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Owning and Investing Inside a Permanent Life Insurance Policy Part 2

Insurance comic

In Part One of this series, I outlined some of the considerable tax benefits related to owning permanent life insurance. This part shall deal with how to reduce risk if you do proceed, while the third article shall talk about some of the newer investment options that may help achieve this goal. For today, however, I’ll focus on other ways outside of the new investment choices, to help reduce risk.

Despite the benefits, as someone trained to see the dark cloud inside every silver lining (i.e “law school”), I see the potential minefields and quicksand that can go along with every situation, including owning permanent life insurance. Moreover, I have seen first-hand from clients inherited from other advisors some of the cautionary tales that can send chills into the spine of every financial planner who is not a sociopath. Accordingly, I want to pass along some tips to hopefully prevent you from being another chapter in the sad canon of insurance sales gone wrong, while also helping you keep your existing or future policies operating on all 8 cylinders. As I said in my last offering, permanent life insurance is like an investment portfolio – it needs to be managed on an ongoing basis in order to optimize performance.

Square Pegs and Round Holes

This article isn’t going to rehash any of my previous musing on the merits of permanent or term life insurance, although I like to think I provided a rousing introduction to the issue in Part One of the series — space is limited and, as typically seems to be the case, I have a lot to say. Instead, I propose to jot down a quick checklist of things to consider before saying “yes” to permanent insurance. Although I am a big fan of permanent insurance when the right policy is combined with the right client, the wrong product with the wrong client is a recipe for disaster.

  • Is it the right tool for the job? Although life insurance can do a lot of things well, the real question is whether it is the best tool for your main purpose? For example, although life insurance can be a great tax deferral vehicle, so can TFSAs and RRSPs, which also provide you with far more investment options and flexibility. Even if those are topped up, if investment for your own retirement is the key goal, I also suggest looking around at other options to diversify your existing investments when deciding whether or not to buy permanent insurance.
  • Too much of a good thing? Even if permanent life insurance makes sense for you, particularly inside a corporation, make sure that you’ve not purchased too much of a good thing. Although a slice of cake may be delightful and a second helping a tasty treat, that third or fourth serving is seldom a good idea. Just like the rest of your investment portfolio is properly balanced, be careful about overconcentrating too much into permanent life insurance. Although permanent insurance can be used as a very tax-effective retirement tool, particularly if used as collateral for loans to finance your retirement, I do not want my clients’ entire retirement contingent upon bank or insurance company lending practices and current CRA tax policy. In a perfect world, I still prefer using insurance primarily for its traditional purposes such as estate maximization, providing cash to pay final taxes, preserving legacy assets or ensuring that your estate is large enough to take care of everyone left behind. Although potentially using permanent insurance to fund your own retirement is an enticing option, I don’t want it to be the cornerstone strategy for paying for your beach vacations. Even when used for traditional purposes, I also like to see a comfortable margin for safety should my clients need more money for retirement than expected or their investments underperform.
  • When do you need the money? Most permanent insurance strategies can take a decade or decades to work the best after you buy the policy. They also often require many years of funding along the way as well. Accordingly, you will need to have other assets to fund your needs along the way and you also need to be relatively certain that you will be able to continue making your targeted premium payments over the long term, with some room to spare. Cashing in your policy can be very expensive from a tax perspective and many insurers have significant cancellation fees if you cut bait particularly over the first 10 years. Furthermore, like a car, you need to properly fuel your insurance policy in order for it to take you to your destination, with a little extra in the tank just in case. Accordingly, if you can’t make the planned contributions, you’re likely to run out of gas along the way and you may feel like you’ve been stranded at the side of a road without a cell phone.

