April 2006

Tax Planning For An Owner-Managed Business

People who own and operate their own businesses need to be aware of tax savings opportunities that arise during the life of the business. This article will introduce some of the more common tax savings opportunities to you through the use of a hypothetical company, ABC Company (ABC).

John Smith, who is 35 years of age, incorporated ABC in order to manufacture widgets. John was sure that he could enhance the current process for manufacturing widgets. He expected that this enhanced process would make ABC a valuable company.

It took John two years and $1 million of direct costs to develop his process. Fortunately for John, the costs ABC incurred qualified for refundable federal and provincial scientific research & experimental development (SR&ED) credits of $350,000 per year. These refunds were critical for financing ABC during its start-up phase. John was dismayed when he heard that fewer than 1 in 5 businesses entitled to make a SR&ED claim actually do so. ABC was able to make continuing SR&ED claims each year for successful and unsuccessful attempts at improving the widgets themselves as well as the process by which they were manufactured.

After the manufacturing process was perfected, a facility from which ABC would manufacture widgets was then acquired by a separate company also controlled by John. John wanted to be sure that he protected his interest in the real estate from the creditors of ABC, particularly given the litigious nature of some of his U.S. customers.

John expected that approximately 1/2 of ABC's sales would be to U.S. customers. In order not to subject ABC to U.S. federal and state taxes on its profit, ABC limited its direct presence in the U.S. ABC used independent sales agents in the U.S. and any required installation work was sub-contracted out to an independent U.S. business.

ABC became very profitable by its fifth year in business and the taxation of corporate profits became an issue. John was aware that the federal and provincial small business rates of tax were only available on the 1st $300,000 and $400,000, respectively, of profit. On corporate profit in excess of these amounts double taxation would result after personal dividends were paid. John made the decision to bonus down to $400,000 of taxable profit and reinvest his salary, net of tax withholdings, back into the business in order to pay down debt and support ABC's growth initiatives.

After another ten successful years in business, ABC had been able to pay down its debts and was beginning to accumulate cash. In order to creditorproof these accumulated surpluses John decided to do two things. The first was to set up an Individual Pension Plan (IPP). An IPP is a registered pension plan that serves the same purpose as a RRSP. The main advantages of an IPP over a RRSP were that it allowed John to contribute larger amounts and the assets of the IPP were secured from the creditors of John. John also transferred his common share interest in ABC to a separate holding company on a tax-deferred basis. This allowed ABC to pay tax-free dividends equal to the accumulated cash in ABC to the holding company and move it out of the reach of ABC's creditors.

After fifteen years in business, John was beginning to have difficulties with some of his own suppliers. The cost of their products were increasing astronomically and the quality was mediocre at best. John decided that another company, XYZ Company (XYZ), would be established to supply these products to ABC as well as others in the industry. It was decided that John's wife Jane would be the sole shareholder and director of this company. This would provide each of ABC and XYZ with access to its own set of small business tax rates on the 1st $300,000 - $400,000 of profit they earned. Given the demands of managing ABC on John, an independent manager was hired to run XYZ.

As ABC was celebrating its 25th year in business, John who himself had just recently turned 60 years of age, was beginning to feel like it was time to withdraw from the business. He and Jane had always had plans to travel the world and had promised to spend more time together after ABC was established. John was convinced that his two children were ready to run the business and that they were deserving of being rewarded for their efforts in the business for the last ten years.

John made the decision to freeze his equity interest in ABC. John subscribed for and gifted 50% of the new common shares to each of his married children. This allowed the children to share in the future growth of ABC. The subscription and gift by John, as opposed to a subscription for shares directly by the children, added a layer of protection to the family in the event that one of the children had marital problems in the future.

John, Jane and their children accepted an offer last year to sell ABC, XYZ and the company holding the manufacturing facility for $15 million in the aggregate. Since all four family members were shareholders they each had $500,000 of qualified small business corporation share exemption available to shield a portion of their capital gain.

These tax savings opportunities can be available in differing factual circumstances and do not need to be implemented in the same order discussed above. It is advised that you consult your own tax advisor before acting on any of the recommendations made.

Chris Bodnar, C.A.
Chris Bodnar, CA, is a tax partner with the firm of Crawford, Smith & Swallow, Chartered Accountants LLP, specializing in estate planning, corporate reorganizations and U.S. taxation, and provides tax advisory services to individual, trust and corporate clients of all offices in the Niagara Region

Readers are urged to consult their professional advisors prior to acting on the basis of material in this newsletter. If you have any questions regarding the content of this newsletter, please contact Crawford, Smith & Swallow. Copies of the newsletter in PDF format are available on our website.