A business consumes a large portion of your resources, time, and attention throughout its lifetime, and your family’s financial security may depend on its success.
This guidebook follows the lifecycle of a business and its owner. It explores a range of subjects unique to business owners, from consideration of the best structure for your business to the development of a succession plan and transition from the business into a well-planned and well-funded retirement. It will be separated into 10 different decisions business owners will face and should be asking themselves throughout the lifecycle of their business.
Planning ahead can protect the business you’ve worked so hard to build, help you achieve your business goals, and ensure your future prosperity. Your professional legal, tax, and financial advisors are there to help you make the critical decisions, wherever you happen to be, on the challenging and rewarding journey through the life cycle of your business.
This guidebook is for information only and is not intended to be or to replace legal or tax advice. Please be sure to consult with qualified legal and tax advisors before implementing any strategies.
Key Decision 1:
What is the best structure for your business?
Make the right choice for yourself
Whether you already own your business, are thinking of starting a business from scratch, or are buying n existing business, choosing the right business structure can have a major impact on the future success of your enterprise as well as your personal tax and estate planning.
Your decision should consider a range of factors including the nature of your business and where its located, the number of people involved, taxation considerations, your potential exposure to liability, and the company’s financial requirements.
Be sure to seek expert advice. Your professional advisors can help ensure that you are well-informed about the legal and taxation issues you may encounter and that you understand the personal and business implications of your decisions.
Sole Proprietorships
A sole proprietorship is the simplest form of business organization and is often the most inexpensive to set up. This can be a good option for small enterprises or when you are just starting your business because you, as the business owner, have direct control over business decisions and receive all the profits. However, with this kind of structure, you are legally responsible for the debts and obligations of the business. This means that both your business and personal assets may be subject to the claims of creditors, this is called “unclaimed liability”.
How is a sole proprietor taxed? You must file a professional tax return to report your business income. You should include the income, or losses, from your business on your personal tax return as part of your overall income for the year. Your net business income is taxed as personal income, so there are limited tax planning opportunities; however, you may be able to deduct your business losses from your other income sources.
Partnerships
Setting up a partnership is more complex and is more expensive than setting up a sole proprietorship. A leu advantage of having a partner is that they generally bring additional sources of investment capital and provide a broader management base. However, finding suitable partners can be a challenge. In addition, this kind of business structure can mean a division of authority, so there is potential for conflict between the partners.
A written partnership agreement, thought not required, can help minimize potential conflict. In many cases it sets out the terms of the business, protects the interests of individual partners in the event of disagreement or dissolution of the business and generally defines how the partners will share the business profits.
Your personal liability for the business and the actions of your partners can differ depending on the type of partnership. Be prepared for the possibility that your partners’ decisions will be legally binding on you, and ensure you discuss all aspects of this decision with your legal advisor.
If you are considering investing in a partnership, you should review the tax and legal implications carefully with your professional advisor.
How is a partnership taxed? A partnership is not a taxable entity. This means that instead of the partnership paying tax, the partnerships income or loss flows to the individual partners, who report their proportionate share of income or loss on their personal tax returns.
Corporations
A corporation is a separate legal entity from its shareholder and has the legal characteristics of an individual. It can own property, incur legal liability, lend, borrow and carry on a business.
If you’re thinking of starting or investing in a corporation there can be a number of advantages. It can provide greater business continuity as shares can be bought and sold without affecting the company’s continued operation. It is also easier to raise investment capital for a corporation, and you may find that the size and resources of an incorporated business make it easier to attract specialized management expertise. In addition, as an owner-manager and shareholder, your liability is generally limited to your shareholding, so your personal assets are protected from the company’s creditors unless you have provided personal guarantees for loans to the corporation.
Its important to obtain legal advice when setting up or acquiring an incorporated business. Corporations are closely regulated than sole proprietorships or partnerships and may be more costly to set up. You will be required to hold annual shareholder meetings, meet certain record-keeping obligations and comply with requirements under the legislation governing the corporation. This can mean more administrative, legal and accounting expenditures.
If you are a professional and are thinking of incorporating your practice, please review Appendix 2 for information specifying to professional corporations.
How is a corporation taxed? Since a corporation is a separate legal entity, a corporation files its own corporate tax returns and pays taxes on the income it earns. A corporation’s income is calculated separate from the business owners or shareholders personal income.
Business planning quick tip
Inexpensive and simple to set up, sole proprietorships are generally more suitable for smaller enterprises with a single owner/manager who wants direct personal control. Costs are usually higher for partnerships and corporations, but its easier to raise investment capital, making them a better choice for larger enterprises. They also offer tax and legal advantages that may appeal to certain enterprises regardless of size. The good thing that you can change your business structure as your business develops and circumstances change.
