- Retiring; Exiting via Sale, Succession or Winding-Up.
The proverbial question is always “How Much Do I Need To Retire On”?
How Big of A Stack Do You Need?
There are a couple of ways of looking at this. If you retire at age 65 and live for 35 more years, the Rule of 72 says with inflation of 2%, the cost of everything will double by the time you are 100. So the time for doubling is ‘72 divided by 2’ which is 36 years. And age 100 is quite close to age 101 (65+36).
The other way is to look at yourself as a candidate for a loan, the bank would double your expenses and halve your revenue. And as mentioned in the previous example, if $1,000,000 yields a fixed annuity of $60,000 per year, you might want to consider whether you’ll be ‘needing’ more.
Maybe you’ll need $2,000,000 in assets and $120,000 per year to live on. Especially since the beginning of 2016, hydro/electric bills increased incrementally but cauliflower and bacon prices spiked (cauliflower prices have since normalized). Gasoline prices dropped for a bit but have since crept back to over $1.00 per litre. Low interest rates generally equate to a low Canadian dollar thus making necessities (staples and consumer goods) more expensive to import (most often paid for in US dollars).
Although $120,000 per year may seem like a lot, you do need to live somewhere (thus paying at least property tax or rent). And a good portion of that $120,000 will be paid in tax (and OAS might be clawed-back). CPP might contribute to the $120,000, but that is only $15,000 per individual (based on maximized contributions). If you spend $5000/year on gasoline, car insurance and maintenance you’ll see that your base ‘necessity’ costs to retire start to add up. You are (unfortunately) going to need more. The cost of everything is increasing. And especially if your retirement income is not indexed to inflation.
Thus the formula for Retirement Income =
CPP /QPP + OAS + RIF + LIF + IPP + RCA + TFSA + Annuities + Cash +Investment Income from business +IRP + Income-Property + etc ….
As a Business Owner your target for Retirement Assets and Income could be as high as 2 times as the original Nest Egg planning that has occurred. So, as in the example, strive for $2,000,000 instead of $1,000,000.
If you are an Ultra High Net Worth individual (UHNW) you might not have any cause for concern. Other Business Owners can start to look at Pensions and Pension style investing. The Defined Benefit pensions are the most highly sought after workplace pensions and are proving to be very appealing especially if they are indexed to inflation. But it all boils down to the considerations required when taking cash out of your business (while operating or upon Exit) such that you can fund your working life-style and your retirement years.
Scenario – Is This You?
A 70 year old doctor, who for a variety of health reasons can’t qualify for certain insurance offerings, and can’t sell their business, but has $2M cash held within the MedCo. The spouse was not setup as a shareholder of the corporation and has already pre-deceased the Doctor. And as retirement looms for the doctor, what tax-efficient options are remaining?
At one point, keeping cash in your business for the purpose of tax deferral was paramount. Now as the business matures the opposite is the case, how do you take cash out of the business?
Keeping cash in the business for investment and/or tax deferral, and then switching to removing cash from the business, requires careful planning and the expertise of Tax Professionals.
Cash can come out of the business to you as a form of Capital Return or perhaps income. A few of the Cash/Capital Removal Strategies are overviewed below.
As mentioned above, especially if you were taking Salary, you were in the habit of withdrawing cash from your business OpCo. Perhaps paying dividends to shareholder and beneficiaries via HoldCo’s or Family Trusts.
Preface: Selling the Business
There are 90 year old business owners, still working, who have assets in excess of $100M and only draw $30,000 per year in salary, but this is not the norm. There are far more business owners who believe they can sell their business for ‘X’ and yet they find out they had a J.O.B. (Just Over Broke), and their business is worth very little. Also, and quite unfortunate, non-specialty medical professionals (MedCo’s, DrCo’s, etc …) may find that their business won’t be valued highly because a new Doctor could open up literally ‘next door’ and the patients would migrate over with no compensation to the original medical professional who established a local presence.
Selling the Business
Selling your Business, to a new Business Owner, an existing partner or possibly within the family, involves an exercise in valuation; whether or not there is a Buy Sell Agreement (BSA) in place. A BSA will define the terms for ‘internal’ share deals; sale or redemption. Share sales are considered Capital Gains whereas share redemptions are considered dividends (taxed at a higher rate based on the difference between redemption price and Paid-Up Capital (PUC, not discussed here). But it all starts with a Valuation.
