Premises, as affected by such change, shall be substantially or close to the same size as defined herein. "

Concern: The Landlord has the right (whenever it pleases) to change, modify, increase, decrease or reconstruct your Premises or move you as many times as he so desires, and without compensating you.

Solution: You need to ensure that you address and negotitate this issue PRIOR to signing your OFFER TO LEASE.

As usual, please do not hesitate should you have any questions.

Canadian Taxes Deadlines - Due Dates

As a business owners, you should be aware of these important dates:

Canadian Fixed Due Dates

January 15 - December payroll remittance
February 15 - January payroll remittance
February 28 - T4 and T5 filing deadline
February 28 - NR4 filing deadline
March 15 - February payroll remittance
March 15 - Personal income tax instalment
March 31 - Family Trust filing deadline
April 15 - March payroll remittance
April 30 - Personal Income Tax Return (regular deadline and interest charges begin for self-employed)
May 15 - April payroll remittance
June 15 - May payroll remittance
June 15 - Personal Income Tax Return deadline for self-employed (penalty deadline only)
June 15 - Personal income tax instalment
August 15 - July payroll remittance
September 15 - August payroll remittance
September 15 - Personal income tax instalment
October 15 - September payroll remittance
November 15 - October payroll remittance
December 15 - November payroll remittance
December 15 - Personal income tax instalment

GST/HST - MANDATORY REGISTRATION

You have to register for GST/HST when you no longer qualify as a small supplier because your total worldwide taxable supplies of goods and services exceed the small supplier limit of $30,000 in a single calendar quarter or in four consecutive calendar quarters. However, you also have to register for GST/HST if you are a taxi or limousine operator whose fares are regulated by federal or provincial laws, even if your revenues do not exceed $30,000.

For more info click here

Holding Company: What Is It and How Does it Work?

Here is a great article written by Rolland Vaive, CA, TEP, CPA - an excellent accountant based in Ottawa (Orleans) and specializing in complicated tax matters.

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Speak to any tax accountant for more than a minute and they'll surely be talking about holding companies, or HoldCo's for short.

A holding company is not a term which is defined in the Income Tax Act. It is a term which is used to define a corporation which holds assets, most often income generating investment assets. It does not typically carry on any active business operations.

A HoldCo can arise for a variety of reasons. In the early 1990's, the personal marginal tax rate in Ontario was slightly higher than 53%, while the corporate rate of tax was considerably lower than that. High income individuals who had significant investment assets could realize a tax deferral by transferring their investment assets to a HoldCo, particularly in situations where they did not need the income which was being generated by the investments. This breakdown between the corporate rate of tax and the personal rate of tax lead to many HoldCo's being formed.

HoldCo's may also come about as an effective means of creditor proofing profitable operating companies, as a result of Canadian estate planning, or as a means of avoiding U.S. estate tax and Ontario probate fees.

Regardless of their origins, the investment income generating HoldCo is taxed in an unusual manner, which I will attempt to explain.

The underlying concept of HoldCo taxation is called "integration". In general terms, integration means that an individual should pay the same amount of tax on investment income if they earned it personally or if they earned it through a corporation and withdrew the after-tax income in the form of dividends. When we look at some real numbers, you will see that this in fact generally holds true. However, it is possible to exploit some breakdowns in integration, at which time it may become quite beneficial to earn your investment income through a HoldCo.

Let's look at the theory. We often hear about how corporations are taxed at low tax rates. In situations where a private company is earning income from active business operations carried on in Canada, that is quite true. In these situations, the rate of tax would be a flat tax rate of 18.620% if the company was resident in Ontario. The other provinces have similarly low rates of tax on "active business income". The low rate of tax does not apply to investment income, which is what the HoldCo would be generating.

For an Ontario resident private company generating investment income, the combined Federal and Provincial rate of tax would be a flat 49.7867% on all forms of investment income, other than dividends from other Canadian corporations. Bear in mind that only 1/2 of capital gains are included in income, so the effective corporate rate of tax on capital gains would be 24.8934%.

