Recently, a Canadian Institute of Chartered Accountants (CICA) survey identified the emerging trend of CA practices providing succession planning services to their top owner/manager clientele. Currently, 76% of small and medium-sized firms offer succession planning as a competency with another 14% determined to enter this specialized market. The firms participating in this survey identified that succession planning presently makes up less than 5% of total billable hours. However, many expect to see it grow to 10% in the near future.
Why? Canadian entrepreneurs face a growing number of challenges, taxes, regulation, competition, an increasing Canadian dollar; these are enough to deliver more than a little stress. Demographic realities deliver another unhealthy dose. According to Statistics Canada 15% of Canadians are set to retire within the next 10 years. Many entrepreneurs facing the reality of retirement do this without having done adequate planning for their businesses or themselves. For too many financial planning begins and ends with a cursory estimation of needed retirement funding, the annual RRSP contribution made begrudgingly, and the annual pilgrimage to his/her accountant and for even less to their Certified Financial Planner (CFP).
Some entrepreneurs may feel secure that their personal financial planning efforts are adequate, but in too many cases the business owner has prepared for his/her personal retirement, but not the retirement of his/her business. Exiting the business, if not adequately prepared for, offers to many unwelcome surprises made worse by shocking and often unnecessary tax bills.
When asked on how they plan to fund retirement most business owners answer that the sale of their business will fund the vast majority of their retirement needs. When the onion is pealed back, too often we find that the business owner is an expert on how to build a business, but a complete neophyte on how to exit it. Canadian business owners still believe that the buyer of their enterprise will buy the shares of the corporation. Therefore many still believe that they, and their family members, will all be entitled to a $500,000 lifetime capital gains exemption for the sale of shares of a Qualifying Canadian Small Business corporation.
This perception is quite often a mistaken assumption. Currently the vast majority of Canadian small businesses valued less than $10,000,000 are not sold pursuant to a share sale, but rather by a sale of the business assets. This is particularly true of franchises, the sale of which is rigorously described in the Franchise Agreement.
Asset sales result in income being generated within the corporation. This can lead to much higher tax bills than were expected. For instance if a business sells for $3,000,000 pursuant to a share sale the shareholders, in most cases, will enjoy a $500,000 capital gains exemption and tax on 50% of the remaining gain, which should equate to tax at between 23-35%. Therefore for a small business, the shares of which are owned in equal amounts by husband and wife would see tax on $500,000 each, generating a tax bill of approximately $232,000 each or $464,000 in total.
The asset sale generates a much larger tax bill. There is no $500,000 exemption in asset sale transactions, and as such the entire sale amount is treated as income. Assuming again a business that sells its assets for net proceeds of $3,000,000, the tax bill is staggering. The traditional advice to the business owners is to bonus out the proceeds of sale, pay the tax and invest safely to ensure a robust retirement. That payment of bonus will attract personal income tax, and in many provinces a provincial health care tax. In Ontario the payment of two $1,500,000 shareholder bonuses to our two principals will generate an Ontario Employer Health Tax of $58,500, which must be paid before the individuals ever receive their bonus payments. The remaining amount will be paid out in two payments of $1,470,750 which will generate a tax bill to each shareholder of $665,693 or $1,331,386 in total. When faced with this potential bill most business owners are understandably irate.
Is there a means of reducing this tax? The answer fortunately is yes. The resolution of this problem does not require rocket science, or a precarious interpretation of income tax which invites that unwelcome CRA (Canada Revenue Agency) knock on the door. In fact the structure that can turn the tables for Canadian business owners emanates from the pages of the governments own play book that is the Income Tax Act in s. 248 (1).
Designed originally as an anti avoidance measure in 1986, the Retirement Compensation Arrangement can, in most cases, radically reduce the overall tax paid on an asset sale of a business. It does so in by postponing the date on which final taxes are paid. It makes time and flexibility an ally of the business owner, thus allowing for future tax planning by deferring and controlling distributions of income to future years.
Let’s look at our previously mentioned case. How can the business owners facing a $3,000,000 asset sale utilize an RCA to reduce overall taxation? Before any structure can be implemented the contributions that the company is going to make to the plan must be “reasonable” in the eyes of CRA. A recent tax ruling from CRA stated that using an Actuarial Valuation goes a long way to establishing reasonableness. In our case we were able to use $120,000 as the income average over a thirty year employment history to establish the limit for contribution at $3,010,000 for our two business owners. This meant that virtually all of the proceeds of sale could be contributed to the RCA. The immediate tax due on the sale had thus been postponed.
What happens next? The RCA must be established. The plan itself is a trust which will receive one half of the total contribution, or in this case $1,500,000. The remaining $1,500,000 will be held by CRA in a Refundable Tax Account (RTA) which, in expected government style, pays no interest. The trust is responsible for filing an annual return to show deposits, withdrawals and investment returns. While there are no formal rules on what an RCA may invest in, we do know from recent CRA opinions that the investments should be of an arms length nature. All investment returns, regardless of their nature, are subject to an annual refundable tax of 50% of the return. The RCA trustees are therefore wise to seek a tax efficient investment strategy which is predicated on stable and conservative pension like returns. Frequently permanent life insurance and corporate class funds are used to achieve these investment requirements.
What does the RCA provide? Well, through postponement of the initial tax our RCA beneficiaries have made flexibility their ally and created a vehicle which should reduce their overall tax burden. By avoiding the one time large payment of tax they are now able to parcel out that lump sum into smaller payments, the result being lower overall taxes paid. There are no rules on withdrawals from an RCA, and as such Mom and Dad can each take a payment, or not, when they want to.
To make matters simple, let’s assume that the asset never grows. What is the tax on $3,000,000 dollars paid out over 10 years via an RCA? Well, that equates to one payment per year to each of our beneficiaries of $150,000 each. That will generate a tax bill of $52,733 each per year, or $1,054,660 over the ten year (twenty payments) period. That represents a tax savings of $276,726.
The income needs of business owners will determine the investments owned by the RCA. If the individuals do not require income from the RCA immediately after sale, and have an estate or other insurance need, they could consider using an insured RCA. In that case a permanent life insurance contract is used as the investment, and as such all growth in the cash value of the insurance policy is shielded from Refundable Tax. Ten years later our retired business owners have a significantly larger asset pool to draw upon. The pure insurance component of the policy should be owned by their holding company pursuant to a professionally drafter Shared Ownership Agreement. This will allow for the payment of a death benefit to be received tax free by the corporation and paid out to the shareholders, or their beneficiary’s tax free. To otherwise hold the entire policy in the RCA would result in a substantial payment that would otherwise be tax free, being rendered taxable as it had to be paid out through the RCA trust.
With all Canadian business owners facing the inevitability of retirement it is time for them to plan to retire their businesses as well. Not all businesses get passed down to the next generation, some by contract cannot. The use of the Retirement Compensation Arrangement can radically reduce the tax burden faced at sale. For all entrepreneurs planning ahead for the inevitable sale is not just recommended, the devotion we give to our enterprises mandates it.
Obviously, RCAs require a specialty in areas such as tax, actuary evaluation, employment law and employee benefit plan construction. Many business owners and their accounting professionals will need to seek expertise to aid them in the RCA setup, maintenance and exiting stages. Therefore, it is well worth the time and money to hire an RCA consultant who will assist in the design, implementation and maintenance of the RCA solution.