Retirement planning and Estate Planning:
Financial peace of mind is crucial for enjoying retirement. For business owners there are two distinct ways of engineering this security: creating personal savings by drawing funds over time from the business or “saving within the business”, which involves reinvesting cash flow in the business to make it more profitable in the hopes that there will be more in the business to pay out at retirement or the business will provide higher proceeds if sold.
There are advantages and disadvantages to both. Withdrawing money from the business over time allows you to diversify your investments and it offers flexibility, but you will have to pay tax on salary and dividends withdrawn from the company and draining cash from the company may be financially dangerous to the company. Saving within the company may be advantageous because business returns should be higher than portfolio returns you might earn, but this technique carries higher risk, since any business is generally riskier, and risk management is not always possible.
There is no right or wrong answer to the question of how best to provide for your retirement – you will have to decide what you are most comfortable with and what makes most sense in your situation. But the important thing to remember is that as the owner of a business, you do have flexibility when it comes to creating a source of income in retirement, and you should consider each of these retirement savings options when planning for retirement:
• Maximize RRSP contributions – If you receive a salary from your corporation, this salary will be earned income for the purpose of making RRSP contributions. As discussed in our Answering Your RRSP Questions tax bulletin, you can contribute 18% of your previous year's earned income up to a maximum amount for the current year, less your pension adjustment (PA) for the previous year. For the years 2004 the maximum amount is $15,500 (increasing to $16,500 for 2005 and to $18,000 for 2006), less your PA for the prior year (if you are a member of a pension plan).
• Pay yourself a retiring allowance – You can make an additional contribution to your RRSP on retirement by having your corporation pay you a reasonable retiring allowance (which the company can deduct). Provided that you worked actively in the business before 1996, a retiring allowance paid to you can be transferred to your RRSP, up to the following limits:
o $2,000 for each year of service before 1996, plus
o $1,500 for each year of service before 1989, provided that you were not a member of a company-run pension plan.
• Use an Individual Pension Plan – It may be possible to set up a pension plan for yourself, and other family members, known as an individual pension plan or IPP. For older business owners, the potential retirement benefits provided by an IPP can greatly exceed the benefits provided by regular RRSP contributions. The rules are complicated, however, and these plans are more costly to run when compared to a conventional RRSP.
• Redeem freeze shares in retirement – In the next section on estate planning, we talk about estate freezes, which are a technique that basically freezes your gain in the company and allows future value growth to go to your children. Generally, as a result of an estate freeze you will hold fixed-value preference shares after the freeze. Once you retire, these shares can be redeemed over time, proving you with dividend income from the corporation. Such redemptions will also reduce the accrued gain that will be taxable on death.
• Sell shares to family members – Rather than having your shares redeemed, you can sell your shares to other family members (but not to a corporation they own). Such a disposition would be taxed as a capital gain rather than a dividend (generally at a lower tax rate).
As we said, given that there is risk associated with all businesses, it is usually prudent to use some or all of the methods discussed to save for retirement. Remember, if the business should fail or experience cash flow problems, it is important for you to have other sources of income to fall back on.
Estate planning techniques
Once you have set your succession plan, you should then ensure that your estate planning goals are coordinated with this plan. When coordinating the estate and succession planning, balance is critical. There are many tools you can use to maximize your estate, but you also need to ensure that the steps you take do not have a negative effect on your succession plan. In the rest of this section, we discuss estate planning considerations within the framework of a succession plan.
In many respects, family business owners face the same estate planning issues as individuals in general. Consequently, all of the issues discussed in our Estate Planning tax bulletin may apply to an owner of a business (a copy can be obtained from your advisor, or from our website at http://www.bdo.ca). However, as the investment in the business is usually the most significant asset held by most family business owners, there are a number of important estate planning issues they need to address.
Freezing the value of your shares
As we discuss in the Estate Planning bulletin, an individual is generally deemed to dispose of his or her assets at fair market value at the time of death. Exceptions to this rule include the transfer of property to your spouse at their tax cost and an intergenerational rollover that is available for certain transfers of qualifying farm property.
Where a tax rollover isn't available, at the time of death you will be subject to tax on accrued gains on your assets, including your investment in the business. For many business owners, the investment in the business will have a high value and a low tax cost, which means that without planning, a significant tax liability will arise on death. This problem is compounded by the fact that the asset generating this liability is generally not liquid. The tax liability for most non-business owners, on the other hand, often is dealt with by liquidating investments to pay the tax.
Finding a way to reduce, or at least defer tax, on death is crucial if the business is to remain in the hands of the family. Most business families use two important estate planning tools to deal with this issue – an “estate freeze” and life insurance.
Defer tax with an estate freeze
Though it is difficult to reduce the tax payable on gains that have already accrued, there is a common technique, called an "estate freeze," that you can use to limit your capital gains in the future. By freezing the value of your investment, future gains will accrue to shares held by your heirs and the gain won't be taxed until they sell their shares (or have a deemed disposition on death).
