Small business owners need better advice, expert says

Small business owners are often considered the backbone of the local economy. Taking enterprise value into account, it is no surprise that their net worth tends to be among the highest in their community, making them prime targets for prospecting advisors.

Yet despite their preferred client status, many are not getting the tax and estate planning services they need, according to Sandy Cardy, vice president of tax and estate planning at Mackenzie Financial.

“Given that we feel we are handing everything over to the CRA, there are numerous strategies in this country that are not being utilized by Canadians,” Cardy told an audience earlier this week at Mackenzie’s Mack U. continuing education program. “If we were to take a lot of those strategies and help our clients with them, look at them in aggregate and factor in the time value of money, they will make a dramatic difference in net worth down the road.”

Cardy points to a survey conducted by CIBC, released earlier this year, indicating $1.2 trillion in business assets will change hands due to retirement within the next five years.

“But most of them don’t have a clear succession plan for exiting their small business,” she says. “Sixty per cent of entrepreneurs aged 55 to 64 have yet to start discussing their exit plans with their families or their business partners.”

Only 10% of small businesses survive to the third generation, largely due to a lack of planning or a poor choice of successor, and only 1 in 5 small business owners maxed out their RSP in 2003. Collectively, the self-employed have $370 billion in loss carry forwards, Cardy says.

“The demographic tail wind that continues to fuel demand for estate planning underscores how important it is for people out there to sit down with somebody through this whole process and get some objective advice,” says Cardy. “Investors today are seeking CFO type advisors who can provide and integrated mix of estate planning and tax-sensitive solutions.”

The transfer of control to the next generation or a business partner can be a stressful proposition for many entrepreneurs. But if the transfer is not conducted correctly, the owner can face massive tax headaches from the resulting wealth.

Even if the owner holds onto the business to the point of their death, the tax and probate consequences for their estate and their heirs can be staggering.

Cardy suggests small business owners may want to consider using a secondary will to transfer their shares of the business, with their primary will covering their personal assets. Because the valuation of the business is governed by corporate resolution rules, the estate can avoid probate costs.

For the business owner who wants to retire and turn the company over to their heirs or business partners, the sale of the business will form the basis of their retirement, so it is important to extract as much value as possible.

CNIL Balance

Find out if your client has a Cumulative Net Investment Loss (CNIL) balance with the CRA, Cardy suggests. The government has been tracking everyone’s CNIL balance since 1998, and this balance can erode your client’s capital gains exemption claims. For instance, if a client wants to claim 250,000 in capital gains, and has a CNIL balance of $50,000, they can only claim exemption on $200,000.

“For many of us, if we have a CNIL balance, it won’t come to rear its ugly head in any way,” Cardy says. “Where it does become important is with your clients who have a small business and if they have a CNIL balance in the same year they’re trying to take their capital gains exemption, that CNIL balance is going to erode what they can take as a capital gains exemption.”

To reduce the CNIL balance, a small business owner can increase their dividend payments to themselves. These payments are considered investment gains and will offset the cumulative loss in the CRA’s notional account.

At the same time, the client may want to reduce the salary they pay themselves by a corresponding amount to avoid raising their personal tax exposure and avoid excessive drainage of assets from the business they intend to sell.

Following the above example, the small business owner would only need to pay themselves $40,000 in dividends, because the amount would be subject to a 25% gross up, which would wipe out their CNIL balance. They can now claim their entire capital gains exemption.

Individual pension plans

One underused strategy which Cardy says is attracting more attention is the individual pension plan (IPP), but she advises this is best suited to small business owner concerned with creditor proofing their retirement income — pensions are creditor proof, while RRSPs are not. She also warns this strategy will require a knowledgeable actuary and the creation of either a corporate trust or an individual trusteeship to manage the pension.

The advantage of the IPP is that it allows the owner to lower the taxes paid by the business while funding their retirement. Any income earned by a small business above $300,000 is taxed at the highest corporate tax rates, but contributions to an IPP will reduce the bottom line earnings.

A small business owner can name themselves and their spouse to as members of the pension and draw on it after they retire. One caveat is that upon the death of the last member, the pension’s assets are rolled into their estate and become subject to taxation and probate fees.

Cardy says clients can defer taxation on the IPP indefinitely, though, by adding members. If the owners of a Mom and Pop operation have a child who works in the business, they can add the child to the IPP.

To avoid erosion of the heir’s RSP room, though, Cardy suggests structuring their IPP participation as a 1% employer-paid, defined contribution plan.

The pension would then survive the original founder and serve as the pension for their heir. As the company is handed down from generation to generation, this process can be repeated.

Not only does the IPP allow the family to arrange retirement funding, but they can continue to extract value from the company while they still own it. Federal law allows the company to make additional contributions to the IPP if the plan does not earn at least 7.5% a year, based on an actuarial evaluation carried out every three years.

It is therefore in the interests of the business owner to allow the IPP to underperform, so investments in the IPP should be very safe. Not only will this preserve capital and maintain the value of the pension, but to avoid hitting the 7.5% return rate, thus allowing the company to make those additional contributions.

Another advantage of the IPP is that contributions are not subject to provincial health taxes, currently found in Ontario and Manitoba. Using bonuses to lower the company’s earnings would not achieve this same tax efficiency.

“When it comes to estate planning, there often isn’t a right answer or a wrong answer to many of the dilemmas,” Cardy says. “But you can use your extensive knowledge base, coupled with your emotional intelligence, and help clients navigate through many of these life issues.”