What to do if Permanent Life Insurance Does Make Sense

Assuming that you’re read through the previous section and are satisfied that permanent insurance is the thing for you, the next step is ensuring that product you’ve selected fits like a bespoke suit rather than something you picked up off the rack. At the risk of wildly mixing metaphors, this part of the process is also sort of like the early stages of a relationship – it’s important to set realistic expectations in order for things to work out over the long term. Here are some ways to achieve these goals:

  • Canvass the Market. There are a lot of different insurance products out there, with many different combinations of bells and whistles. I like working with an advisor who can shop around to find the insurance product that best suits my clients’ individual needs. While one company may sell a product that is ideal for some, it might be a little too tight around the chest or have the wrong sleeve length for someone else.
  • Work with Someone You Trust. Although shopping the market is always a good idea, I also firmly believe it is vital to work with someone you think knows what they’re doing and has your best interests at heart. Accordingly, if you have someone you think is the bee’s knees, I don’t necessarily seeing it as a deal-breaker if they can’t sell you every policy under the sun so long as their product is competitive after you’ve looked around and you’re convinced that they will be in it with you for the long term. At the end of the day, you need someone who can continue to help you manage your policy in order to make it hum and sing on an ongoing basis. Although price and product both matter a lot, so does working with the right person.
  • Use Conservative Projections. I love the fact that most insurers now run policy illustrations (projected results compared to alternative investment strategies) showing results at 3 or more different rates of return inside your policies. For Universal Life (“UL”) policies, I generally prefer to see illustrations showing a 5% rate of return, with alternative illustrations at perhaps 3% and 7%. Although you may hope and expect bigger and better things from your policy, I am not comfortable with my clients proceeding unless the results look good with less-than-stellar returns in the policy and the alternative investment is assumed to outperform the policy by at least 1% before taking income tax into account. For Participating Whole Life (“Par”) policies, I want to see how things look if the current dividend scale (essentially the yield on the cash value of the policy to oversimplify things) is at least 1 to 2% less than its current rate, as I think there is a good chance rates could drop unless interest rates eventually pick up significantly. Ultimately, not only does the future performance of the policy dictate how big a payout and cash value there will be down the road; it may also influence how much money you need to put into the policy along the way. I never want my clients to be in the position of having to pay into a policy for 15 years rather than 10 because of unrealistically lofty expectations or, even worse, have to cancel or reduce their insurance at that point because it has become unaffordable. While this can’t be guaranteed, setting the investment return bar low at the beginning dramatically reduces the chance of unfortunate outcomes later.
  • At Least Consider Level Term Policies, Have a Conversion Plan or Invest More Conservatively. One of the reasons for the subprime mortgage debacle south of the border last decade were the “teaser” rates for the initial period of the mortgages. Although it saved money in the short term and allowed clients who couldn’t afford a home to purchase a place to call their own, it meant disaster when the other shoe dropped and clients had to start paying based on higher rates or even come up with lump sum cash “balloon” payments. In the permanent insurance world, UL have something that is slightly similar. Many policies allow client to base their annual required premium payments on either the cost of what it would take to buy a one year term policy each year so that each year’s premium costs more than the one before or having a set annual premium cost etched in stone for the life of the policy.

The former (“Yearly Renewable Term” or “YRT”) means very cheap rates initially that start to increase dramatically as clients age and their chances of dying that particular year go up, while fixed amount or “Level Term” policies mean essentially prepaying some of the future costs now which means bigger cheques initially, but having cost certainty for life. YRTs let more of the money you put into the policy in the early years grow in that policy’s investment fund and, if the markets are kind, this extra compounded growth is more than enough to help pay the higher insurance costs later as you age. The problems come if clients do not fund their policies as planned, investment returns are lower than expected, you have a couple bad years in a row, or the clients live to a very ripe old age. In these scenarios, the client may have to come up with extra money to pay into the policy at a time in life when it is no longer affordable, which can mean letting the policy lapse, borrowing to fund it or reducing the amount of coverage.

Thus, although YRT policies can do well if the markets cooperate, they can mean more risk later. To combat this risk, at least get quotes on how a Level Term policy performs as a comparison, plan to convert from a YRT to a Level Term a set age, knowing the pricing in advance, or reduce investment risk inside the policy. In particular, since the need to put extra money into the policy will depend on the cash value of the investment fund, shooting for lower, less volatile and less risky returns inside your policy vastly reduces the chances of having to put more money into your policy during retirement if the markets have several bad years in a row. Since most insurance funding strategies involve only paying into the policies for a limited number of years and then using the extra money contributed during this time, plus investment growth, to pay for the years ahead, this means having to sell some of your UL policy investments every year based on current stock market conditions. Thus, a few years of having to sell some of these investments at the worst possible time can crater a policy. As a result, unless you have ample additional funds to top up your policy, a large margin of safety or are invested in a specially designed policy that has or will reduce insurance fees to a pittance, I suggest looking at lower risk investments, particularly those that pay at least some income that can be used to cover premiums. Furthermore, be sure to regularly review and rebalance your investments inside your policy, just like you would for the rest of your investment portfolio.

