Estate Planning For Small Business Owners
Proper estate planning can be the difference between paying 50% in taxes, and being able to leave most of your estate to your family members and loved ones. With the possibility of being triple taxed, CDA, holding companies, the lifetime capital gains exemption, you could easily save over half a million dollars in taxes.
What Is Estate Planning?
There are a lot of nuances to estate planning and it can quickly become complex without the right guidance. The first layer of estate planning is organizing how your assets will be managed during your lifetime and after you pass away. However, it goes beyond management and disposal of assets; a proper estate plan should also have strategies in place to minimize taxes and fees after you pass away, which could end up being over 40% without proper planning. Then there are individual strategies you can implement like setting up a trust, avoiding probate and setting up an estate freeze.
Aside from the financial aspects of an estate plan, you need to include in your Will an executor, a power of attorney, funeral arrangements and any bequests.
Why Is Estate Planning Important For Small Businesses?
Estate planning is even more important for business owners. Many have spent years of their life sacrificing time and money to build their business, and a proper succession plan or sale strategy can help the business owner save hundreds of thousands of dollars. We’ll cover valuable topics like an estate freeze and the lifetime capital gains exemption in the following section.
Estate Planning Considerations for Small Business Owners
Lifetime Capital Gains Exemption
If your plan is to sell your business before you pass away, or have it sold upon your death, you will want to utilize the lifetime capital gains exemption (LCGE).
The LCGE allows for some or all of the sale proceeds of qualified property to be exempt from capital gains. The current capital gains inclusion rate is 50% on the first $250,000 and 66% on the remaining sale profit.
So if you sold your qualifying property for $1.5 million, you would take 50% of the first $250,000 ($125,000) and 66% of the remaining $1,250,000 ($825,000) and be subject to the tax owing on the total ($950,000). If you live in BC and made no other income that year, you would pay a little over $465,000 in taxes, that’s nearly half of your sale down the drain.
As of June 25, 2024, the exemption amount is $1.25 million. So if you sold your qualifying property for $1.5 million, you would first subtract the exemption amount, then be subject to taxes on 50% of the first (and only) $250,000. You’re now paying taxes on $125,000, which in BC is approximately $33,000.
In order for you business sale to qualify for the LCGE, it must meet the following criteria:
At the time of sale, the shares being sold are that of a small business corporation and are owned by you, a partnership that you were a member of, or a person related to you.
A small business corporation is a Canadian controlled private corporation in which 90% or more of the fair market value of its assets:
are used mainly in an active business carried on primarily in Canada by the corporation or by a related corporation
are shares or debts of connected corporations that were small business corporations
are a combination of these two types of assets
24 months prior to the sale, the shares were not owned by anyone other than you, a partnership that you were a member of, or a person related to you.
24 months prior to the sale, more than 50% of the fair market value of the assets of the corporation were:
used mainly in an active business carried on primarily in Canada by the Canadian-controlled private corporation, or by a related corporation
certain shares or debts of connected corporations
a combination of these two types of assets
Multiplying The LCGE
Believe it or not, there is a way you can multiply this exemption amount. You can place private company shares in a family trust and name family members as beneficiaries. Upon disposition of the shares, any capital gains the trust realizes on the sale may be allocated to the beneficiaries, who would use their exemption to reduce or eliminate tax on the capital gains allocated to them.
Corporate Owned Life Insurance
Corporate Owned Life Insurance is essential for safeguarding your family and protecting your business’s interests and continuity. From a strategic planning perspective, there are many benefits to COLI such as business loan protection, charitable giving, funding capital gains tax at death, retirement funding, wealth accumulation in a tax sheltered manner, and more.
There are three ways to fund a COLI policy with corporate dollars:
The business owner owns the policy personally, and uses the dividend paid out by the corporation to pay the premium.
The business owner owns the policy personally, and earns an increased salary to pay the premium.
The corporation owns the policy and pays the premium directly.