Tax planning for corporations
As an owner-manager, you may be able to benefit from some of the tax planning opportunities available to incorporated businesses:
- The small business tax deduction provides potential tax-deferral opportunities and a reduced corporate tax on active business income up to the small business limit that is retained in the corporation. Be aware there are a number of rules that reduce the corporation’s ability to claim the small business deduction.
- If your business qualifies as a qualified small business corporation (QSBC), all or a portion of any gain realized on the sale of the shares can potentially be sheltered from personal taxation using the capital gains exemption.
- By incorporating, you may have the opportunity to split income and reduce taxes by paying dividends to adult family shareholders in certain circumstances.
- Adding other family members as common shareholders directly or through a family trust (commonly achieved by implementing an “estate freeze”) can allow you to transfer future tax liability on the growth of the company to lower-income family members and multiply the use of the capital gains exemption on the sale of QSBC shares.
Talk to your professional advisors about the structure that’s right for your business or whether your current structure is providing you what you need to achieve your goals.
Key Decision 2:
How can you reduce your taxes?
Organize your business assets in the most tax-efficient manner
As a business owner, you may have substantial personal assets invested in your business in addition to the long term commitment you have made to your business and its employees. This can have significant implications, not only for you and your business but also for your family’s financial security.
To protect your investments, both business and personal, your business strategy should include carefully structured tax and estate planning components to ensure you have organized your assets in the most tax-effective manner and utilized the tax planning strategies that are available for the benefit of your business and your family.
Personal tax planning
There are several income-splitting strategies available to owners of private corporations in Canada that may benefit you and your family. They include:
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Income splitting by paying a salary to family members
Consider income splitting with lower income family members by employing them in the corporation and paying them a reasonable salary based on the services they perform. The salary they receive may also create registered retirement savings plan contribution room for them and generate Canada Pension Plan/Quebec Pension Plan (QPP) pensionable earnings. Note that the tax rules provide a disincentive to paying a salary or bonus that exceeds the value of the services rendered.
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Income splitting by paying dividends to your adult family members
If you have an active corporation, you may be able to transfer some or all of the future growth of the business to the next generation of your family using an estate freeze with a family trust. this strategy may also allow you in to income split by paying dividends from the corporation to your spouse and adult children. If they have no other income, they may be able to receive substantial tax-free dividends from the corporation (the amount varies depending on the type of dividend and the family members province/territory of residence). There are rules that will cause the dividends paid to your family members to be taxed at the top marginal tax rate. Therefore, it is important to speak with a qualified tax advisor if you are contemplating this strategy.
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Multiplying the capital gains exemption
it may be possible to multiply the capital gains exemption on the sale of the qualifying shares of your business. This could significantly increase the family’s after-tax assets following the sale. One way to do this is by having your operating company owned by a family trust where your family members are the beneficiaries of the trust. When you sell the qualifying shares owned by the trust, the resulting capital gains can be allocated to each beneficiary, and they can each claim their capital gains exemption. For example, a family of four can claim four times the capital gains exemption versus the business owner, who can claim the capital gains exemption only once. This results in additional tax savings for the family. Keep in mind that certain rules restrict the ability to claim the capital gains exemption with respect to minors and non-arms length sales.
You may also wish to consider some potential estate planning opportunities. Freezing the value of your company can help you limit your tax liability on death. You can also defer capital gains on the future growth of the business and attribute them to the next generation while retaining control of the business.
It is important to note that if you wish to use a family members capital gains exemption on the sale of your business, the family member will be entitled to some of the sale proceeds. The funds will no longer belong to you as the business owner, so ensure this is a practical strategy for your circumstances.
Tax Planning for Your Business
If you’re the owner of a private Canadian corporation earning active business income, consider whether the following strategies would work for your business:
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Setting up a retirement plan
Consider setting up an Individual Pension Plan (IPP) as part of your retirement plan. An IPP is a defined benefit pension plan that, in certain situations, provides greater annual contribution limits than an RRSP. IPP contributions increase with the age of the plan holder.
Contributions to the IPP are tax-deductible for your corporation. The investments inside the IPP grow on a tax-deferred basis and are only taxable when you start withdrawing funds from the IPP.
IPP assets may offer creditor protection and typically suit business owners who are age 40or older and earn significant employment income. This means that you will need to draw a salary from your business.