  • Be Clear on When Contributions Stop. Some permanent policies stop asking for premiums at age 100 while others make you keep paying for life. Why take the risk of having to continue paying until you are 115 if medical advances continue to mount if you can get a comparable policy where you’re done at age 100 come hell or highwater? It can be very stressful to clients in their 90’s and their families if funds are tight to realize that a policy could lapse if the client lives to a century. Knowing that the policy will be “paid up” at that time lets everyone breath a bit easier, allows people to plan so that can ensure the policy survives those few more years and, even better, lets them know that the fund may start to grow again from age 100 onward. If insurance premiums become a thing of the past at that time, the size of the investment fund now may be able to take off again since you now have the money you would otherwise need to pay in premiums each year staying in the fund and compounding.
  • Make Sure the Right Person or Entity Owns the Policy. Chess and financial planning are both about how you move and organize your pieces. Permanent insurance is the same. To get the best results, you need to make sure that the policy is owned where it can do the most good. Furthermore, it can often be quite expensive if you need to switch it up later, so it’s vital to get it right the first time. Although I love owning insurance corporately for the tax advantages, this can be a disaster if you are planning to sell the company later or perhaps close it down during retirement. In both instances, there can be a very large tax bill that could have been completely avoided when trying to remove an insurance policy from a company, particularly if there is a large cash value. In other cases, if creditor protection, privacy or will challenge avoidance are the key issues, it makes sense to own the policy personally. Finally, some people may be better off owning life insurance inside a trust, particularly since the investment fund in the policy is exempt from the 21-year rule that otherwise taxes unrealized capital gains inside the trust at that time. Ultimately, professional advice is essential in this area specific to your own situation and goals.

Regular Repair and Maintenance

For perhaps about the 51st time, I shall repeat that owning life insurance is like owning an investment portfolio – both require regular repair and maintenance. In fact, I see life insurance as one of those fiddly foreign cars that aren’t properly understood by all mechanics with a host of issues not associated with domestic models. Here are the things to keep on top up if you want to keep your permanent insurance policy in peak condition:

  • Pay as Promised. As stated earlier, just like you need to keep gas in the tank if your car is going to take you to your destination, you need to make the targeted contributions or adjust your route along the way in order to achieve a less ambitious goal. If you have not properly funded the policy, it is unrealistic to expect that you won’t have problems later. Accordingly, if life changes and you can’t make your expected contributions, you need to work with your advisor to recrunch the numbers to decide on next steps. It could mean cancelling the policy, reducing the amount of insurance coverage so the money already committed won’t run out or switching to a less expensive type of coverage. In some cases, you may also consider donating it to charity, as this can often produce a surprisingly large tax credit for older policies.
  • Rebalance and service. It may be the case that you have several types of different investments inside the policy, which can often be a really good idea for larger policies in order to diversify risk. Just like you do for the rest of your portfolio, if you have a UL policy, you will need to look at the underlying investments at least once a year to ensure that you have the right investments for your current time horizon and that they remain in the right proportion, as well as reviewing performance. As a word of caution, however, for some policies, particularly in the early years, there is a minimum amount that has to be on hand to go into each fund at a time. If there isn’t enough money to make the minimum contribution, the money sits in a low interest account until you have reached critical mass. Thus, rather than initially contributing to 5 different funds inside your UL policy, you may need to narrow down your choices so your money actually gets invested promptly or plan to regularly switch how each fresh contribution is allocated so you still get diversity but not at the expense of having too much money sitting on the sidelines. If nothing else, it’s good to be clear how things work for your policy.
  • Do the 100-point inspection. Most people know that retirement projections are just educated guesses based on a host of variables and assumptions rather than fact. Insurance illustrations are the same way. Your investments may underperform in your UL or exceed expectations. Your Par policy may decrease its dividend payments, stay the course or, hopefully, one day, increase them again. Accordingly, it is important to recrunch the numbers at least every few years in order to see if you are on target and, if not, to discuss changes. For cars, it is a lot easier to take action when there is just a rattle under the hood than when the engine seizes. For insurance, it is a lot easier and less expensive to fix your policy by putting in some extra money or reducing coverage many years before the policy actually runs out of money rather than trying to come up with a solution when that time is already nigh at hand. At the same time, review who you have selected as beneficiaries, as well as your investment mix and related issues as outlined in the previous bullet. This is also a time to review the total amount of coverage you require and to see if it needs to be topped up or if you can either reduce some of your permanent policy or perhaps cancel term coverage that you have carried until now. Finally, if you have YRT premiums, keep up-to-date on how your premiums are scheduled to increase and discuss whether it makes sense to switch to Level Term coverage at that time instead.