Generally, a COLI policy should have the corporation as the beneficiary. When a corporation receives the death benefit from a life insurance policy, the amount of the total proceeds (less adjusted cost basis) will be added to the capital dividend account (CDA) as a credit. The corporation can then issue tax free capital dividends to the shareholders. In the case of a small business, these would be your family members or Will beneficiaries.
Estate Freeze
An estate freeze is a transaction where you lock in, or freeze, the value of appreciating assets. The intent is to transfer the future growth of those assets to other taxpayers, typically your family members. In most cases, these family members will be in a lower tax bracket than you, so your family’s overall tax bill would be lower.
An estate freeze is implemented by exchanging property that will grow in value, namely the common shares of your business, for property with no growth potential, like fixed-value preferred shares of your business.
By implementing an estate freeze, you may be able to limit your accrued capital gain on the property and transfer future capital gains to your intended beneficiaries without triggering immediate tax consequences. The freeze will generally be done using one of the rollover provisions under the Income Tax Act (Sections 51, 85 and 86).
There are many more benefits and nuances to an estate freeze, so make sure to check out our in depth blog on this topic.
What Is Included In An Estate Plan?
There are a lot of considerations of an estate plan, and not all of them are financially related.
Your Will is a legal document that outlines how you want your property and assets to be managed upon death. It also may contain instructions, such as how you want your funeral to be arranged, who becomes the guardian of your pets or minor children,
Your beneficiaries are the people who will receive your property and assets. These are typically a spouse, your children or grandchildren,
A trust is optional, but a great strategy to utilize. Trusts can help save money on taxes by allocating income to a beneficiary in a lower tax bracket, protect you and your estate from creditors as you don’t legally own the property in the trust, pay capital gains tax on a lower fair market value today rather than after your assets have appreciated in value.
An executor is someone you appoint in your Will to be in charge of your estate after you pass away. An executor will carry out your wishes that you specified in your Will. This is often an individual, such as a family member or friend, however corporate executors can be named.
A power of attorney is a legal document that gives someone the authority to manage your financial affairs in the event you become incapacitated. You can also prepare documents that allow someone to make non-financial decisions for you, such as medical and healthcare decisions, if you become incapacitated.
Small Business Succession Planning
A good succession plan should consider who is taking over your business, who and what kind of support you need, what your exit strategy is, and tax minimization strategies. The first three points are something you need to consider and decide for yourself.
As for tax strategies, we’ve covered many in this article that apply to succession planning. The lifetime capital gains exemption and an estate freeze are great strategies. Here are a couple considerations regarding the LCGE:
It’s important to make sure your business is structured properly to take advantage of all the tax savings available. If your business does not meet the requirements to utilize the LCGE, you may want to explore purification techniques which can help purify your business, so that you can claim the LCGE when you sell.
In the event of a business sale, if the buyer is interested in buying the assets of your business, not the shares, you generally won’t be able to claim the LCGE. You may be able to negotiate a higher sale price so the after-tax proceeds of an asset sale are similar to a share sale where you could claim the LCGE.
Estate Planning and Taxation For A Small Business
We’ve covered taxes sporadically throughout this article but let’s consolidate them into one section.
Federal Tax Rates
The federal corporate tax rate is 38%. After the federal tax abatement it’s 28%, and after the general tax reduction, the net tax rate is 15%. For Canadian controlled private corporations (CCPC) claiming the small business deduction, the net tax rate is 9%.
In order to be considered a CCPC, your corporation must meet all of the following requirements at the end of the tax year:
it is a private corporation
it is a corporation that was resident in Canada and was either incorporated in Canada or resident in Canada from June 18, 1971, to the end of the tax year
it is not controlled directly or indirectly by one or more non-resident persons
it is not controlled directly or indirectly by one or more public corporations (other than a prescribed venture capital corporation, as defined in Regulation 6700 of the Income Tax Regulations)
it is not controlled by a Canadian resident corporation that lists its shares on a designated stock exchange outside of Canada
it is not controlled directly or indirectly by any combination of persons described in the three previous conditions
if all of its shares that are owned by a non-resident person, by a public corporation (other than a prescribed venture capital corporation), or by a corporation with a class of shares listed on a designated stock exchange were owned by one person, that person would not own sufficient shares to control the corporation
no class of its shares of capital stock is listed on a designated stock exchange
Provincial Tax Rates
In BC, the lower corporate tax rate is 2%, while the higher rate is 12%. Income that is eligible for the federal small business deduction will be taxed at the lower rate up to $500,000. IF the income is not eligible for the federal SBD, or is income made above $500,000, it will be taxed at the higher rate.
