If you're like most business owners, you're going so flat out running your firm you don't spend enough time managing your personal finances. That means you're failing to take full advantage of wealth-building opportunities and neglecting key wealth-preservation tactics. PROFIT knows how tough it is to find the time to devise a personal financial strategy, so we've done some of the work for you.
We've created this handy checklist of wealth-management moves for entrepreneurs, explaining why, when and how to make each one. Read it and reap.
Establish a holding company
You've worked far too hard building your business to leave its assets vulnerable to creditors—and the statistics show there's a decent chance that creditors will one day come calling. In order to protect your lifestyle and discourage lawsuits, you should put the following safeguards in place, then review your creditor protection annually.
Although incorporating your firm provides a degree of separation between your personal assets and liabilities and those of your business, putting your operating company (opco) under the ownership of a holding company (holdco) provides an extra layer of protection from creditors. That's because creditors can't make claims against assets held by the holdco.
Once your holdco is set up, transfer the opco's extra cash to the holdco in the form of a dividend, which will be tax-free to the holdco. But you should carefully consider your definition of "extra cash." Although an opco can legally transfer 100% of its profits to the holdco as a dividend, doing so could deprive the opco of cash required to fund daily operations, make capital investments and cover emergency situations. Also, bank lenders will require you to maintain the debt/equity ratios specified in any loan covenants.
That said, what goes up can come back down. Should the opco require cash, it can borrow it from the holdco under a general security agreement. The holdco isn't required to charge any interest, but doing so might be a wise option, depending on your firm's tax situation. Better yet, the holdco then will be a secured creditor of the opco, second in line only to bank lenders. Deborah MacPherson, a Calgary-based tax partner with accounting firm KPMG Enterprise, advises working with your bank to ensure the transfers adhere to its terms of credit.
You should also consult with another source of specialized advice. "The general rule of thumb is to transfer as much as possible from the operating company to the holding company," says Peter Merrick, president of Merrick Wealth Management Inc., a Toronto-based provider of financial planning and risk-management services. "But this is one of those cases where you need a good tax advisor to do an accurate assessment for you."
Don't neglect to look into other ways to creditor-proof your personal assets, such as family trusts, spousal RRSPs, individual pension plans (IPPs) and life-insurance products, all of which are discussed elsewhere in this article. And don't put the exercise off. "The time to creditor-proof your company is when times are good—not on the eve of bankruptcy," says Merrick, noting that the Fraudulent Conveyance Act legally prevents you from creditor-proofing your company if it's on the brink of bankruptcy.
Always know what your firm is worth
What's your company really worth? Most business owners can't offer the correct answer. Why? Because in the mind of the average entrepreneur, selling the business is years, if not decades away. But knowing the price that your business would fetch if it were sold today offers many benefits, and is important if you do an estate freeze. (See "Make your kids capital gainers)
The true value of your company is crucial information to have if someone offers to buy your business. A valuation also reveals how much of your overall wealth your company represents so you can determine how much you should hold outside the firm in order to be properly diversified. (See the next checklist point.) It gives you a key number used in retirement and estate planning. And, points out David Lloyd, chief wealth-management officer at Newport Partners, a Toronto-based private wealth-management company, "A successful entrepreneur who hasn't had his business valued in 10 years is probably underinsured." That's why wealth-conscious entrepreneurs obtain a business valuation every three years from a chartered business valuator. Your accountant should be able to help you find one.
Don't bet your life on the business
As much as you love your company, you shouldn't let it monopolize your personal investment portfolio. Unfortunately, many business owners do just that, taking on an enormous risk by leaving all—or almost all—of their net worth tied up in their firm.
Al Feth, a Waterloo, Ont.-based financial planner, says that as a rough rule of thumb, you should aim to have 30% to 40% of your net worth in an investment portfolio outside your business. He concedes that most business owners find this a tough target to reach, especially in the early years of their operations, when they're inclined to put every spare dollar into their company. But, says Feth, you should do as much as you can to avoid betting everything on the fortunes of your firm.
Even if you hit this target, of course, you'd still have the majority of your assets within your company. But provided your company is incorporated, says Feth, you'll enjoy huge tax advantages that make it prudent to have your business as your main repository of wealth.
Sole-proprietor businesses have fewer tax advantages, so people who own those should keep more of their assets outside their company.
For those outside assets, you should hire a fee-for-service certified financial planner or advisor to structure a diversified portfolio for you, then review it annually. Bear in mind that more than 90% of the total long-term return on equities and fixed-income products is due to asset allocation. A good financial planner will help determine the right asset allocation for you, given your age, financial goals and risk tolerance.
Also ensure that you have a proper mix of equity investments (such as Canadian and international blue-chip stocks or mutual funds) and fixed-income investments (such as bonds, treasury bills and income funds). Most pension managers recommend a 60/40 split in your portfolio of equity and fixed income, respectively—or 50/50 for more conservative investors. And, crucially, you should rebalance your portfolio once a year to maintain your optimal split.