In addition to ensuring tax on future gains will be deferred, an estate freeze will allow you to effectively lock-in the tax liability that will arise on your death (subject to changes in tax rates in the future). By locking in the tax liability, you can plan ahead to ensure this tax liability can be met without disrupting the business. For most businesses, life insurance is an excellent tool for providing liquidity on death.
How does an estate freeze work?
There are many ways to accomplish an estate freeze. One common method is to transfer the assets you wish to freeze, such as shares of your operating company, back to the operating company in exchange for fixed value preferred shares of the operating company. This transfer can be accomplished on a tax-deferred basis using tax rollover rules.
Your heirs (or a trust for their benefit) can then subscribe for the new growth shares (generally common shares) of the operating company. At the time of the estate freeze, the value of these common shares would be nominal, but as the value of the business grows, this growth will accrue to the new common shares held by your family or a trust.
In many cases, a business owner will actually take back two classes of shares on an estate freeze – the preferred shares we just described, plus a special class of non-participating voting shares. By holding these shares, you can retain control over the corporation, provided the special voting shares carry more votes than the new common shares. This will be especially important if you intend to have your preferred shares redeemed over time.
You can also freeze your estate by using a trust. Under this alternative, you can transfer the assets you wish to freeze to a trust whose beneficiaries would be your intended heirs. This allows future growth to accrue to your beneficiaries without giving them control over your assets.
The major difference between using a trust and a corporation for an estate freeze is that it is generally not possible to transfer property to the trust on a tax deferred basis. Consequently, tax may have to be paid on any accrued gains on the assets at the time of the transfer. For this reason, this form of an estate freeze is not common for an owner of an established family business. However, if accrued gains are small or the gain arising from the transfer can be offset with a capital gains exemption claim, freezing with a trust can be advantageous, as assets held in the trust will not be subject to the deemed disposition rules that apply on death. It should be noted, however, that for tax purposes assets held by a trust are subject to a deemed disposition at fair market value every 21 years.
When to freeze?
To maximize your deferral, an estate freeze should be carried out as soon as possible, as this will limit the accrued gain on your shares and ensure that future growth accrues for the benefit of your children. However, before you freeze, there are two important issues you need to address:
1. If you freeze the value of your shares now, will this leave enough value for you to live on in the future?
2. Has the timing of your estate freeze been properly coordinated with your succession plan?
When dealing with the first question there is an important point to keep in mind. Though it may be possible to undo (or "thaw") an estate freeze, it is generally a good idea to assume you might not be able to access the future growth of the business to support yourself. Consequently, if you're not sure how much wealth you need to keep, there are two fairly simple alternatives to a full estate freeze:
• Defer the freeze – For younger business owners, especially those with young children, if you're not sure how much wealth you need to keep, it may make more sense to simply defer the freeze until you have a better idea of your future needs. At this point, however, you may still want to determine the tax that will eventually be payable and purchase some life insurance to cover the projected liability.
• Use a partial estate freeze – When you freeze, there is no requirement that you to give up all of your common shares. Therefore, you can choose to freeze only a portion of your holdings. This will allow growth to start accruing for the benefit of your children while allowing you to retain an interest in future growth for yourself. If you're sure you won't need all of the expected future growth in the business for yourself, but you still aren't ready to give up all of the growth, a partial freeze makes sense. Also note that once your future plans become clearer, you can implement a second estate freeze in the future.
A partial freeze can also provide an added benefit. Though we have focused on the use of an estate freeze as part of an overall succession plan, a partial freeze can allow you to multiply the availability of capital gains exemptions, should you decide to sell the business. Where a family trust holds common shares, the gain arising from these shares can be allocated by the trust to your children. Your children may then be eligible to offset some or all of the gain with a capital gain exemption claim.
More sophisticated plans can give you more flexibility as well. Ask your advisor for more information.
Coordination with your succession plan
For an effective estate freeze, your children have to own at least some of the common shares of your company, either directly or through a trust. But as we discussed earlier, depending on your succession plan, you may want your successor to have a greater interest in the business than other children who will not be active. Consequently, you'll need to consider this when planning for an estate freeze.
As most business owners are reluctant to turn over full ownership of common shares to their children (especially if they are minors), a family trust is generally used to hold the new growth shares until they are ready to turn over ownership to the children. If the trust is discretionary, the division of the common shares among your children can be deferred. However, even with this flexibility, the timing of your estate freeze is still important.
Family trusts are a powerful planning tool, but they also have limitations. One important limitation is the 21-year deemed disposition rule. Under the tax rules for family trusts, your trust will have a deemed disposition every 21 years. Therefore, if the trust still holds the shares 21 years after the estate freeze, the trust may be subject to tax on a capital gain equal to the gain that has accrued over the 21 years.