Holding Companies
This is less about how to utilize holding companies, and more about how to avoid being triple taxed on your assets. If you want to learn more about holding companies, check out our holding company FAQ.
If you pass away with non liquid assets in a holding company, you might be triple taxed on those assets. First, there is a deemed disposition of the shares of the holding company upon your death, which could lead to a taxable capital gain on your final tax return. Second, if your estate does not have enough cash to pay your final tax bill or other debts, it may have to liquidate the assets in your holding company which would lead to another taxable capital gain, this time at the corporate level. And third, a taxable dividend must be paid from the holding company to your estate to pay the first layer of tax.
Strategic use of holding companies can offer great tax saving benefits, be sure to talk to qualified professionals before setting one up. If you would like to talk to us about holding companies, please reach out.
Other Tax Strategies
As mentioned previously, the LCGE allows some or all of your sale proceeds to be exempt from capital gains.
In general every two dollars of charitable donations will eliminate one dollar of tax on the sale of your business. If you are selling your business in your lifetime (and not passing it on after you pass away), the charitable donations should be made before the end of the tax year in which the sale of your business occurs for this strategy to be effective.
You can also consider triggering capital losses to offset capital gains. If you have other assets such as publicly traded securities that are in a capital loss position, consider selling these prior to the end of the year to trigger the capital loss. The capital loss can be used to offset the capital gains realized from the sale of your business, allowing you to reduce your taxable income and tax liability for the year. Of course this decision should be made based on investment merit as well. Make sure the opportunity cost of selling an investment isn’t greater than the tax savings you’re getting.
Estate Planning Advisors
It is highly recommended to seek professional guidance when you are estate planning as a small business owner. The tax savings greatly outweigh the fees paid to qualified professionals, and the peace of mind you gain from working with trusted advisors is invaluable.
At Parr Business Law, we’re invested in your success. As your trusted advisors, we handle the legal side of your business so you can focus on creating growth. Our commitment to lasting relationships means we’ll be with you every step of the way as you build your legacy. We specialize in Wills, probate, trusts, power of attorney, holding companies and other estate planning strategies.
Common Estate Planning Mistakes To Avoid As A Small Business Owner
Mistake 1: Not understanding the incentives offered by the federal government to Canadian entrepreneurs. Aside from the LCGE, the Canadian entrepreneurs’ incentive reduces the capital gains inclusion rate to one-third for entrepreneurs. This reduced inclusion rate is applied to gains that exceed the individual’s lifetime capital gains exemption.
There is a limit to this one-third inclusion rate, however the limit will rise by $200,000 annually until it reaches $2 million in 2034, whereby you will be able to claim the one-third inclusion rate on a lifetime maximum of $2 million in capital gains.
Mistake 2: Not seeking advice and guidance from qualified professionals. When the difference between a good estate plan and a bad one is hundreds of thousands of dollars, paying a small fee for professional advice is a huge return on your investment. There are a lot of DIY options online these days, and unfortunately, they are not one size fits all. These are intended to be sold to everyone and they are usually very basic. They won’t know all the nuances of your personal business, your goals or your family dynamics. Experienced professionals will tailor their services to each specific individual and their needs.
Mistake 3: Not starting early enough. An example is how you need to be cognizant of the fact you want to sell your business 24 months prior to the actual sale in order to claim the LCGE. You also cannot make a valid will if you’ve lost mental capacity. You may think it’s unlikely you’ll become incapacitated but it does happen to unsuspecting people every year. There’s no reason why you need to wait to start estate planning, you can always make changes to your plan as you see fit in the future.
