Cover all bases for clients

In October’s Advisor’s Edge Report (see “Big dreams, low risk appetite”), I discussed this year’s IAFP conference case study, which looked at a real-life entrepreneurial couple that had moved from Australia to Canada.

The case

Josie, 41, and Damien, 40, recently arrived in Canada, own several rental properties. They’re self-employed; their textile importing business is a sole proprietorship.

The couple also has big dreams. Though they plan to retire at age 55, they have two young children. Damien also wants to start a graingrowing farm in Quebec.

Their investments, primarily real estate, are mainly illiquid. Coupled with their mortgage debt and any potential business losses they may have to cover, the advisory team from B.C. Partners in Planning is concerned the two might have trouble covering debt payments.

Their rental property debt is tax-deductible, since the properties are income-producing assets.

Turns out, however, Josie and Damien can also earn respectable returns by sticking to conservative portfolios. In particular, Josie has invested in dividend-paying blue chips—30 in total—and has received an average yield of 3.5%.

The BCPIP team says her portfolio is well-diversified; it consists of 25% fixed income, 5% cash and 70% equities. Over the long term, she can expect a 5%-to-6% return.

The surprise bonus? Josie is a joint beneficiary (with her siblings) of a $3.8-million family trust. Using her trust earnings, the planning team was able to complete a debt swap when helping the couple buy their home in Quebec.

Though this was a complicated process, they were able to gain extra tax-deductibility through the purchase (see “Big dreams, small risk appetite”).

What others had to say

The BCPIP team mainly focused on the couple’s desire to buy this home and start their farm. Others at the IAFP conference, however, were more concerned with helping the couple better protect their assets.

Kenneth Morrison, a CA with Provision Accounting Group in B.C., and Carmen Thériault, Q.C., leader of Bull Housser & Tupper’s Wealth Preservation Group, gave alternative points of view. Morrison has two main recommendations.

He suggests Josie and Damien turn their proprietorship into a corporation to take advantage of possible tax savings, as the CRA has “attacked salaries [paid to family members] by deeming them unreasonable and having them disallowed,” he says.

The result can be double taxation if the CRA then levies taxes on the salary that was previously deducted from revenues.

Corporate tax rates have dropped in recent years, so paying dividends rather than salaries can be more advantageous.

“The amount of annual corporate income subject to low rates has risen to $500,000 per year,” he says. “So, the couple should pay corporate tax and then pay dividends to family members.” They could use a family trust to achieve this income splitting.

Morrison notes dividends are not tax-advantageous to children until they turn 18. Also, “The advantage of dividends over salaries is that the dividend recipient does not have to work in the business.”

The family would also benefit from saving within the corporation rather than using an RRSP for retirement funds. He says there’s no restriction on corporate investments, and there is more flexibility to withdraw funds. They’d also get a dividend tax credit on company income.

The flexibility of the corporate option is crucial for Josie and Damien, as they have limited liquidity and cash flow. Morrison adds the dividends and corporate savings are more accessible since they’re not locked into registered accounts. That might tempt the couple to spend it on frivolous items.

SEE CHART at end of article: Using an RRSP versus Investing Corporately

His second recommendation was to structure the farm to qualify for a tax-free intergenerational rollover to family members, as well as the $750,000 tax-free capital gains exemption.

In addition, the Supreme Court of Canada issued a decision on August 1, 2012 that opened up the possibility of deducting farm losses if farming constitutes a significant part of a taxpayer’s income, even if it’s not his primary income source.

While deductible losses related to secondary farm income are usually limited to $8,750, the couple may now have the option to claim larger amounts.

He added Josie should revisit her family trust, given the CRA could perform an audit if it’s not properly settled. Thériault agrees, and suggests Josie obtain a copy of the document creating the trust to get all the details concerning the trust assets to determine what her rights are while she’s alive and what happens upon her death.

“Without that information, she won’t fully understand or be able to enforce her rights as a beneficiary,” says Thériault. “She won’t be able to protect any entitlement she and her children might have in relation to the trust assets.”