Valuing the Business
To determine the sale price, and/or to qualify for the Lifetime Capital Gain Exemption (LCGE) via a share sale, about $824,000 in 2016, the valuation will be based on operational assets (not ‘cash’). ‘Purifying’ of a business involves removing cash from the business and can help reduce income deemed to be Capital Gain. In layman’s terms, ‘purification’ of a business involves ensuring that 2 years prior to the sale of the business, 50% of the assets of the business are operational. And at the time of the sale, 90% of the assets of the business are operational. Cash is not considered an ‘operational’ asset so it is recommended that while you leave cash not needed for lifestyle expenses in the business, you also regularly invest in asset classes that allow you to withdraw/expense cash from the business.
Sale of a business can involve an Asset sale or a Share sale (via the OpCo, most likely not HoldCo) . In either case, selling Shares or Assets, there are tax consequences and if you can foresee this transaction, it is best to start 2 or more years in advance of the sale. This is particularly important because to ensure the application of the Qualified Small Business rules, and multiplying the CGE (through shareholder and beneficiary structure of HoldCo’s and Family Trusts), you must own the qualifying shares of the OpCo/HoldCo, for two years before the sale.
Removal of cash to prepare a business (or the assets) to be ready for sale should also require an examination of the investments that aren’t used in active business income. These (passive) investments should be removed from the business as well 2 years in advance. It is also possible to pay a tax-free Capital Dividend (from Paid-In-Capital or the CDA) to shareholders/HoldCo before the sale of the company to help prepare the business for sale. In either case, a regular plan for removing cash from the business, possibly to the HoldCo, will help ensure a smooth transition to ready the business/assets for sale.
Taxation when Selling Business Assets
If you are selling the business’ assets, tax is paid on the taxable income portion of the asset sale (if applicable), and then you can pay shareholders a taxable dividend; tax optimization and “What If” scenarios/testing will also be performed in advance of the transaction.
In 2017 the rules for the sale of a business with Goodwill, and related intangible assets, such as Patents, will change. This was part of the 2016 Federal budget that says in 2017 Goodwill, etc … will be treated akin to that of a depreciable asset. Your Tax Accountant will help you understand the details involved in this analysis.
Business Sale Details
A couple of other considerations in the sale of your business involve Key Employees and Foreign Investments. Retention of Key Employees may involve many different strategies, possibly even a partial sale and perhaps non-compete clauses. A partial sale in this case is very similar to selling (partial) shares to Family Members; both involve a partial Estate Freeze. Foreign tax considerations require specialized knowledge that is best provided by your Tax Accountant.
Of interest, Estate Freezes are a simple way of capturing the value of shares (all, or just a block) at a point in time. It’s generally a share exchange that allows the business to continue, but for valuation purposes there is a definitive date and definitive value that allows share capital transaction to proceed; for example, on June 20th 2016 the business was worth $3.4M. The business is ongoing during this effort, not shut-down, and the Estate Freeze can also help with taxes and other Estate Planning initiatives.
Note1: There are also other liability considerations that might be associated with the corporation that make the asset sale more attractive (but not tax efficient); purchasers of the shares inherit the business liabilities. This is of particular interest if you sell a minority stake in the OpCo via a Private Equity transaction (possibly through a royalty based return of capital – the Kevin O’Leary typical Shark Tank deal structure).
Note2: Buy-Sell Agreements (BSAs) may also impact the available choices when selling shares or assets.
Individual Pension Plans (IPP)
One way to remove cash from a business is to fund your own Individual Pension Plan (IPP). This is a Defined-Benefit ‘Registered’ option akin to the Defined Contribution RRSP, but it is funded by the business and (typically) only for business owners those that own 10% or more of any voting share of the corporation. The business (OpCo or HoldCo) pays all IPP related fees; for both administration and investment. As the IPPs are part of a Trust arrangement they are (generally) protected from creditors.
Prescribed Growth IPP’s
Of particular pertinence now, especially considering Provincial and Federal initiatives (ie. the creation of the Ontario Retirement Pension Plan (ORPP) in Ontario and the possible expansion of CPP) is that this investment vehicle has a ‘prescribed growth’ component. Other than the CPP, no other asset class, ie. RRSP, TFSA, etc …., has a ‘prescribed growth’ mandate. And this is key as it is the reason many teachers, civil servants, etc … are regularly visiting ‘Retirement Beach’ via a Defined Benefit plan. It is true that an IPP has greater contribution limits, per se, than an RRSP, but the ‘prescribed growth’ requirement of pension legislation is what makes this unique asset class so attractive. Often the IPP is portrayed as ‘forced savings’, but the Wealthy Barber would disagree, it is regular paying yourself first through regular contributions. An IPP is a necessary lifestyle expense that just so happens to be paid into and maintained by the business. The IPP is a great way to withdraw cash from your corporation; especially if you can Buy Back Past Service (described below).