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Maintain Qualified Small Business Corporation (QSBC) Status
when you sell shares of your corporation, you may be able to take advantage of the capital gains exemption. This exemption is available to individual shareholders of active Canadian private corporations and can present sizable tax savings.
To qualify for the exemption, ensure your corporation meets the QSBC status. Certain corporate structures may make this easier. Since surplus assets may limit your ability to claim the exemption, you may want to transfer non-business investments to a holding company. This can “purify” the operating company and reduce the accumulation on non-qualifying assets.
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Earning Canadian Dividends Income in a Corporation
Canadian source dividends from publicly traded securities are generally subject to a flat refundable corporate tax. If you are earning Canadian public dividends in a corporation, consider paying out a dividend in the same year if you will be paying taxes at a lower tax rate personally as the corporation will receive a refund on the taxes paid.
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*Life Insurance as a Tax-Exempt Investment in the Corporation
if you have surplus funds accumulating in your corporation, you may be taxed at a higher rate on the investment income earned in the corporation than if you earned this income personally (depending on the province/territory). There may also be a double taxation on your death if you own a corporation. Tax planning solutions are available to help you address this problem.
A corporate-owned tax-exempt life insurance policy can provide income protection for survivors, fund buy-sell agreements or pay capital gains tax on death. Life insurance premiums are generally not tax-deductible, but it can be advantageous to purchase life insurance through a corporation rather than personally. The corporation’s surplus assets can be invested in the insurance policy, grow on a tax-sheltered basis during your lifetime, provide a supplementary source to retirement income and be potentially paid to your beneficiaries as a tax-free death benefit. Speak with a license life insurance representative for more information.
Business planning quick tip
If you own a private Canadian corporation, you may be able to use several strategies to reduce taxes. These tax strategies include income splitting with lower-income family members, maintaining your small business tax status if you are planning to sell the shares of your corporation and investing surplus assets in a tax-exempt insurance policy and other tax-efficient investments.
Key Decision 3:
What Should You Do with Surplus Cash?
Preserve and maximize your surplus assets
If you are the owner-manager of a private Canadian corporation and have surplus cash accumulating in your company you many be wondering whether to retain the funds in the company or withdraw them while paying as little tax as possible. If so, there are a number of questions you should consider before you take action.
Is there a business need for the cash?
if you have surplus cash in your corporation, ask yourself if you will need it for business purposes in the short term. Will you need to use the cash to pay instalments of income tax or sales tax such as GST? Does your business experience seasonal slow periods when cash flow will need to be supplemented? Consider whether you will have to pay down debts or make any major purchases in the near future.
If you have excess cash that won’t be used for business purposes, the investment income earned on this surplus cash will be taxed at the corporate investment tax rates, which may be slightly higher than the top personal tax rates, the rates vary by province/territory.
Do you need the surplus cash for personal purposes?
Do you have personal expenses that are coming dure, such as income tax instalments that must be paid on time? You may also be considering a major purchase like a vacation property or planning to help out with a family members education cost, wedding expenses or a down payment for a house. If you know you will need to withdraw surplus funds from the corporation to meet these personal expenses, consider when you will need the funds. It is important to understand the tax consequences of making the withdrawal and whether it will be possible to make several withdrawals over a period of time to minimize tax costs.
What are the funds going to be used for?
If you don’t need the surplus funds in immediately for business or personal purposes, what are your reasons for moving funds out of a corporation? Sometimes, it may be beneficial to withdraw the funds from the corporation, as investment income earned on the excess funds remaining in the corporation may be taxed at a slightly higher rate than the highest personal tax rate. However, in some cases, the opposite is true and there many be a potential tax deferral advantage when investment income is earned and kept in a corporation. High levels of passive income could also reduce your operations ability to access the small business tax rate on active business income in certain circumstances. A good starting point is to analyze your long-term goals, which could include:
Planning for retirement – are you going to use the funds for your retirement by contributing to an RRSP or IPP?
Estate planning – do you want to enhance the value of the estate you will pass onto your family? Many potentially effective estate planning strategies involve insurance-based solutions. The funds may grow on a tax-sheltered basis and may be accessed at retirement to supplement retirement income, or they may be paid out tax-free on death.
Asset preservation – if you want to mitigate risk of funds being subject to claims from corporate creditors, consider transferring excess cash to a holding company. Speak to a qualified tax advisor about how to accomplish this.
Tax planning – keeping excess investments or an insurance policy in a corporation may disqualify your shares from being QSBC shares so that you are not entitles to the capital gains exemption on the sale of your business. Therefore, you may want to withdraw excess funds from the corporation. A proper corporate structure may allow you to extract cash from the operating corporation on a tax-deferred basis.
