Financial Planning for Small Business Owners

On the training day for my first job as a dishwasher, I was told to imagine I was a business owner. “The better your business washes dishes,” I was told, “the more money your business will make.” I was in high school at the time and the concept of being a business owner lingered in my mind, but I didn’t give it serious thought until my undergraduate years at UBC.

The idea of being my own boss, setting my own hours, and being in charge of business decisions resonated and, before I knew it, I was taking introductory courses in business planning, human resources, and marketing.

Upon graduation, I had an introduction to what it took to run a successful business – textbook knowledge coupled with a few years of experience running a kitchen.

What I didn’t know then, and what isn’t taught in school, is what it takes for an entrepreneur to successfully balance the complexities of business management with personal financial planning.

In the early years of business ownership, the natural focus is on growing the company, and doing so leaves little spare time for anything else. Personal financial planning during this formative period can fall to the back-burner because it doesn’t result in higher revenues or new clients today.

The value of a small business, however, can become a significant portion of an owner’s retirement nest egg so it is important to have an understanding of how business decisions today impact personal finances tomorrow.

Income Strategy

The share structure of an incorporated business drives income splitting opportunities. For this reason, some business owners will issue shares to a spouse, or even adult children.

A business owner interested in maximizing after-tax income might collect compensation in the form of dividends rather than salary, because the former has a more favorable tax drag – this strategy is compelling for those looking to eliminate personal debt, because drawing dividends can result in a higher after-tax income. Minimizing taxation today, however, might have unintended consequences of reducing RRSP or IPP contribution room and entitlement to the Canada Pension Plan.

A business-owner household that otherwise has no defined-benefit pension sources might consider drawing primarily salary, even though it might not be as tax efficient, if it means income in retirement comes from diversified sources (an overall risk reduction strategy).

Risk Management

Insuring human capital against the loss of a key person improves the chance of business survival should such an event occur and is prudent succession planning.

Also, your household standard of living can be significantly impacted by prolonged disability, critical illness, or premature death. Protecting yourself and loved ones through insurance products will help mitigate these risks.

Life insurance premiums are paid from after-tax dollars, and having the company own your policy might make sense where the business has a lower tax rate than the owner.

Wealth Accumulation

Annual corporate profits not distributed to owners can be retained and reinvested into operations. Alternatively, these same profits can be allocated to a corporate investment account or corporate-owned permanent life insurance policy, or some combination of both. These strategies of accumulating wealth within the company may be preferred to drawing annual net income into personal taxation for deposit into personal accumulation vehicles (such as an RRSP or TFSA).

Some might prefer to draw a higher income to take advantage of tax-deferral benefits of an RRSP, which helps lock savings into a long-term vehicle that is difficult to access - it is easier to avoid spending money in an RRSP than cash in a corporate bank account.

Retirement

Extracting value from a business on favorable terms requires planning well ahead of retirement. Succession planning lies at the heart of the matter and generally takes the form of selling either business shares or assets.

Both have tax consequences and the timeline over which this occurs is often driven by optimization strategies. Drawing a retirement income from business proceeds must be integrated with strategies for government pensions, RRSPs, and other sources. Planning
around the clawback of income-tested benefits such as Old Age Security requires looking not just at your financial circumstances today but projecting into the future.

Estate Planning

Business owners have many options for creating structures to help minimize tax on assets that will pass on to the next generation. Estate freezes, family trusts, and corporate-owned life insurance are common strategies and working on these earlier in the cycle, as opposed to later, is highly recommended.

So what does it take for an entrepreneur to successfully balance the complexities of business management with personal financial planning? It takes the knowledge, experience, and coordinated efforts of your financial advisor, accountant, and lawyer, so that you focus on growing your business instead of having to learn theirs.