Demographics dictate that in the next 10 to 15 years, as many as 80% of small business owners will either sell or pass on their business to their heirs. There are many options as to how this will be accomplished, but the bottom line is that a significant amount of wealth will be freed up through this process. A key consideration is how an owner can accomplish this transfer with the least amount of tax being incurred.
“Small business owners are generally experts in their fields, but are often unaware of the intricacies of orchestrating a tax-efficient sale,” says Michael Soble of the Reynolds Soble Group at BMO Nesbitt Burns. “And they may not have a professional advisor, like a lawyer or accountant, who is familiar with all of the options.”
One of the strategies that are often overlooked in connection with a business sale is the use of a Retirement Compensation Arrangement (RCA). Properly structured and implemented, an RCA can drastically reduce the overall tax impact of a sale, and also provide the business owner and others with a creditor-proof, flexible, and tax-efficient pension plan.
Business sales typically involve assets or shares. Most owners prefer to sell the shares and gain access to the $750,000 lifetime capital gains exemption. Most purchasers prefer to buy the assets, and in the case of franchises, this is often stipulated in the Franchise Agreement. The tax treatment on each type of sale is different, and an RCA can be particularly useful in connection with an asset sale.
The rules surrounding the establishment, funding, ongoing management, and withdrawals from an RCA are quite complex and beyond the scope of this article. To summarize, an RCA is established under the rules of the Income Tax Act, and allows a company to make tax-deductible contributions on behalf of key employees for purposes of building a retirement pension.
The contribution guidelines are quite generous (compared with RRSP limits, for example) and often actuarially determined based on income and years of service. Funds are not locked in as with a normal pension plan, they are creditor-protected, withdrawal rules allow for flexibility in terms of timing and amounts, and there are few investment restrictions inside the RCA.
According to Soble, “The bottom line is that once the RCA is reasonably funded (which can be from the proceeds of a sale of assets), there is a great deal of flexibility as to how the money can be invested, the amount and the timing of withdrawals, and even passing along RCA assets to spouses and other beneficiaries.”
Establishing an RCA has some complexity and requires specialist input in the areas of tax, actuarial review, accounting, and investment management, so the dollars involved need to be enough to make it all worthwhile. However, the potential benefits are huge, in terms of immediate and future tax savings, and significantly increased retirement income and estate planning flexibility in the future.
“We are seeing more and more opportunities for RCAs pop up in connection with business owners as they start to actively plan for selling their businesses,” says Mike Reynolds. “The challenge is to make sure they are aware of this option before it’s too late, and to bring into play the specialists who can make it happen when it does make sense.”
Mark Borkowski is president of Toronto-based Mercantile Mergers & Acquisitions Corp. Mercantile specializes in the sale of mid-market companies to strategic buyers or private equity firms. He can be contacted in confidence at email@example.com (416) 368-8466 ext. 232