Successful Entrepreneur Bound by Ties to a Family Business
John, 57, and Dorothy, 54, live modestly, but their plans, based on John’s sale of his company to his son, expose them to complex issues.
Situation: Businessman planning retirement expects to be repaid firm capital by new owner, his son, but must shelter it, determine other sources of income to use
Solution: Maintain tax deferrals on RRSPs and TFSAs, live on pensions and taxable savings, tap RRSPs at 71, evaluate trust to protect assets from foreign tax
In Alberta, a businessman we’ll call John, 57, is moving toward retirement. He sold his business, a marketing company, to his son, age 26, and now works for him for an annual salary of about $30,000.
John’s wife, who we’ll call Dorothy, is 54, a provincial civil servant who takes in $100,000 a year before tax. After tax and Dorothy’s benefits deductions, they have $7,000 a month to spend. They live modestly, but their plans, based on John’s sale of his company to his son, expose them to complex issues.
John and Dorothy’s current $130,000 a year gross income won’t last, for Dorothy wants to retire in two years and John, who has heart problems, will see his paycheque from the son’s company end in five years, leaving them dependent on their financial assets and Dorothy’s $1,500 monthly civil service pension. Their goal: to have a retirement income of $100,000 a year after tax, about $130,000 before tax.
John and Dorothy came to Canada three decades ago with little but their wits and a drive to succeed. Their problem is keeping a capital reserve for the business and financing a retirement mostly with their own money. Complicating the problem is a buyout deal with the son, now the business owner, who has to transfer capital from the business to John’s holding company. The transfer will leave the company dependent on John, for he will now be the company’s banker by default if it gets into trouble or needs money for expansion. The money will change pockets, but John has to keep it for the business. What seems an assured, well-financed retirement hangs by the thread of a small company’s health.
“We want to leave our jobs and maybe the province in the summer of 2016,” John explains. “We want to spend time travelling and volunteering around the world, perhaps spending much of the year in the U.S. where it is warm. The question is: Can we do it, if we can, how should we do it, and to what extent should we rely on annuities?’
If the couple can defer taxes on their savings, guard capital for the company they in effect control, and manage U.S. tax exposure, their plans can succeed.
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with John and Dorothy. “These are thoughtful, provident people,” he says. “They can harvest cash flow to have $100,000 a year after-tax. The problem will be to do it in a tax-efficient manner and to preserve the capital base of the family business.”
Maintaining Tax Deferrals
The couple has substantial financial assets which total $1,156,000 in non-registered accounts, $483,800 in RRSPs, $1,714,000 in John’s holding company owned 51% by John and 49% by Dorothy, and about $51,000 in Tax-Free Savings Accounts. Accessing the money is problematic, for withdrawals from their RRSPs will probably be fully taxed at peak marginal rates. It’s desirable to let the money grow tax-deferred until, in his 71st year, the latest date for setting up a Registered Retirement Income Fund or making other distribution plans, the RRSPs have to be tapped. Payouts can begin the following year.
Taking money out of the holding company may be taxable, too. Leaving money in TFSAs to grow without tax is wise. So spending non-registered financial assets appears to be the best initial move, Mr. Moran suggests.
If the $1,156,000 held in non-registered accounts grows at 3% after inflation and is organized to pay indefinitely, it will generate $34,680 a year before tax. The money will have appreciated to $1.2-million by the time John is 60. At age 60, the money can then pay $37,800 a year with a 3% return after inflation but before tax.
Income in Retirement
Total income at John’s age 60 would then be $37,800 from non-registered assets, $7,140 from John’s age 60 CPP benefit, which he prefers in view of his own father’s relatively short life span, and Dorothy’s civil service pension at $18,000 a year, for a total of $62,940 plus $60,000 taken from the holding company. That would be about a year’s income at 3.5%, a modest draw. The sum would be $122,940 a year. After 18% average tax, they would have $100,800 a year to spend. That would meet their retirement income target.
At Dorothy’s age 60, she could take a reduced CPP benefit of $5,710. Then at age 65 for John and 66 for Dorothy, both having been in Canada for 40 years after age 18, as regulations require, they can draw Old Age Security at $6,704 a year. That would push total pre-tax income to about $142,100.
If they split qualifying pension income, they could have individual income of $71,029, which is just below the OAS Clawback trigger point of $71,592. The actual clawback amount would depend on how much non-registered dividend income they report, for the gross-up used in calculating tax due balloons taxable income and tends to increase the clawback, Mr. Moran cautions. Their spendable income after 18% average tax would be about $9,700 a month.
When each is 72, Registered Retirement Income Fund payments would have to begin. With two years of contributions by Dorothy of $2,400 a year, the RRSPs would have grown to $513,250. Using a 50/50 split, John would have $256,625 of RRIF capital and have to take 7.48% of it for his RRIF payment. That would be about $19,200. Three years later, Dorothy would take a similar amount when she starts her RRIF.
In fact, there would be some accumulation in her RRSP, slightly pushing up her distribution. With climbing payouts as mandated by RRIF regulations, a $100,000 minimum annual after-tax income could be sustained indefinitely with backup savings in their TFSAs and without taking more income from the holding company whose capital would remain available to the business John sold to his son.
They could generate more income by using annuity type payouts which add return of capital to income and reduce all capital to zero at a designated date. However, annuities would force John and Dorothy to find new ways to shelter the money they get but don’t need. They could even buy actual annuities from an insurance company with payouts guaranteed for their lives. But these days, with bonds — the core of annuity investments — paying little, they are a costly way to get guaranteed income. In the end, there is no need to buy an annuity from an insurance company, Mr. Moran says.
There is an elephant-sized problem looming if John and Dorothy spend more than half their time (it’s more complicated than that, but 50% is a starting point) in the U.S. and so become taxable there. Their personal assets including their TFSAs and the hold company’s capital could be exposed to U.S. income and inheritance taxes. They could have to pay substantial accounting and perhaps legal fees to comply with U.S. tax law.
A trust could help avoid foreign taxes on the holding company, preserve assets for their adult children, keep capital available to the family business, and reduce or eliminate probate, red tape and costs after the parents pass away. It would be prudent for John and Dorothy to take advice from a tax lawyer with cross border experience, Mr. Moran suggests.
(C) 2014 The Financial Post, Used by Permission