Conclusion

Despite my natural focus as a finder of dark clouds and my many words of warning in this article, I still see permanent insurance as a wonderful solution for financial problems, but just not for every problem. As most people selling insurance spend more time talking about what can go right, however, I just wanted to provide a counterbalance so you can get the right policy in the right amount for your situation and, just importantly, know what steps to take after policy issuance to keep things on track once you are the proud owner of a policy to call your own.

Although I fervently desired to have enough space to also discuss some of the newer investment issues inside UL policies today that can reduce risk, that will have to wait for another day.

 

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Buying and Investing Inside Universal Life and Permanent Life Insurance Policies  – Tips for Potential and Current Policyholders

tax imageDo you own an incorporated business or holding company? Are you a wealthy Canadian looking for additional tax-sheltering opportunities? Are you someone who is looking for investment opportunities with some potential creditor protection and preferred tax status? What if you have more money in your holding company than you will ever spend in your life and are looking for a way to both reduce both your final tax bill, as well as the cost to your heirs and estate of getting this money out of your company? If you can answer yes to any of these questions, or have already done so and presently own permanent life insurance, I suggest diverting a few moments from the dreams of spring and read on.

Sadly, by the time you read this humble offering, any permanent policies you purchase in the future will not be as attractive as those issued before the end of 2016 – as I have written about previously, a host of changes to the tax rules will water down some of the potential tax savings and effectively eliminate some of the more exotic tax planning strategies. On the other hand, permanent life insurance can still offer an embarrassing amount of tax minimization and estate maximization benefits when the right product is matched with the right client. The next few pages will outline for those of you who already own permanent insurance as well as those of you who might benefit some of the reasons why permanent life insurance might be worth considering. The companion article to this piece outlines some of the ways of reducing risk when investing inside permanent insurance policies, in addition to ways of heading future problems off at the past before mere disappointment turns to financial despair. As is the case when owning an investment portfolio, an insurance policy must be managed carefully and potentially rebalanced in order to produce the best results.

Many thanks to my friend and life insurance pro, Lee Brooks, BBA, CFP at View360 Insurance Advisory, for his help on this series of articles, particularly for his advice in the first article of this series and his coming input on investment options inside life insurance policies.

Life Insurance– the Tax Benefits

The most obvious, most common and probably the best use of life insurance is to protect your family from economic catastrophe if you die ahead of schedule. In instances like this, such as when you have a young family and the size of your bar tab exceeds your home equity, term insurance is generally the way to go. In situations like this, your need is not permanent – as your children grow and your mortgage shrinks, the economic impact of your unexpected demise will hopefully decrease, as should the size of your insurance policy designed to cover off this risk. Moreover, as money may be tight and there are many other things clamoring for your financial attention, such as debt repayment and retirement funding, buying cost-effective term coverage allows you to get the amount of coverage you need while still hopefully having enough money left to address these other concerns and perhaps even vacation on a tri-annual basis.

Moreover, for most of us, there will come a happy day when you and your family have enough dollars in the bank so that no one will need sell the family heirlooms to make ends meet if you suddenly passed into the great beyond. Or, alternatively, perhaps the day comes when you decide that your children are now old enough to be responsible for their own financial future and you now wish to spend the money you’ve previously committed to life insuranceon violin lessons or on your wine collection. In either instance, that might be the time to cancel your insurance as it is no longer needed. Thus, why buy permanent insurance at considerably higher prices when insuring only a temporary need?

