middle aged man

The situation

Farhad Ansari* is a superstar marketer, but his days of leading a successful agency are numbered.

The 51-year-old joined Buzzword Creative three decades ago as a junior copywriter, and steadily worked up to chief creative officer. He’s enjoyed a storied career, having worked on Fortune 500 accounts and launched multiple international campaigns. His boutique agency brings in $15 million per year in revenue and employs 100 people. He makes $350,000 per year plus a 50% bonus and travel allowance, supplemented by a defined benefit (DB) plan. He has no equity in the company.

Buzzword’s revenues had been slipping as more clients moved their business to bigger, one-stop shops. A competitor smelled blood in the water. Buzzword, a private company, was acquired eight months ago by Spin Enterprises, a TSX-traded firm known for its bottom-line focus. The sale terms stated Buzzword would continue to operate independently. Shareholders are demanding efficiencies, however, and have made much of the fact that Spin has its own chief creative officer, Judith Mansbridge. Judith and Farhad get along well — they’ve even collaborated on a few campaigns — but the board says one has to go. Judith is more digitally savvy and familiar with the demands of a public company, so she’s staying.

Out of respect, Spin has offered to position Farhad’s departure as a retirement. He’ll receive two years’ salary and benefits in severance, and his pension will begin after that. However, due to Canadian tax rules, his pension only replaces one-quarter of his current salary. He must sign a non-disclosure agreement and a broad, three-year non-compete clause. Essentially, he’s out of work for the next three years.

Farhad is devastated he can no longer lead Buzzword, a company he feels he built; he’d planned to retire at 60. He also has a lifestyle befitting his high-flyer status: in addition to his Oakville, Ont. waterfront mansion, he has a cottage on Lake Joseph and a property in Tuscany, Italy. His two pre-teen children attend expensive private schools and his partner, Mauricio, is a musician with a modest income. All told, his family’s living expenses total $300,000 per year. The family hasn’t saved much for the future because of Farhad’s pension, and didn’t expect to live on it so soon. They have $500,000 in a combination of their TFSAs and open accounts, plus $20,000 in Farhad’s personal RRSP (his RRSP room is mostly used up by his pension). Mauricio also has $30,000 in an RRSP.

How should Farhad negotiate the package? And what tax-efficient options are available when he receives his severance?

* This is a hypothetical client. Any resemblance to real persons is coincidental.

The experts

Rudy Fischer

Rudy Fischer, partner, RK Fischer & Associates, Sarnia, Ont.

Abby Kassar

Abby Kassar, vice-president, high net worth planning services, RBC Wealth Management, Toronto

Lea Koiv

Lea Koiv, president, Lea Koiv & Associates Inc., Toronto

Answers have been edited for length and clarity.

Negotiating the deal

Rudy Fischer: The non-compete clause is going to give Ansari the leverage he needs to get more money. If they’re going to ask him not to compete for three years, they must be willing to pay him for a minimum of three years.

Abby Kassar: Or if it’s not going to be a salary for three years, then negotiate the non-compete for a
two-year period.

RF: That non-compete is going to stop him from being able to re-establish himself. They can’t put him out of work for the next three years. He needs to negotiate that.

Sometimes non-compete clauses say, “You can’t touch my customers, but you can offer the same type of services.” It depends on how you define that non-compete.

AK: Perhaps it allows him to work in a non-related industry but in a similar capacity. Could he take that position, and how would that impact his severance? If his severance is paid out monthly, and during the same period that he’s receiving the pension, would they terminate it if he found work?

In terms of whether he should take a lump sum or monthly payments, that becomes a question of taxation. With a lump sum, he’d be looking at receiving the entire amount and paying withholding tax upfront, but then he has the opportunity to invest that amount to be able to grow and use it to fund his life needs.

However, it may be better to have it paid out over time so he can take advantage of his marginal tax rate in future years. For instance, if Ansari has no other source of income in future years or his other income is lower (i.e., his pension will be less than what he’s making right now), then by receiving his severance pay in future years, he’d be able to use all the marginal tax brackets up to $220,000 for each taxation year, with less income taxed at the highest rate.

If he receives the amount as a lump sum, anything over $220,000 will be subject to the highest rate in the year he receives it. In future years, if his income is less than $220,000, he won’t be able to use all of the marginal tax brackets up to $220,000.

A monthly payment would also allow him to accrue more pension credit than a lump sum payment. He could use the retiree allowance rules, which, until 1995, allowed you to transfer a “retiring allowance” into your RRSP without using RRSP room. He’s been working for 30 years. With about $2,000 eligible per year for the years he worked up to 1995, he would probably qualify for a $14,000 retiring allowance that can go into his RRSP on a tax-deferred basis without using his RRSP room.

