Retirement Planning For Business Owners

Registered pension plan coverage has steadily diminished in Canada over the past generation. This trend has made retirement planning more complicated for retirees who are increasingly reliant on their accumulated savings to provide an income in retirement. Business owners have additional complexities and considerations both before and after retiring.

One advantage of retiring from self-employment is that it may be easier to phase into retirement. Employees may not have the option to transition to a part-time role with their employer and are at risk of restructuring or downsizing leading to a late-career job loss. Business owners can delegate some of their work, reduce their workload or hours, or simply say no to new business to implement a staged retirement transition.

However, succession planning can be challenging. Small businesses that revolve around the owner may find that the business really is them. That does not mean the business cannot continue with a new employee or owner. Some businesses are saleable to employees, to third parties, or to a business owner’s children. This can impact the financial and tax implications of succession.

If a business owner sells their goodwill, including their client list, accounts receivable, inventory, or equipment, they will pay capital gains tax on the proceeds that exceed the tax cost of these assets—about 25 per cent, varying by province. If a business is incorporated, 50 per cent of a capital gain may be eligible to pay out tax-free personally to the shareholders as a capital dividend.

If a business owner sells the shares of their corporation instead of selling the assets, those shares are typically subject to capital gains tax. However, the shares may qualify for the Lifetime Capital Gains Exemption (LCGE). The 2021 exemption is $892,218 for an individual taxpayer. A corporation that owns shares of another corporation it sells cannot qualify for the LCGE—only an individual qualifies. If planning is done in advance, multiple family members’ lifetime exemptions may help reduce or even avoid capital gains tax payable on more valuable businesses.

The LCGE can be claimed on the sale of Qualified Small Business Corporation (QSBC) shares as well as qualified farm or fishing properties. A QSBC is generally a Canadian-controlled Private Corporation (CCPC) in which 90 per cent or more of the assets are used in an active business carried on primarily in Canada by the corporation or by a related corporation. Qualifying shares must typically have been held for at least two years prior to the date of the sale.

Once a corporation is no longer active, to the extent there is cash or investments within it, the corporation effectively becomes an investment holding company, often referred to as a “holdco”. It may make sense in some instances to deplete and wind up an investment holding company, while in others, it may make sense to maintain it.

If a corporation’s assets are relatively modest, the ongoing tax and legal requirements may not be worth it compared to just withdrawing the retained earnings and closing the company. If a corporation has enough assets, it may make sense to maintain for much of or throughout retirement depending on other assets and income sources of the shareholders.

Business owners who have typically paid a salary to themselves during their working years generally transition to paying dividends in retirement with corporate savings or investments. One reason is that salary is generally only deductible against business income of a corporation. It is difficult to justify deducting salary against corporate investment income. Dividends are a payment of after-tax profits from a corporation to a shareholder. They are taxed at a lower tax rate personally than salary to account for the fact they are being paid to the shareholder from after-tax corporate income. Depending on the other taxable income and sources of the shareholder recipient, dividends can be taxable at a low tax rate or even tax-free to an individual.

Paying dividends may recover corporate Refundable Dividend Tax on Hand (RDTOH) for tax paid previously on corporate investment income. Corporate tax refunds resulting from paying dividends out to a shareholder may be higher than the tax payable by the shareholder receiving the dividends, and this can result in a net tax advantage overall. A corporation’s Capital Dividend Account (CDA) representing the cumulative tax-free half of net capital gains may allow the payment of tax-free dividends to shareholders as well.

New Tax on Split Income (TOSI) rules limit the benefit of paying dividends to a spouse who does not work in a business, since those dividends could be considered split income, taxable at the top tax rate. It is easier to split dividend income with a spouse shareholder in retirement when a corporation is no longer earning business income, or the business owner is aged 65 or older. A spouse must be an existing shareholder or be added as a shareholder of a corporation to receive dividends.

A business owner does not need to pay dividends out of their corporation in retirement. There is no such requirement. However, if they have a Registered Retirement Savings Plan (RRSP), withdrawals must begin by no later than age 72. As a result, RRSP withdrawals are less flexible than withdrawals from a corporation. A RRSP also has restrictions on what it can invest in, unlike a corporation. A corporation can buy real estate, invest in other businesses, and is not limited by the qualified investment rules of registered investment accounts. There are also more options for leaving corporate assets to your children as part of your estate plan than with a RRSP. As a result, RRSP withdrawals are often preferable to corporate dividends in retirement, although it may make sense to consider a combination of the two.

Retiring business owners who are in good health should consider deferring their Canada Pension Plan (CPP) and Old Age Security (OAS) pensions. This deferral reduces their income early in retirement, making it easier to take RRSP withdrawals at a low tax rate, and it also helps protect them against the risk of living too long given CPP and OAS pension are payable for life. Retirees can increase their CPP by as much as 64 per cent and their OAS by as much as 55 per cent by waiting from age 65 until age 70 to begin these pensions (assuming a two per annual inflation rate).

A business owner who has determined they have more assets than they are likely to need during their retirement can benefit from more advanced strategies. One such option is an estate freeze. A shareholder can freeze the value of their shares of a corporation and issue new shares to their children (including indirectly through a trust they control) so that some or all the future corporate asset growth accrues to their children. This can reduce tax on death when a taxpayer is deemed to sell all their assets with the resulting tax payable on their final tax return.

Life insurance is another option to reduce tax payable on the death of an incorporated business owner. If corporate funds are used to pay life insurance premiums instead of invested, the value of the corporation will be lower upon a shareholder’s death as a result. The life insurance death benefit then pays tax-free into the corporation and may be available to withdraw from the corporation with little to no tax payable by the deceased shareholder’s beneficiaries. By comparison, the value of a deceased shareholder’s shares is subject to capital gains tax as high as 27 per cent and their beneficiaries may have additional tax to pay to withdraw funds from a corporation.

Tax planning, tax filing, saving, and investing are more complicated for a business owner than an employee during their working years. Retirement does not end that complexity, but it often provides more opportunity for retirees with corporations. Conscious and deliberate retirement, tax, and estate planning for a business owner can help them increase and simplify their after-tax retirement income, as well as maximizing their estate value for the benefit of their children, grandchildren, and other beneficiaries.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.