Withdrawing funds from the corporation
If you’ve decided to take funds out of your corporation. Consider potential strategies that could help you make the withdrawal and minimize the tax consequences.
Tax-free strategies:
Expense reimbursement – keep records of your business expenses you paid personally. If your corporation reimburse you, you won’t pay tax on funds you receive, and the corporation may get a tax deduction for the business expense.
Repayments of shareholder loans to the company – shareholder loans, such as personal assets you loaned to the company or dividends declared but never paid to you, can be repaid without tax consequences to you
You could also consider other non-taxable methods such as paying a capital dividend if your corporation has a positive capital dividends account balance.
Taxable strategies
Taxable methods of withdrawing funds from the corporation include paying yourself a salary or dividend. Although paying a taxable dividend results in personal tax, it may at the same time create a tax refund to the corporation if the corporation paid refundable taxes to the CRA when it earned passive income. Income splitting opportunities may also be available, for example, by paying a reasonable salary to a lower income family member for services rendered or paying dividends to adult family member shareholders (keep in mind that there are rules that may cause the dividends to be taxed at the top marginal tax rate in the hands of family members).
Business planning quick tip:
You can use a simple “decision tree” to analyze the issues related to surplus cash in your business and how it may be used:
1. Consider whether there is a business need for the surplus cash any time in the foreseeable future
2. If there’s no business need, consider whether you have an impending personal need
3. If not, consider longer-term goals, such as retirement or asset protection
4. Should you decide to withdraw surplus funds, consider the most tax-effective ways to do so
Key Decision 4:
How can you build employee loyalty
Provide enhanced benefits to attract and retain top talent
As a business owner you know how important it is to recruit, reward and retain your top talent.
It can help ensure business continuity and protect the knowledge you have accumulated within your organization, and it may hep make effective succession planning decisions when the time comes. The loss of a key employee can be very expensive to an organization, so give some thought to how can motivate key employees and keep them focused on the company’s priorities.
Employer-sponsored plans
Employees are increasingly conscious of the necessity to provide for their retirement. Employer-sponsored savings plans are on of the most important aspects of retirement planning and can help you ensure that your employees enjoy a financially secure retirement. Before setting up a retirement plan, discuss the options with your professional legal, tax and/or financial advisors. Here are some of the more common types of retirement plans offered by employers.
Group registered retirement savings plans (Group RRSPs)
Group RRSPs are one way you can encourage your employees to save for retirement throughout their careers. They could be an option even for a small business owner. These plans operate like regular RRSPs, possibly with additional restrictions, and can be more cost-effective and easier to administer than pension plans.
Registered pension plans (RPPs)
RPPs are employer-sponsored pension plans. In general, employer and employee contributions are tax-deductible, and the income earned within the plan grows tax deferred. Funds accumulating within the plan for individuals’ members are generally locked in by provincial/territorial or federal legislation. There are two kinds of RPPs:
Defined contribution (DC) and Defined benefit (DB) pension plans
Employees with a DC pension plan choose the investments within their individual plan, and the retirement benefit is based on the value of the investments in the plan when the employee retires. This can be a less costly option for you as an employer than a DB plan and is easier to administer.
In contrast, DB plans guarantee a specific benefit to the employee at retirement, calculated using a formula based on earnings and years of service. DB plans generally specify an age, usually 65, at which employees are expected to start receiving retirement income. As an employer, you face potentially greater obligation with a DB plan than with a DC plan because you must make the investment decisions and guarantee the employee gets a fixed benefit in retirement. If there are insufficient funds in the plan, you may also be required to top up the plan by making a greater current cash flow commitment to the DB plan than expected. If there is a surplus in the plan, you may have reduced payments.
Enhanced retirement benefits
The following options may help you enhance the retirement savings plans of your key employees:
Supplemental executive retirement plans (SERPs)
Limits on registered plan contributions and benefits can leave your higher income employees with retirement benefits that are inadequate to maintain their standard of living. A SERP may help bridge the gap between the maximum pension available under the company’s RPP and what a higher income employee would receive were there no maximum it can also be a way to help you retain your valuable employees and encourage their long-term loyalty.
One of the most common forms of a SERP is a retirement compensation arrangement (RCA). An RCA is a non-registered pension arrangement that can help you provide supplemental benefits for key employees.
RCAs have no legislated contribution limits (provided contributions are “reasonable”) and no investment restrictions. Employees may also be able to benefit from certain investment strategies involving life insurance.