If he doesn’t want to take all of that into income this year, he could negotiate having a retirement compensation arrangement (RCA) set up. It will allow him to spread that tax liability over a number of years, as opposed to receiving it upfront.

Lea Koiv: For the RCA, there are two issues. One is the safety of the capital that’s being set aside: he should ensure that, in case the company fails, his entitlement is safe. The second is the severance payment. These plans often have clauses in them saying “It is intended that the payments be paid out” in a certain fashion, but it may allow for advance payments if he experiences some unanticipated events. If he does end up being unemployed during the severance period, then maybe the payments can be changed so that he receives higher income when he’s unemployed.

When Ansari is negotiating his package, key to him would be a health plan, including medical and dental. An ongoing health plan is a non-taxable benefit. Given his family situation, with his spouse not making money and two kids still in school, I think health costs could be potentially significant.

AK: Further, would he or his family continue to receive his remaining severance or benefits if he became disabled, or after death?

Pension considerations

AK: If he’s able to negotiate his non-compete and get back into the workforce, his initial plan was to work until 60. If he’s able to work and generate income, then he can also negotiate having the pension paid out later. So if he can start it at 60, he may be able to receive a higher pension.

But it would also depend on whether he’s going to have a commuted pension and transfer it out, or if it’s going to accumulate in the plan until he’s ready to receive that pension. So that might also be something for him to negotiate.

LK: A fundamental issue: Is his pension fully funded? He doesn’t have an equity stake in the company, so he is a high-income individual. The pension plan fits the definition of a designated plan. And since it’s a designated plan, the maximum funding valuation kicks in, which limits what the company can put into the pension plan until he’s actually beginning to pull a pension out.

His pension plan has a huge hole in it, since the contributions are capped with the maximum funding valuation rules. I think he should look at how he can get as much company money into his registered plan as soon as possible, which would be when his pension begins to be paid.

Once all members of the plan have started to draw a pension, the maximum funding valuation methodology no longer applies. This would allow the company to make a significant contribution because of the terminal funding that would now be permitted. He’d want his supplemental pension funded because the value of both the entitlement from his registered plan, as well as the RCA that he should have set up, are so significant.

And to the extent that he’s getting a package, he could look at having the pension in excess of the Income Tax Act maximum to be funded in an RCA, and to also flow the severance entitlement through an RCA.

Because he has a low-income spouse, he would want to take maximum advantage of pension splitting: what comes out of the registered pension plan at any age, even if he’s in his 50s, can be fully split. An amount coming out of an RCA can only be split at 65.

To incorporate?

AK: If he decides to start a consulting company or his own business, then he may set up a corporation and consider the tax benefits of going sole proprietor or incorporated.

RF: A corporation is a shield that protects the assets of his private life because his liabilities are limited to what’s in the business. Depending on how you structure things, you can put money into a business as a shareholder loan. As a shareholder loan, you put the money in tax-free, but you can also pull it out tax-free. Ansari can put money in to fund that business on a time-to-time basis as he sees fit, and still shield his personal assets from his business activities.

Missing plans

AK: He’s asset rich and cash poor. The real estate is an expense, and it could potentially provide him with great cash flow. If he was to downsize his Oakville home as a principal residence, he’d be able to receive the proceeds tax-free and invest some.

LK: He needs to do some capital gains planning on his properties. Each of those could potentially qualify for the principal residence exemption (PRE). With the PRE, you don’t designate the asset; you choose the years for which you designate a specific asset.

Let’s say he bought the waterfront cottage and mansion on the same day and sold them on the same day. When you look at claiming the PRE, let’s say the mansion went up a total of $2 million and the cottage went up by $1 million. Then you’d divide the gain by how long you’ve owned the asset. Let’s say he’s owned both 20 years. The mansion has gone up by $100,000 annually, and the cottage $50,000 annually. If I sell both, then I could designate them 10 years each. But I wouldn’t. I would designate the mansion, because it’s gone up $20,000 per annum, for the whole time.

It’s really important to remember that, since 2016, even sales where the whole capital gain is exempt have had to be reported on personal tax returns. Failure to do so could result in the exemption being denied.

RF: I don’t think Ansari can afford to retire right now. He can’t continue to spend $300,000 a year. He’s got to go on a cash-flow diet because he spends whatever he makes. He would have had an issue if he was going to retire at 60, as well.

AK: What is the lifestyle he wants to lead and what does he want to do in retirement? He needs to have a financial plan prepared and have a cash-flow projection. If he were to downsize his home, how much would he be able to set aside to fund his retirement? And if that were to be invested, will it last his lifetime? If not, he needs to look at reducing his expenses. It’s a difficult discussion, but one that needs to be had.