Multiple studies have shown that the hefty management fees most active fund managers charge often turn a decent return on investment into a mediocre one. Tell your financial planner that you want to stick with low-cost options such as exchange-traded funds (ETFs) and index mutual funds. This step alone could save you up to 2% annually in management fees—a $2,000 savings on every $100,000 invested in the lower-cost products. On a $1-million portfolio, that's an extra $20,000 per year in your pocket.
Make your kids capital gainers
Don't let the taxman put a damper on that big payday party you'll enjoy when you sell your company. And don't wait till you're planning to sell to analyze the tax implications of a sale. As Newport's Lloyd points out, "More than half of all businesses sold come from unsolicited offers, so you have to be prepared."
Configure your company's ownership structure to take maximum advantage of the $750,000 lifetime capital gains (LCG) exemption to which each of your family members is entitled. In other words, don't be the sole shareholder of an opco; instead, ensure that everyone gets in the game.
How? At a cost of $5,000 to $8,000, you can create a family trust as well as a holdco, allowing tax-free capital gains to accrue to other family members—your spouse, children or even grandchildren. It's common practice to list a spouse as a shareholder in the holdco and other family members as beneficiaries of the family trust. With a family trust, you can remove people from the list of beneficiaries, whereas with a holdco, shareholders are listed for life.
"Timing is key," advises KPMG's MacPherson. "The capital gains must have accrued over time in order for each of your family members to be eligible for the full $750,000 exemption."
To ensure that these capital gains start accruing to family members as early as possible, you should perform an estate freeze. This locks in the value of your shares in your company as of the date of the freeze. Any post-freeze increase in your company's value will go to your spouse and children. Each of them will then be able to apply his or her lifetime capital gains exemption to the taxes owing when the business is sold. A nice bonus is that you'll know, and be able to plan for, how much in taxes you'll owe when you sell your company.
To execute an estate freeze, you'll need to have your firm valuated. Then your company will issue you fixed-value shares equal to your current equity in the business, and issue growth shares to family members named in your holdco and/or family trust. The tax savings can be huge. "Each lifetime exemption gives a family member [up to] $170,000 in tax savings," says MacPherson. "If a company is structured properly, a family of four could save $680,000 in taxes—not just the $170,000 it would save if only the entrepreneur held all the company shares."
Adjust your compensation mix annually
For most people, how much they make is the ultimate variable in their wealth accumulation. But quality is as important as quantity for business owners, because different forms of compensation have different tax implications. The wealthy entrepreneur continually considers what his ratio of salary to dividends should be. One basic consideration within this balancing act is paying yourself enough salary to maximize your RRSP and CPP contributions. The RRSP contribution limit for 2011 is $22,450, which you'll reach if you pay yourself a salary of $124,722.
More complicated is determining how much compensation to take in the form of dividends. Tax rates on dividends vary widely from province to province—from 15.8% in Alberta to 30% in Quebec—and are slated to rise in some provinces and to fall in others. Of course, your firm also pays taxes on the income from which a dividend would be paid. Only once your accountant has calculated the combined percentage from these two rounds of taxation—and taken into account other variables beyond the scope of this story—will you know how the total tax hit would compare with receiving the same amount as salary.
Another thing to consider: "If you don't need the money as income or salary, have your operating company pay dividends to the holding company," says MacPherson. "There will be no tax on that dividend until you take the money out."
Don't forget to put family members on the payroll, too. Presuming that your spouse or kids are in a lower tax bracket than you, this approach will generate more after-tax income for your household. You can also have a family trust pay dividends to any of your children aged 18 or more—or a holdco pay dividends to any child who's a shareholder in it. Depending on the tax bracket and other tax credits your kids may be eligible for, they may end up paying little or no taxes.
Even if you haven't set up a holdco or a family trust, hiring your kids for summer jobs at your company will give them an income they can use to help fund post-secondary education, reducing the amount you have to provide. And, provided you don't pay them more than about $20,000—which is very unlikely if they work there only for the summer—they'll still be eligible for the tax credits that will keep their taxes minimal or non-existent.
Find the silver lining in every expense
No sensible employee would pay business-related expenses out of her own pocket. Neither should you as the business owner. Make sure that you annually review all the expenses you incur in providing services to your firm, then ensure that the company coffers pay for any that are deductible as a business expense. If your company is incorporated, you should talk to your accountant about running as many expenses as possible through the company in order to minimize the taxes paid.
"The expenses may only be partially deductible," says MacPherson. "But it's still more cost-effective to pay for these through your company's earnings and not your personal income."
Possibilities to look at include a vehicle (if, say, you or your business-partner spouse use it more than 50% of the time for business), golf-club memberships if you do business on the links and any seminars and workshops you take on subjects related to running your company better.
One key expense your company should pay for is an employer-sponsored health-services plan for outlays such as prescription drugs, dental bills and eyeglasses. The firm pays the monthly premiums, which are tax-deductible. And all your family members—as well as your employees—will enjoy a non-taxable benefit.
