Your client wants to retire, but no one in the family is interested in taking over the business and they can’t find a buyer. What can they do?
Your client may have to wind down their business to support their retirement. Winding down typically involves selling business assets, paying off liabilities and extracting after-tax corporate funds personally. There are many ways to do this, including the following tax-efficient options.
Sale of assets
When your client sells their business assets, they typically realize a capital gain on the disposition if the assets have appreciated in value. Under the current tax rules, 50% of these capital gains would be taxable in your client’s corporation, and the non-taxable portion would be added to the corporation’s notional capital dividend account (CDA).
The balance in the CDA can be used to pay tax-free capital dividends to shareholders. This could be one way for your client to receive tax-free capital dividends from their corporation to support their retirement. Any funds that can’t be paid as tax-free capital dividends may be paid using one or more of the options discussed below.
Keep in mind that if your client sells any depreciable assets in their corporation and the sale proceeds are greater than the undepreciated capital cost (UCC) of the assets, previously deducted depreciation expense may be brought into the corporation’s taxable income in the year of disposition. This is referred to as “recapture of capital cost allowance,” and 100% of this amount is included in the corporation’s taxable income.
If your client has philanthropic goals, they may consider making in-kind donations using corporate assets for a two-fold benefit.
The first benefit arises from the tax deduction available to your client’s corporation based on the fair market value of the in-kind donation. This helps your client lower the corporate tax liability in the year the tax deduction is used.
The second benefit arises where certain types of capital property, such as shares of public corporations or mutual funds, are donated. These donations are eligible for a zero capital gains inclusion rate, so no taxable income arises. In addition, the non-taxable capital gain (i.e., 100% of accrued capital gains in the case of a donation) would be added to the corporation’s CDA, allowing your client to receive additional corporate assets tax-free as a capital dividend.
Your client’s corporation can use after-tax corporate dollars to pay outstanding liabilities. This includes any existing shareholder loans owed by the corporation. If your client previously loaned money to their corporation as startup capital, the corporation can pay off the loan to your client using corporate funds on a tax-free basis.
Your retiring client may qualify to receive a retiring allowance (also known as severance pay) from their corporation. These payments can help your client extract corporate funds and transfer them directly to their RRSP for continued tax-deferred growth until withdrawal.
The “eligible portion” of retiring allowance can be transferred directly to your client’s RRSP under paragraph 60(j.1) of the Income Tax Act for years prior to 1996 when your client was considered an officer or employee of the corporation. The remaining “non-eligible portion” requires existing RRSP contribution room for tax-deferred treatment.
These payments from the corporation aren’t subject to CPP or EI withholdings; however, income tax withholdings apply on the “non-eligible portion” not transferred directly to your client’s RRSP.
If your client has exhausted the options above, extracted funds from the corporation are typically treated as taxable dividends on your client’s personal tax return. If the corporation has a balance in its refundable dividend tax on hand (RDTOH) account, issuing taxable dividends triggers a tax refund for the corporation, allowing it to recover previously paid “refundable taxes” on investment income earned inside the corporation.
Depending on your client’s personal tax bracket, they may benefit from receiving taxable dividends over several years rather than winding down the corporation and extracting all after-tax corporate dollars in one year. Distributing the taxable income over several years would allow your client to access lower tax brackets over the years and minimize total tax liability.
If your client’s spouse or common-law partner is also in a low tax bracket, your client may be able to further reduce the total tax liability by splitting dividend income with their spouse or common-law partner over several years. It’s important to work with a tax advisor to ensure any dividend payments to your client’s spouse or common-law partner aren’t subject to the highest marginal tax rate under the expanded tax on split income (TOSI) rules that came into effect on Jan. 1, 2018.
These are some options you can use to initiate a discussion with your client and help them prepare a detailed plan for their retirement that minimizes taxes and helps them keep as much of their hard-earned corporate wealth as possible.