Further, the couple should review their wills and insurance needs, as their circumstances are complex and they have two young children. The BCPIP team put their real estate into a trust, but the rest of their assets could still be subject to probate and division.

Thériault says they might also “consider creating an insurance trust independent of their wills to hold insurance proceeds. This would involve designating a trustee to receive the proceeds, as well as to hold them in trust for the intended beneficiaries on terms similar to what you might see in a will.”

She adds, “This would eliminate probate taxes on the insurance proceeds, and the trust created would qualify as a testamentary trust for tax purposes. Income in the trust would be taxed at graduated rates, creating the possibility of ongoing tax savings.”

Farming also can be dangerous. She says granting a power of attorney helps ensure assets are properly managed if you’re incapacitated.

And she reminds the couple, “the law governing powers of attorney varies from province to province. You should have a POA prepared for each jurisdiction in which you reside or own assets.”

Finally, Thériault suggests they look into a marriage agreement, “in cases where one spouse comes into the marriage with greater wealth than the other, or when one may receive significant gifts or inheritances from family during the marriage.”

More diversification

The final presentation addressed the couple’s resistance to portfolio diversification. Marlene Lee, vice president of research for Dimensional Fund Advisors in Texas, says their advisor should show them long-term historical data to give perspective.

The couple has a strong home bias and prefers bonds to mitigate risk, but she says they also lack a long-term view on market trends.

Canada’s average real equity returns since 1900, 7.1%, have underperformed other countries; Finland (9.0%), South Africa (8.9%), Australia (8.9%) and Sweden (8.8%) were among the top performers globally.

But countries like the U.S. and Canada likely have survivor bias, she says, since both have made it through major disasters and recessions successfully.

Josie and Damien should rethink their position as the economy shifts.

Using an RRSP versus investing corporately

RRSP Annual Contribution $31,970 Investment rate (tax-deferred) 4.00%						Investments Held Corporately Annual Contribution $50,550 Investment rate 4.00% Less avg. tax rate 9.30% Investment rate (after tax) 3.63%
Yr	Balance beg. of year	Inv. Rate 4.00%	Annual Contribution	Balance end of year		Yr	Balance beg. of year	Inv. Rate 4.00%	Annual Contribution	Balance end of year
1	–	–	31,970	31,970		1	–	–	50,550	50,550
2	31,970	1,279	31,970	65,219		2	50,550	1,834	50,550	102,934
3	65,219	2,609	31,970	99,798		3	102,934	3,734	50,550	157,218
4	99,798	3,992	31,970	135,759		4	157,218	5,704	50,550	213,472
5	135,759	5,430	31,970	173,160		5	213,472	7,745	50,550	271,767
6	173,160	6,926	31,970	212,056		6	271,767	9,860	50,550	332,177
7	212,056	8,482	31,970	252,508		7	332,177	12,051	50,550	394,778
8	252,508	10,100	31,970	294,579		8	394,778	14,323	50,550	459,651
9	294,579	11,783	31,970	338,332		9	459,651	16,676	50,550	526,877
10	338,332	13,533	31,970	383,835		10	526,877	19,115	50,550	596,542
Years 11–19						Years 11–19
20	884,649	35,386	31,970	952,005		20	1,348,996	48,942	50,550	1,448,488
21	952,005	38,080	31,970	1,022,055		21	1,448,488	52,551	50,550	1,551,589
22	1,022,055	40,882	31,970	1,094,908		22	1,551,589	56,292	50,550	1,658,431
23	1,094,908	43,796	31,970	1,170,674		23	1,658,431	60,168	50,550	1,769,149
24	1,170,674	46,827	31,970	1,249,471		24	1,769,149	64,185	50,550	1,883,883
25	1,249,471	49,979	31,970	1,331,420		25	1,883,883	68,347	50,550	2,002,781
Balance: RRSP $1,331,420						Balance: Corporately $2,002,781

Katie Keir is assistant editor of Advisor Group.