The value of a good tax strategy
Many owners are unaware of what’s available to them A professional can help them attain goals and dreams
Bruno Palermo, co- owner of a Toronto- based auto repair shop, says that by applying certain tax strategies he’s been able to put enough money aside to be in a position to purchase investment properties.
“ After being in business for 21 years, I was quite familiar with the basics of tax savings,” says Palermo, who co-owns Silver Service Auto Repair.
He’s referring to common deductions, which typically include all the expenses involved in operating your business: the costs of owning and maintaining an automobile, office supplies, computing and electronic equipment, meals and entertainment, and so on.
“ But after getting some professional accounting advice I realized I was just scratching the surface,” he adds. “ My accountant plotted tax strategies on a map and put it in layman’s terms, which made it easy for me to understand.”
Brett Starkman — Palermo’s accountant — is a tax partner with Schwartz Levitsky Feldman LLP, which serves both small and large corporations as well as individuals. Starkman says it’s important for his clients to understand how tax strategies work.
“ It’s more than just numbers; it’s about being able to afford university tuition for your children, good dental care, a cottage, a family vacation.” He explains that many small business owners are unaware that they have recourse to numerous tax strategies to minimize their tax obligations and in turn be in a position to attain their personal goals and dreams.
Indeed, many entrepreneurs quickly realize that their personal and business finances are a tangled web.
Bill Phillips, owner of Woodlore International in Brampton, which manufactures office furniture, found that his biggest tax challenge was how to pass on his flourishing business to four sons without triggering an astronomical tax bill. Starkman advised him to set up a family trust, pointing out that such a trust is not only a strategic vehicle for reducing one’s tax exposure, but also an ideal estate planning tool.
In other words, a family trust makes it possible to take advantage of additional tax strategies, such as income splitting and multiple capital gains exemptions. Starkman suggested to Phillips that he make use of his own $ 500,000 capital gains exemption by exchanging his common shares for preferred shares, and then issuing new common shares to a family trust for a nominal price. Now the beneficiaries of the family trust – his wife and four children – will now be in a position for each of them to use a $ 500,000 exemption if and when the company is sold. The result will be tax savings in the the hundreds of thousands of dollars. Both Palermo and Phillips agree that even with their business experience, they would not have been able to take advantage of this strategy if not for professional advice. When asked what are some other common tax- saving mechanisms available to small business operators, Starkman listed a few.
“ One of the best tax strategies around is the $ 500,000 capital gains exemption,” he says.
According to Canada Revenue Agency ( CRA), you may be exempted from taxes on the first $ 500,000 when you sell shares in a Canadian small business corporation. But in order to qualify for this exemption, there are many conditions to meet, one being that 90 per cent of the small business corporation’s assets must be used in an active business, or a holding company may own such shares. Starkman adds that leveraging the capital gains exemption to its fullest potential might mean setting up a structure to realize multiple capital gains exemptions.
In other words, by implementing certain procedures you may allocate shares in your business to yourself, your spouse and your three children — and once you decide to sell your business you’ll be able to take advantage of five $500,000 capital gains exemptions, instead of just one.
Similarly, income splitting also spreads profitability with family members in order to qualify for lower tax brackets. Income splitting can be done with a spouse and children, as long as these children are over the age of 18 and you pay them a “ reasonable” salary for any “ reasonable” work they do for your company.
“ The income- splitting tax strategy lets you transfer a portion of your income to a family member with a lower income, thus reducing the marginal tax rate on your income,” says Starkman.
Phillips says he does income splitting with his wife, who is the secretary on his board of directors, while Palermo says his partner does it with his 18- yearold son — and he plans to do the same but his children are only 7 and 9.
Incorporating your business is another strategy that can reduce your tax burden. As Starkman points out, an incorporated small business qualifies for a lower taxation rate. The first $ 300,000 of income is subject to the small business tax rate, which in Ontario — combining the federal and provincial tax rates — is approximately 19 per cent. By comparison, as a non- incorporated entity your business would be taxed at the top personal marginal rate of 46.41 per cent over approximately $ 114,000 of income.
Also, as an incorporated entity you have the choice of either taking a salary or dividends as a means of further reducing your tax exposure. Even if you’re currently operating as a sole proprietor, you can incorporate and transfer your assets to a small business corporation on a tax- deferred basis under Section 85 of the Income Tax Act of Canada. Tax deferral can also be taken advantage of within an incorporation.
“ Unlike your personal taxes, a corporation has the flexibility of choosing its year end,” says Starkman, explaining that this can be used to create tax deferrals. He gives an example by pointing out that if the corporation has a year end of July 31 and has a profit of $ 1 million, by using bonuses the corporation can claim a $700,000 deduction, thus reducing the taxable income to $ 300,000, eligible for the small business tax rate. Thus, the $ 700,000 can be allotted to the individual’s next taxation year. Good estate planning will also play an imperative role when trying to minimize taxes and manage the overlapping of an entrepreneur’s personal and business lives. Starkman explains that one very powerful strategy in estate planning for a small business operator is the capacity to freeze the value of the company while allocating its future growth to the inheritors of the business.
“ If your business is worth $ 500,000 today, you can freeze its value today, then you can issue shares to family members — and its future growth will accrue to those shareholders,” he says.
“ Ten years later your company has grown to a value of $ 2.5 million and yet on your death there will only be income taxes on the allotted $500,000, for which you may use your capital gains exemption.” Starkman goes on to say that one of the least glamorous taxminimizing strategies — the RRSP — is nevertheless one of best tax breaks around. The RRSP can be further leveraged by converting it to a self- directed RRSP, which opens up all kinds of possibilities.
Palermo says that he, his partner and his employees value their RRSPs so much that their contributions are automatically deducted through their weekly payroll. Starkman also suggests small business owners consider the Individual Pension Plan ( IPP) as opposed to RRSPs.
“ The allowable contributions to an IPP are significantly larger than those permitted in an RRSP,” he says, adding that upon the implementation of an IPP, there is even the capacity to make a past service contribution — which may be up to $100,000 — and in turn the company would realize an equal deduction. Starkman notes that a properly formulated tax-reduction strategy may also include willprobate planning as well as life insurance products.
Since no two businesses are alike, there is really no perfect cookie- cutter solution when it comes to tax planning. Agood accountant in conjunction with a lawyer will be able to design a customized tax- reduction plan that will take into consideration all the variables of an individual’s situation. These might include: marital status, whether there are children and if they want to continue the business, profitability of the business, whether there are partners, and future lifestyle and retirement goals, to mention a few.