Individual Pension Plans (IPPs)
As previously mentioned, an IPP is a DB pension plan. It can be set up for a business owner but also for key employees to provide for their retirement. IPPs are typically suited for those who are age 40 or older and earn significant employment income.
Learn from Experience
While financial compensation often attracts your key employees, non-financial benefits often help you retain them. Sufficient tools and time to do the job are essential to employee satisfaction, while training and career development help to keep them motivated. Aim to foster a social environment and a sense of team and demonstrate your commitment by ensuring that work/life balance can be achieved.
If you lose a key employee, hold an exit interview so you understand the reasons for their departure. Their dissatisfaction may indicate problems among other key employees and may save you from another costly loss.
Key Decision 5:
How will you reduce risk overall?
Safeguard your personal and business assets from creditors
As a business owner, you’ve worked hard to accumulate your assets, so it’s important to protect them from risk. Review your situation and consider if you need to “creditor protect” your business. If you operate as a sole proprietor or a partnership, your personal as well as business assets may be at risk from creditors with a claim against your business.
There are a number of potential solutions. One is to keep your personal and business assets separate wherever possible and carefully structure your holdings to minimize your potential liability before any insolvency issues arise. This can be an effective way to protect yourself, particularly if you undertake such planning in the ordinary course of your business. The following are some other strategies that may help:
Protect personal assets
- Gifting assets – if you gift assets to family members, you may reduce the number of assets that may be available to your creditors, but bear in mind that those assets may now be at risk from creditors of the family members who receive them. Unless the gift is to a spouse, it’s considered a sale at fair market value for Canadian tax purposes and could potentially trigger a capital gain.
- Using insurance – depending on the province/territory you live in, placing funds in an insurance policy or segregated funds may safeguard them from potential future claims. In many cases the investment component of an insurance policy and the interests of the beneficiaries under the insurance policy may offer protection from the claims of creditors.
- Sheltering assets within registered plans – funds in an RRSP are potentially protected from creditors in certain provinces/territories. Further, RRSPs are generally creditor protected in the event of a bankruptcy. Remember that registered pension plans governed by pension legislation may also offer protection from the claims of creditors, subject to specific exceptions.
- Transferring assets to a formal trust – The legal ownership of the assets passes to the trustee, so, if properly structured, these assets could be protected from future creditors. However, you may lose control of the funds transferred, depending on the nature of the trust. Determine whether you can afford to transfer control of those assets. If you can, choose a trustee know will manage them appropriately. Remember there could be significant tax implications in placing assets in a trust, so obtain professional advice to ensure you understand the consequences before you make a decision.
Safeguard your business
When you’re working on a strategy to protect your business assets from risk, certain actions can create the impression that you intend to put assets beyond the reach of creditors. This can work against you in the event of a lawsuit and can be particularly important if your company is experiencing financial difficulties. Try to avoid the following:
- Transferring property for less than fair market value
- Transferring property without proper documentation
- Transferring property where you retain an ongoing interest or continue to behave like the property owner
- Transferring property without a change in possession
Protecting your corporate assets may involve transferring them between a number of separately incorporated businesses. The idea is that if one business fails, it won’t leave another in a vulnerable position. It is important to demonstrate that each corporation is a legitimate legal entity, carrying on business independently.
Ensure that transfers between companies occur at fair market value and are documented as though they occurred at arm’s length. To reinforce this, if you have a number of corporations with a common trade name, ensure that all documentation is prepared in the correct corporate name and signed by the authorized signing officer.
To protect your valuable business assets, you may want to structure your business so that your operating company only owns the minimum number of assets necessary to carry on its business. Consider having these assets owned by another company and leased back to the operating company so they are not available to creditors in the event of a claim.
Benefits of incorporation
Incorporating your business may be one way to protect personal assets. As an owner-manager, you are only liable to the extent of your shareholding, so you are not personally liable for the debts of the company. Compare this with sole proprietors, who are personally liable for all the debts and obligations of their businesses, and partnerships, where you can be personally liable for the actions of other partners. If you do incorporate, be careful about giving personal guarantees for loans to your business. The protection provided by incorporation can be lost in such a case and you could be personally liable for the repayment of the loan.
Surplus assets in your business
Consider keeping cash reserves low. If you have accumulated surplus assets in your business that you don’t need for operating expenses, consider transferring them to a holding company. This can help protect them from creditors of the operating company. You should also consider the pros and cons of having your company contribute to an IPP. This can help boost your retirement funds and assets in an IPP are creditor protected.
