6 Key Considerations for a Business Owner Who Wants to Retire
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.