Assume you'll be disabled this year
According to Statistics Canada, one in eight working Canadians will become disabled for more than three months, and half of these people will be disabled for more than three years. Those sobering statistics should push disability insurance to the top of your list of insurance needs.
Protect yourself and your family from disability-related income loss by making sure your policy has a benefit period extending to age 65 and will replace all of your monthly after-tax income in the event of a claim. The latter depends not only on the premiums paid but also on whether tax deductions were claimed against them. "The rule is: if you pay the premium with after-tax dollars, the monthly benefit is tax-free," says Lorne Marr, president of LSM Insurance Canada, a Markham, Ont.-based independent insurance broker. "In most instances, people don't deduct the premiums."
You should also have a good term-to-100 life-insurance policy that will cover all your family's annual expenses and personal debt if you die unexpectedly. As well, your company should buy life, disability and other forms of insurance for you and other key people in the business. The firm will be the policy's beneficiary; in the event of death or disability, the policy will make a payment to the company to compensate for the setback of losing a key executive.
The standard rule of thumb is to buy five to 10 times the key person's salary. For a 45-year-old male non-smoker making $200,000 a year, the premiums will cost about $2,000 to $4,000 annually.
In all cases, review your insurance coverage annually to ensure that it's keeping pace with your changing financial situation.
Get your spouse in the game
Once a year, consider making a contribution to your lower-earning spouse's RRSP instead of your own.
The benefits are twofold. First, creditors won't be able to access the assets of the spousal RRSP—provided that the spouse isn't a director or guarantor of either the business or the personal debt of the person who makes the spousal contribution. Second, the tax savings can be hefty. A business owner in the 46% tax bracket who makes the maximum RRSP contribution in 2011 to a spousal plan instead of his own can save about $10,000 a year in taxes, depending on his other tax credits and deductions.
As well, consider a spousal loan, in which the higher-income spouse makes a loan to the lower-income spouse, who then uses the money to buy investments. The resulting investment income is taxed in the hands of the lower-earning spouse, at the lower rate.
Each quarter, the federal government sets the interest rate that the borrowing spouse is required to pay. Currently, it is the lowest it has ever been—just 1%. What's more, your spouse is allowed to deduct the interest. So, as long as your spouse can earn more than 1% on his or her investments—plus the taxes you pay on the interest you receive on the loan—this is a good tactic.
Launch an individual pension plan
It seems that corporate Canada can't do away with its defined-benefit pension plans fast enough. But for the independent business owner, they're an attractive option—if the planholder is the business owner.
Such is the case with an individual pension plan (IPP), a type of defined-benefit plan best suited to owners of incorporated businesses who are at least 45 years old and make more than $100,000 per year. Your company will make the contributions to this plan, which can exceed the allowable limits for an RRSP. Your firm can fully deduct these contributions, which are considered a non-taxable benefit for the plan's beneficiaries—most likely, your family. Best of all, creditors of an incorporated business can't seize assets held inside an IPP.
The annual contribution limit on your IPP will depend on a variety of factors, including your age, salary and the number of years until normal retirement age. You'll need to have an actuary crunch the numbers, then review your IPP annually to ensure that it still suits your circumstances. The calculations involved are by no means simple ones, and IPP specialists say individual situations vary so greatly there's no such thing as a typical plan.
There are downsides to an IPP. Tax rules require a plan's value to grow by 7.5% per year, meaning your company must cover any shortfall. (If the IPP grows by more than 7.5%, your firm's contribution will drop the following year.) And, other than in special situations, such as a critical illness, once you've put money into an IPP, you can't get it out until retirement.
Still, an IPP makes it possible to set aside significant amounts of tax-deferred income for your retirement. "They're a no-brainer," says Lloyd. "And you can contribute for past service back to 1991."
The best time to contribute? When the business is sold. You can shelter hundreds of thousands of dollars at that time—far more than you could within an RRSP.
Make your advisors work as a team
Protecting and growing your wealth isn't something you should try to achieve on your own. You'll want an accountant, estate lawyer and certified financial planner, all with experience of working with business owners, to work together to advance your financial interests. Have them meet together with you at least once a year. This is a necessity, because even though your lawyer knows the details of your will and your accountant knows the details of your business, neither is likely to know as much as he should about your personal finances. For that, you'll need a fee-based certified financial planner. Your planner will charge by the hour for advice—the going rate is $100 to $150—and not by the number of financial products she can sell you.
Focus this annual meeting on updating your personal financial plan. The idea is to review your goals and confirm that you're using the right tax- and estate-planning strategies to grow and preserve your wealth. The key to success? Be specific. "Get rich" is too vague a goal. Far better: "Achieve a net worth of $2 million by age 50."
And if you find that your team members aren't suggesting the sorts of tactics identified in this checklist, don't hesitate to make changes. "Ask yourself, 'When was the last time this person gave me a good piece of advice to help me?'" advises Merrick. "If you can't answer, 'Within the past year,' find someone new. It's time to move on."