Two IPP Fallacies
- You don’t need to take the Pension. In fact the business owner could opt for an annuity or could convert the assets back to LIRA/LIF or RRSP/RIF depending upon the nature of the assets.
- The IPP Funding Requirement of 7.5% per annum is generally miscommunicated. The funding is really the rate of inflation + 3.5% (net of investment fees). Thus the IPP is perfectly suited for Rules Based Investing (RBI).
Retirement Compensation Agrangements (RCA)
The RCA, Retirement Compensation Arrangement, is a close cousin to the IPP. If the IPP was to be drawn as a square or a rectangle, the RCA could be hexagonal or possible free-formed. The RCA does require consultation, but if you’ve maxed-out the IPP, or have too much cash on hand the RCA may be an attractive investment option for the business owner. And of note, although the IPP is not usually offered to key employees or shareholders with less than 10% of the shares of the corporation, the RCA can be offered to Key Employees as a method of compensation and retention.
IPP and RCA Requirements
Please keep in mind, just like the RRSP, both the IPP and RCA require evidence of Salary compensation. And this is usually evidenced by T4 slips. There may be options to provide a form of Terminal Funding to your IPP and/or RCA. This is akin to paying a lump sum bonus into your retirement account. Upfront there are also ways to ‘service’ your IPP and/or RCA by ‘Buying Back Past Service’; this is a parallel to topping-up the unused RRSP contribution room.
Other IPP Benefits
Of note, the terminology for contributing to your IPP is ‘service’, you ‘service’ your IPP, the prescribed growth Defined Benefit retirement account. The term ‘service’ is quite powerful in the context of investing for retirement. And it is usually associated with a ‘known outcome’. The majority of other asset class investments, including the RRSP, a Defined Contribution plan, have ‘unknown outcomes’ generally because they are not ‘serviced’. ‘Servicing’ the IPP, and for that matter the CPP, creates a ‘known’ outcome, quite desirable for retirement planning purposes.
Rules-Based Investing is a perfect investment strategy for the IPP because you have a mandate to achieve every 3 years when the IPP is re-evaluated. This growth target, inflation plus 3.5% net of fees (very similar to that of the CPP), requires diligent investing and missing downturns in assets classes. If appropriate, opportunities exist to also ‘top up’ the IPP.
The IPP can also accept other registered plans. For example, if you have just retired from an employer with a pension, you may ‘fold’ the pension into the IPP as long as you have a bona fide business (OpCo). It is also possible to temporarily include your RRSP in the IPP as well; and have the associated investment fees expensed to the Corporation as well.
If you have an IPP in place, you will also be exempt from the ORPP (details still pending).
Of note, if you are taking the pension from the IPP, you still need to keep the sponsoring company in place (ie. HoldCo or another OpCo).
Currently the contribution limits to the IPP can be as high as $40,000, versus $25,370 for the RRSP. Your Trusted Wealth Professional will be able to share with you the Age-Index Contribution details of the IPP.
Note: A future publication will be coming; The Business Owners Guide to the IPP, possibly in video format on the www.TrustedWealthProfessionals.com website.
Exempt Life Insurance Policies
Insurance is an attractive method to extract cash from your business. In general the insurance doesn’t pay out when you are alive, so you’ll need to plan and invest for the years when you are not a business owner, but still alive.
Typically Exempt Life Insurance is purchased to cover taxes at Death. Also Exempt Life Insurance can be a method of Wealth Transfer to multiple family generations. Term to 100, Whole Life (WL) and Universal Life (UL), are types of Permanent Exempt Life Insurance. WL and UL also have an investment component that pays out tax free at death. While not inexpensive, generally for those with a substantial Net Worth (not ‘aspiring’ or ‘emerging’ HNW business owners), the investment component is another facet of life insurance that is considered part of Estate Planning that can be funded by the Corporation. Your Trusted Wealth Professional can help you understand the covenants of these policies and cash funding flows required to purchase these products.
Life Insurance premiums are generally not deductible from corporate income. But the policy itself can be used to fund a Buy-Sell Agreement (BSA), the main triggering event is typically death. A BSA is usually how Partners and/or Families transfer shares of the Corporation based on retirement, death, disability, mental illness, divorce, disagreement, bankruptcy, etc … Obviously Life Insurance pays in the event of Death but BSA’s are setup when there are 2 or more shareholders within the Corporation. And the Life Insurance can be personally owned or corporately owned.
