This article looks at the second half of the top 10 damaging tax and estate planning errors entrepreneurs make. Here are the previous five:
- Failure to incorporate, which slows business growth
- Failure to incorporate, which means losing tax-free capital gains value
- Failure to incorporate, which causes exposure to creditors
- Holding investment money in a small business corporation
- Paying personal expenses out of a corporation
Read: 5 common tax mistakes
And here are the next five:
6. Not using the spouse to protect wealth
Every person is a separate legal entity. This is particularly important in cases of exposure to creditors. An entrepreneur can transfer assets to her spouse’s name to distance that money from creditors. As long as this isn’t done to defraud creditors, the strategy will have the intended effect.
This doesn’t affect entitlement to the value of those assets in the event of marriage breakdown—in principle. But these situations are typically volatile, introducing practical complications. So seek professional help.
7. Failure to protect against high taxes when the owner dies
A corporation’s shares are capital property, so on the shareholder’s death they’re deemed disposed for tax purposes. If the shareholder’s children are the beneficiaries, the tax liability may be sufficiently onerous that the business itself will have to be sold or mortgaged to pay the taxes.
When there’s a spouse, the shares can be rolled over to defer taxation. As a practical matter, however, the spouse is often unable to maintain the business. So it may have to be sold anyway, giving rise to taxation. The problem is exacerbated when the spouse needs to sell quickly, making it difficult to get the best price.
Life insurance for the shareholder is the simplest strategy to ensure high taxes don’t force a sale or impose a debt burden.
8. No exit strategy
When there are multiple owners of a corporation, the expectation is that when an owner departs or dies, one or more of the others will buy out his interest. To ensure this happens, the owners should execute a buy-sell agreement detailing the specifics.
Beyond the execution of the agreement, it’s critical for there to be sufficient funding to carry out the commitments at the appropriate time, especially for the sake of the spouse and family of a deceased shareholder. Here again, life insurance is the simplest and most cost-effective solution.
9. Paying for business insurance personally
Insurance to pay for taxes at a shareholder’s death and/or to fund the transfer of the shares can be held personally or corporately.Premium costs often make the corporate option more attractive.
A corporation cannot deduct the cost of insurance premiums, so it’s using after-tax dollars to pay premiums. Alternatively, shareholders could receive taxable dividends out of the corporation to pay the premiums personally. So, no matter how small the dividend tax (which can be over 30%), less insurance can be purchased personally.
The difference in cost would be for naught if the eventual insurance proceeds were worth different values. A corporate mechanism called the capital dividend account can be used to preserve the tax-free status of insurance proceeds, and flow them out to a spouse and other estate beneficiaries.
10. Double tax on capital assets
Corporations can also own capital property, and the value of someone’s shares will, in part, be based on the value of those underlying assets. Tax will be payable on the capital gain on share value when the shareholder disposes of the shares or when there’s a deemed disposition, as at death.
At death, the shares flow to the deceased shareholder’s estate. When the estate later causes the corporation to sell the underlying capital assets (to wind up the business and distribute the estate), the corporation will pay tax on those capital gains that the deceased paid indirectly on the share value increase.
To prevent this result, business owners can make certain elections in their estate plans post-mortem to minimize the damage (see “Tax Treatment,”).
Doug Carroll, JD, LLM (Tax), CFP, TEP, is vice president of Tax and Estate Planning at Invesco Canada.