A portion of the tax that HoldCo pays each year on its' investment income goes into a notional pool called the RDTOH pool. This is an acronym for "refundable dividend tax on hand". Of the 49% rate of tax that is paid by the corporation, 26.67% will go into the RDTOH pool each year and is tracked on the corporation's Federal tax return. If HoldCo pays a taxable dividend to its' shareholders in a particular year, it gets back part of its RDTOH pool. More specifically, the company will get back $1 for every $3 of dividends that it pays. This RDTOH recovery is called a dividend refund, and would be a direct reduction of the corporation's tax liability for the year. If the corporation pays a large dividend to a shareholder, the dividend refund would also be large and may result in the company actually getting money back from the Canada Revenue Agency. In short, the HoldCo will pay a large tax liability on its investment income up front, but it can get a large portion of it back at a later date if it pays out dividends. The dividend refund is an attempt to compensate for the fact that the dividend will attract tax in the hands of the shareholder. Without this mechanism, the 48% rate of tax on investment income combined with the tax paid by the shareholder on the dividend that they receive would result in an onerous rate of tax.

It is possible that a second notional tax pool may arise in HoldCo if it is generating capital gains on its' investment assets. You will recall that only 1/2 of capital gains are included in income. The other 1/2 portion of the capital gain which is not included in income will get added to the capital dividend account, or "CDA", of HoldCo. The CDA balance is something which needs to get tracked by the company on a regular basis, since it does not appear anywhere on the company's financial statements or tax returns. The CDA is important because it is possible for HoldCo to pay a dividend to a shareholder and elect to pay it out of the CDA balance, making the dividend tax-free to the shareholder. If a company realizes a capital gain of $10,000 , only $5,000 will be included in taxable income, with the remaining $5,000 being added to the company's CDA balance. The company could then pay a $5,000 dividend to the shareholder. By electing to do so out of the CDA balance, the shareholder would not be taxed on the dividend.

Lets look at this in conjunction with the RDTOH balance. If the company pas a dividend to a shareholder out of the CDA balance, it is tax free to the shareholder, but it is not going to generate a dividend refund to HoldCo. HoldCo only gets a dividend refund if the dividend is a taxable dividend to the shareholder.

Armed with this theory, we can look at a live example of how this would work. Lets consider the example of an Ontario resident individual who is holding shares that have an adjusted cost base (i.e. tax cost) of $1,000. These shares have experienced a dramatic increase in value, and are now worth $100,000. The individual is going to sell these shares and would like to know if there is any advantage to doing so through a HoldCo. The individual is in the highest marginal tax rate (currently 31.310 % on Canadian source dividends and 46.410 % on everything else). The individual wants the after tax money, so they would withdraw everything from the HoldCo once the shares are sold. If they were to go the HoldCo route, they would elect to transfer their shares to HoldCo at their $1,000 tax cost prior to the sale (to transfer them at fair market value would defeat the purpose), and would have the capital gain realized within HoldCo. In the process of transferring the shares to HoldCo, they could arrange to have HoldCo issue a note payable to them equal to their original $1,000 tax cost.

Integration tells us that selling the shares through a HoldCo should give us the same result as selling the shares personally. If the individual wants to get the money out of the HoldCo following the sale of the shares, they would elect to take part of the proceeds from the share sale out of HoldCo as a non-taxable repayment of their $1,000 note and as a non-taxable payment our of the CDA balance. The remaining cash would be withdrawn from the company as a taxable dividend, leading to a dividend refund in HoldCo.

As this example illustrates, there is no advantage to using the HoldCo to sell the shares even without considering the professional fees associated with the HoldCo. So why do it?

Well, there may be some good reasons for doing it. Firstly, the example assumes that the individual withdraws all of the cash from HoldCo in the year of the share sale, and at a time when they are in the highest marginal tax rate. If the cash from the sale was left in the corporation and withdrawn as a dividend a year or two later when the individual was not in the highest marginal tax rate, then the results may be quite good. The HoldCo would get the dividend refund at a rate of $1 for every $3 of dividends in that later year when the dividend is paid, and the shareholder may not incur a significant tax liability on the dividend that he or she receives.

Alternatively, it may be possible to transfer the shares to HoldCo well before a sale is to happen. In this way, future growth in the value of the shares could be shifted to other family members. When the shares are sold, the growth in value since the time of the transfer could be paid as a dividend to these other family members. If these family members are in a low marginal tax rate, they would not incur much tax on the dividend, and the results could be quite good when compared to the alternative where the shares continue to be held by the individual and sold by him or her personally.

There are a host of issues to be considered before embarking on such an exercise, including the corporate attribution rules and the tax on split income to name but a few.

As always, seek professional advice before undertaking any steps.