Your Trusted Wealth Professional along with your Tax Accountant can determine if it is better to own the Exempt Life Insurance personally or through the Corporation. The investment portion of Corporate Exempt Life Insurance may have also been used as collateral for a corporate loan and there are considerations to be examined in this regard as well. Corporately owned Exempt Life Insurance has the added capability of when the shareholder dies, a dividend can be paid tax-free to the estate or a HoldCo (via the CDA).
Life Insurance policies/rules are changing as of January 1st 2017; specifically for Exempt Insurance. People are living longer these days, and the mortality tables are changing for new policies, and that will affect the premiums and payouts. Your local Wealth Professional will be able to help you choose wisely in this regard.
Also please bear in mind that Non-Exempt life insurance policies have annual taxes on the investment earnings (exempt policies do not have this annual tax).
Insurance serves many other business needs other than accumulating wealth; it can help protect the business (Key Person or Business Loan) as well as form part of an Executive Compensation strategy. Your trusted Wealth Professional will be able to guide you in this regard. Especially for the use of Split-Dollar insurance; as the name says, both Personal and Business interests can be addressed with this arrangement. In all cases, the caveats and funding conditions associated with joint ‘Investment plus Insurance’ offerings, must be fully understood before implementation. Particularly where the cash/investment portion is leveraged for a loan (the usage of cash also could include a ‘living buyout’ option).
Corporate versus Personally owned Exempt Life Insurance
Typically Exempt Policies are positioned as a better use for surplus cash within the corporation, than investing within the corporation (passive business income), because the investment portion of the Policy is tax-free forever whereas the same holding/asset, or other income triggering events from different holdings/assets, within the corporate investment account, will require annual taxation. And at death, the Exempt Policy is received tax-free by the corporation and can be distributed as capital dividends (again, tax-free). The policy is not exempt though from the claims of creditors; whether or not the business owner is alive.
If the same policy is now personally owned, at death the payouts are to the named beneficiaries. But the creditor claims against the personally held policy requires a breakdown between the Investment portion of the Exempt Policy and the Insurance portion. If the business owner is alive or dead, the Insurance portion of the policy, with a named beneficiary (most likely) a direct family member, cannot be pursued as part of a creditors’ claims. The Investment portion of the policy is subject to claims against the business owner personally, possibly through their estate if deceased.
In either case, personally or corporately owning Exempt Life Insurance, your Trusted Wealth Professional will be able to guide you in the correct direction. And explain the recent changes that generally negated the transfer of the Policy from the business owner to the corporation.
Note: Creditors can only pursue assets in your estate at the time of your death.
Insured Retirement Plans (IRP)
Insured Retirement Plans (IRP) can also be used to supplement your retirement income. After contributing the maximum-out the RRSP and/or IPP, you may consider an IRP.
The IRP involves contributing to an Exempt Life Insurance policy and then assigning the policy to a financial institution in exchange for tax-free loan(s). Upon death the financial institution is paid, as appropriate from the death benefit, and excess monies, usually from the investment portion of the Life Insurance are transferred to named beneficiaries in a tax-free manner.
Please note: In general, Insurance products that include both investment portions and insurance portions together, are offered only to the existing HNW business owners. You will need solid earnings and surplus cash to take on certain policies. The ‘aspiring’ HNW or ‘emerging’ HNW business owners may choose to afford regular Term, Critical Illness or Disability insurance.
In certain cases a Management Company, that provide services to the OpCo and charge the OpCo management Fees, can be created, in conjunction with a HoldCo or a Family Trust such that proceeds from the OpCo can flow through to shareholders/beneficiaries. Your Tax Accountant and Lawyer will ascertain that this structure is setup such that the arm’s length adherence is intact. This is appealing to MedCo’s where family members are prohibited from owning shares in the OpCo (and the HoldCo and Family Trust structure have regulatory ownership restrictions). Management Companies have also been established to ‘hold’ property as well such that the arm’s length provisions are not violated. Please consultant your Wealth Professional Team for the correct guidance in this regard.
Personal Expense Reimbursement
If the business owner has been paying for specific expenses through the course of the OpCo’s existence, your Tax Accountant will be able to guide you in the retroactive application of these costs, such that you can reimburse yourself and remove cash from the business.
Bonuses and/or Retiring Allowances
Again, your Tax Accountant will instruct you to the applicability of these cash removal options. Especially if there is an opportunity to ‘top up’ RRSP contributions with a Retiring Allowance.