From tax pitfalls to exit-planning blind spots, a wealth advisor discusses the challenges for which entrepreneurs need guidance
For many, January is an opportunity to approach life with new resolutions and commitments. But for business owners, the beginning of the year is also a critical time to revisit important aspects of their financial plans, particularly when it comes to taxes and exit planning.
“Of course, we’re all aware of the fallout that’s come from small-business tax changes that were first proposed in 2017,” said Marie Phillips, wealth advisor at IPC Private Wealth. “Probably the most important takeaway for business owners as of now concerns the tax on split income (TOSI). While it used to be a useful tax-planning tool especially for professional corporations, it’s very much been closed out, so it’s critical to review the business structure with an accountant to see if any changes will be necessary.”
Aside from the new TOSI, Phillips noted the need to keep an eye on major purchases, particularly with regards to any depreciation that needs to be booked within the business year. Another commonly overlooked pitfall involves borrowed money from shareholder loans: unless a loan is paid back within one year after the end of the taxation year of the lender, the loan amount will generally be included in the taxable income of the person or partnership for the year in which the loan is made.
Many business owners may also be concerned about potential difficulties in dealing with the CRA. There have been notable stories of business owners and professionals finding themselves on the wrong end of tax reassessments and investigations, leading to disputes and appeals that drag on for years.
Phillips cited one example concerning a professional artist whom the CRA reassessed. It rejected thousands of dollars’ worth of expense claims he filed for an art project. The reason: the work was funded by public grants and not sold for profit, which according to the agency meant that it couldn’t be counted and deducted as a business expense.
“The question there was whether it’s fair; after all, established artists don’t do this as a hobby, but this is their business,” Phillips said. “The best way to avoid that, in my view, is for business owners to work with a professional when filing their taxes. Having an accountant, particularly one who’s familiar with the area you operate in, can make a huge difference in identifying potential pitfalls and points of confusion.”
Another area that business owners ought to concentrate on is exit and succession planning. A recent report by the Canadian Federation of Independent Businesses (CFIB) found that just 49% of entrepreneurs have a succession plan — a figure that Phillips found to be on the extreme high side.
“Based on my experience, it’s probably closer to the 8%,” she said, referring to the percentage of business owners that the CFIB said had a formal plan in place. “I’ve read that around 25% actually don’t plan to leave until they have enough money, and another white paper we released here at IPC found that 36% plan to sell when they’re unwell.”
Altogether, that’s 61% that aren’t seriously thinking about how to gracefully hand over the reins of their businesses to the next generation. Phillips believes that the issue can be traced to an array of uncertainties: not feeling they’re ready to leave, not being confident that they have enough money saved, not feeling their heir apparent is ready, just to name a few.
“And those are just for planned exits. What happens in case they suddenly suffer a disability?” she stressed. “That’s why when we speak to business owners, we encourage them to think about their current situation — their earnings, their expenses, and the capital available to them — and have a good strategic business plan in place.”
Another challenge that business owners face, according to the CFIB, is business valuation: many entrepreneurs simply don’t know how to determine their business’s worth. In such cases, Phillips said, it’s best to work with an advisory practice that has strategic alliances with firms and experts who can help.
In the course of planning their exits, business owners generally have to weigh two major options: passing their enterprise on to a family member or selling it to an unrelated third party. But the CFIB pointed out that under current tax rules, a profit from selling to a family member will essentially count as a dividend, while the same outcome with a third party would be deemed a capital gain. That means keeping it in the family wouldn’t be ideal for those who’d like to benefit from the lifetime capital gains exemption (LCGE).
Still, that doesn’t mean letting the business go to an outsider is absolutely the best option. “You have to be careful because they may not understand the culture,” Phillips noted. “And when you have an heir apparent who’s spent years or decades in the business, you can’t discount them outright.”
To make a truly informed choice, business owners may consult advisors and accountants on the pros and cons of more sophisticated planning approaches. “They can discuss the pros and cons of perhaps an estate freeze. They may also consider setting up a family trust where the owner can still plan to exit the business, but continue to take income at a preferred-share level,” she said.
