Unless you run an accounting firm, navigating the complexities of tax law is probably outside of your professional expertise. “That’s not what you’re fantastic at—you’re fantastic at running your businesses,” observed Rachel Gervais, a partner at BDO. But that doesn’t mean you should pay more tax than you should.
One reason your tax bill may be inflated is because you’re not modifying your company’s structure or your personal finance strategy during the business life cycle. What worked at startup doesn’t necessarily make sense today said Gervais, speaking at the PROFIT/Chatelaine W100 Idea Exchange in Toronto on June 5.
Gervais identified several tax traps that can prove very costly for you and your business, both today and in the eventuality of a sale. Here are three particularly expensive ones that you should attempt to avoid.
“Owning” too much of your business
Before you company has sales, assets, offices and employees, there’s just you and your idea. So it’s normal at startup that you be the business’s sole shareholder. But “that’s a no-no for tax,” Gervais said.
At exit, being the sole shareholder means you bear the entire tax burden of your company’s sale price. The solution is an estate freeze, Gervais explains. “We’re going to let you lock in your value,” she said. “You’ve grown the business to $5 million or whatever the number is and now you’re going to let other people come into the structure.” In essence, you’re freezing your tax exposure at the current value of the business.
You don’t have to stop being involved in the business after an estate freeze, Gervais noted. “It doesn’t mean, I’ve built a business to a million bucks, I’m handing it all off to my kids,'” she said. “It means that there are ways to get your kids and spouses involved in the business by participating in the growth, and maybe in the decision-making too.”
Paying too much tax in growth and exit phases
Your business is likely your sole source of income, and it’s only fair that you reap the rewards of it’s success. But “if you’re paying yourself all the income that’s coming out of your business, you might be in a very high tax bracket,” Gervais said.
One way to drop down a bracket or two is to share the wealth with family members. “Family trusts can get involved into the structure,” Gervais said. It allows for you to still control the show, but be able to get income on an annual basis to your spouse, to your kids, or to your parents.”
If other family members work in the company, you can also use salaries to split the income without going the family trust route. “I’m not talking about paying your kid $100,000 to sweep the floor twice a year,” Gervais noted. There’s nothing wrong with paying family members a reasonable amount for the real work that they do within a business. Gervais suggested that you can arrive at a fair amount would be by asking “What would you be willing to pay someone else—an arms-length person—for that service?”
If you have undertaken an estate freeze, or family members already have a stake in the business, then consider issuing dividends. “If you’re each taking a hundred thousand dollars a year, that’s a very different tax rate that each of you is paying than if you alone are taking several hundred thousand dollars,” Gervais said.
Feeling your company is “clean”
The Capital Gains Exemption (CGE) is a lucrative tax tool that allows you to receive up to $813,000 tax free from selling the shares of your business. But to be eligible for the CGE, your company has to fit the definition of a Qualified Small Business Corporation (QBSE). Gervais said many entrepreneurs have heard of the CGE and assume they meet the requirements, only to find out on the verge of a sale that they’re not eligible.
To meet the definition, you need to have a “clean” company. A QBSE must be controlled by Canadian residents, and be privately held. It also needs to have good assets, not bad ones. “Good assets are things like cash that you need to service your business, accounts receivable, real estate , machinery and equipment,” Gervais explained. Bad assets include bad cash, which accumulates when you leave cash in your business for an extended period because you don’t need it. Another common bad asset occurs when you star an investment portfolio within your operating company.
Working to meet the eligibility criteria in advance is the only way to benefit. “[It’s a] very difficult definition to meet, and it’s one you need to continually meet,” she noted. “If you’re not meeting it, you need to do some planning about two years in advance of when you sell your business.”
MORE PERSONAL TAX TIPS:
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