While many business owners have generated significant wealth, their investments are often inaccessible – locked up in their corporation for tax-planning purposes. At some point, however, the business owner may want to liberate those assets, and how he or she does so will significantly impact after-tax cash flow.

Most of the clients we see have corporations in place. These include a lot of holding companies that contain significant tax-trapped cash or investments. This can be the result of having sold assets of an operating company or simply from years of taking advantage of lower corporate tax rates. The number of corporations out there has increased too, thanks to recent legislation allowing certain medical professionals, lawyers, accountants and others to incorporate their businesses.

Along the way, though, and particularly at retirement, it’ll eventually become necessary to work with the client’s other professional advisors to look at ways of pulling that money out.

How you go about doing this needs to be part of a larger plan. Business owners need professionals on their side who work together in a coordinated way. Advisors need to be aware of shareholder agreements, corporate structures and certain corporate tax balances such as the capital dividend account. It’s also necessary to adopt a left hand, right hand approach to working with the client’s external professionals, ensuring all involved are working towards a common goal.

We recommend you work with the client’s other professionals to get this education and understanding. Overall, complex corporate tax rules and structures mean there are no rules of thumb to refer to when planning to withdraw assets on a regular basis or when winding up a corporation.

Eligible dividends

In 2006, for example, changes governing the taxation of certain dividends altered how a lot of business owners were paid from their corporations.

Under the old system, income retained in excess of the small business limit resulted in double taxation. The overall tax paid by the company, plus taxes paid by the shareholder, would be more than if the shareholder had earned it directly. Under the new regime, where income is retained in excess of the small business limit and eventually paid to the shareholder as an eligible dividend, the overall taxes should be approximately the same as if the shareholder earned the income directly.

This change in tax policy means there’s a lot more money being retained inside corporations. How much the company is able to distribute this way is based on some pretty complicated calculations. Missteps can result in rather large tax penalties on the excess payments, which is why it’s necessary to develop a close relationship with the client’s corporate accountants.

Capital dividend account (CDA)

Another area, one where an advisor’s planning will almost certainly have an impact, is related to the company’s capital dividend account. Again, without working with company accountants, the impact you can have might not always be a positive one. Remember:

Companies only pay tax on 50% of the capital gains they realize and pay no tax on life insurance; The capital dividend account tracks the different tax-free amounts accumulated by a private company, so the company can eventually distribute these amounts to shareholders in the form of a tax-free capital dividend;

Capital losses reduce the CDA and the amount available for distribution; and Accidentally paying out a capital dividend in excess of the CDA balance can result in steep penalties.

Timing is everything

When clients decide to retire, many want to wind up their companies right away. Sometimes this is an emotional thing where they’d simply like to close up shop or deal with their taxes today, rather than leave a looming tax bill for their estate.

Consolidating assets is important to some people as well. Others can be put off by the expense and effort required to maintain a holding company. The higher tax rates on investment income earned inside a corporation can also be a deterrent.

Each client’s situation is unique, and requires the client’s professional advisors to weigh the different options available. Holding investments inside the corporation can help some clients avoid Old Age Security clawbacks, minimize their U.S. estate tax exposure or provide an opportunity for income splitting and estate planning.

In addition, once children are beyond the age where kiddie taxes apply, dividends may be paid to them as shareholders for college and university costs while they are still low-income earners. Finally, using corporate assets to purchase corporate-owned life insurance may provide a tax-efficient way of leaving an estate to the next generation.

Timing is also critical when it comes to maximizing the use of the $750,000 capital gains exemption. If the company is expected to grow, a client may want to consider an estate freeze to bring in other family members as new shareholders, who can make use of their $750,000 capital gains exemptions as well. This planning needs to be put in place long before the client wishes to sell the business. There may also be some opportunity to utilize trusts or develop shareholder agreements to prevent spouses (especially in the event of a marital breakdown) from being shareholders of the company.

When having any of these discussions with clients, it can be tempting to jump straight to a tax or investment analysis. Like other financial planning issues, finding the most efficient way to get money for the client needs to start with a careful analysis of the client’s current situation and identification of their longer-term goals and objectives before moving on to the options available.

  • Mike George is director of the Wealth & Estate Planning Team at Richardson GMP Limited, a coordinated group of in-house experts and professionals tasked with the job of providing support to advisors to ensure clients have complete and comprehensive estate plans in place.