For small business owners, safeguarding their financial future requires a strategic approach that focuses on risk diversification and tax efficiency, particularly considering the disparities in taxation between passive and corporate income.

As a growing number of small business owners approach retirement, financial advisors have a unique opportunity to assist them in transitioning to the next phase of their lives. However, successfully navigating the intricacies of business succession and retirement income planning for these clients necessitates a deep understanding of their individual needs and concerns

In retirement planning, advisors must guide clients through a multitude of variables, including spending patterns, income requirements, portfolio returns, tax optimization, inflation, healthcare expenses, government program uncertainties, and various other issues. Small business owners with incorporated businesses face an additional layer of complexity in their planning.

To shed light on the complexities that arise when a small business owner prepares for retirement, let’s delve into a hypothetical scenario:
Imagine a client on the brink of retirement who seeks succession planning for their small business with shares valued at $1 million, which will serve as their retirement fund. This client is anxious about the tax implications and how they might affect their retirement. Their spouse is also a shareholder, and they have two children. The ideal scenario is to keep the business within the family, but the timing and readiness of their children to take over are uncertain. This client is willing to assume a higher level of risk compared to the typical retiree and aims for a 5% annual return to fund their retirement.

In this case, the client faces the dual challenge of retirement planning and the seamless transition of their incorporated small business. Addressing tax and estate planning related to their shares is crucial to avoid an onerous tax liability upon their passing.

One strategy to consider is implementing an estate freeze, which allows for the transfer of the business to the next generation while still retaining control. The client can generate a source of income through dividends on their preferred shares, ensuring that both the value and control of the business remain in their hands.

Furthermore, an estate freeze can facilitate the separation of value from control within the business. This can be achieved through a corporate restructuring that exchanges the owners’ common shares for preferred shares, while issuing non-voting common shares to the children, either directly or through a family trust, enabling the accrual of future business growth. Importantly, this strategy fixes the tax liability at the client’s death and can be meticulously planned with the guidance of an advisor. It also allows the client to utilize their lifetime capital gains exemption and sidestep immediate taxation at the time of the freeze.

To ensure a smooth transition, financial advisors should incorporate a multi-generational client strategy.
If the client’s children are ready to assume control of the business when the time comes to sell, the client and their spouse may consider selling the shares directly to their children or through a corporation owned by the children. This approach is appealing because recent tax regulations facilitate genuine intergenerational business transfers to a child-owned corporation without adverse tax consequences.

Generating Retirement Income for Small Business Owners
Another complex issue confronting retiring small business owners is how to generate income from their investments. They must grapple with three significant risks: the sequence of returns, inflation, and longevity. Addressing these risks requires a well-defined process and framework that places a strong emphasis on diversification.

Ensuring tax efficiency is paramount, especially given the absence of tax deferral on investment income compared to the tax deferral enjoyed by business income. Corporate investment tax rates, varying by province, typically average around 50% on taxable investment income.

For tax efficiency, corporate investments can benefit from capital gains as a strategy to augment the capital dividend account, complementing the 50% capital gains inclusion rate and allowing for tax-free dividends to be distributed to shareholders in the future. This strategy provides business owners with a tax-free method to access funds from the corporation.

Clients interested in more sophisticated investment solutions, financial advisors can explore a higher allocation to private assets, where most of the income is often treated as passive income. Private equity investments may offer unique tax advantages not available to individual investors.

Advisors can also consider incorporating Canadian stocks, exchange-traded funds, or mutual funds that distribute eligible dividends from publicly traded Canadian corporations into the corporate investment portfolio. The advantage here lies in the full refund of corporate taxes when dividends are disbursed to shareholders.

In conclusion, securing tax-efficient succession and retirement income for small business owners requires careful planning and understanding. Strategies like an estate freeze can help with a smooth transition, while diversification and tax-efficient investment options are essential for generating retirement income. By working with knowledgeable advisors, small business owners can ensure a financially secure and tax-efficient retirement, passing on their legacy to the next generation.

At SLF, we’re here to help. For more information contact your SLF Advisor.