On the other hand, some people realize one or more of the following:

  • They will never be able to spend everything they own, particularly inside of their holding companies, and want to look at tax effective ways to maximize their estates;
  • They wish to leave behind a minimum legacy for their family or at least enough money to pay their final taxes without having to sell the family cabin, the family business or other legacy assets;

  • They want to ensure there is enough money to provide a fair inheritance to all of their heirs and need extra assets to ensure that they can pass along the family business, farm or house to some children while still providing enough for their other offspring; or

  • They hate paying tax and want to know about other ways of funding some of their retirement rather than tax coffers;

Permanent life insurance can meet these needs in the right circumstances. As most of us know, it provides a tax-free payout at death to provide instant liquidity to pay final tax bills or guarantee a minimum estate. Some of the subtler benefits are as follows:

  • Universal Life Insurance Policies (“UL”) offer an investment component that can increase the payout at death. This investment account is funded by extra contributions that accumulate inside the policy. You can allocate how the money is invested among many different choices, similar to how you can decide which investments to own inside an RRSP or TFSA. Any gains remain essentially tax-free if they stay inside the policy and are added to the tax-free payout at death.

  • Participating Whole Life Insurance Policies (“PAR”) pay policyholders dividends in many cases once the policies have been in force long enough based on a variety of factors. They also allow extra contributions that can earn extra dividends. If the dividends are kept inside the policy, they also remain essentially tax-free and add to the tax-free payout at death. Unlike UL policies, however, policyholders do not control how the money is invested. It is instead invested by the insurance company.

  • If a policy is owned by a company, only its’ cash value is considered when determining the capital gain owing on company shares at the shareholder’s death. In other words, if a policy promises a payout out $1.4 million but has a cash value of only $400,000, then only the $400,000 value would be added to the value of any other assets owned by the company when determining the value of the shareholder’s company shares at his death, even though the company will still get a cheque for $1.4 million in short order.

  • Continuing from the previous example, not only does the company get the $1.4 million dollar cheque tax-free; our tax system will also let the company pay out a significant portion of the $1.4 million from the company tax-free as a “capital dividend”. In other words, it helps minimize any additional taxes that would be paid by the estate or heirs that normally occur when paying dividends from companies.

  • These capital dividend payments from a company can also be used to further reduce the shareholder’s final tax bill or the future tax bill of a surviving spouse who inherits the shares if the capital dividends are used to redeem and cancel out shares formerly owned by the deceased. These payments cancel out at least some of the capital gains bill that would otherwise be owing (to simplify things). Thus, not only does owning insurance in the company save money by reducing the value of the company at death for capital gains purposes; it can even cancel out some of the remaining gain with the help of a savvy tax professional.

  • Insurance policies can be used as collateral for loans. Some clients use corporately-owned insurance policies as collateral for personal loans (although it is probably wise to pay the company a guarantor fee to do so). Thus, rather than having remove money from a company to pay for your retirement at potentially ruinous tax rates, you might be able to merely pay interest on a bank loan secured by your policy. Although the loan balance will probably continue to grow, so will hopefully the value of your insurance policy. Many policies may not even require payment during your life, knowing that they will be paid in full at your death when the company gets the death benefit tax-free. Even better, even though the bank will scoop some of the death benefit at that time, your company will still get credit for the portion paid to the bank when calculating how much money it can pay out to your heirs as a tax-free death benefit. Of course, if you never need to borrow against the policy to fund your retirement, your heirs will still benefit from the other tax advantages linked to insurance policies already mentioned.

Conclusion

When I talk to clients about life insurance, I seldom tell clients that they “need” permanent life insurance. In my view, life insurance is only “needed” to protect the financially dependent until they are able to fend for themselves. Generally, by the time my clients are well into retirement, this need has either vanished or the money required to keep buying life insurance would be better spent on other things, like their own retirement or, if they really love insurance, on health-related products like Long Term Care coverage.

On the other hand, even though permanent life insurance may not be “needed” in the same way as a term policy decided to ensure your child has enough money for university if you are not around to cut the cheques personally, they can be wonderfully effective tools for reducing a variety of other risks, retirement funding, protecting legacy assets like cabins and businesses, while also maximizing the after-tax size of your estate.

Despite these tantalizing words, however it is important to think of permanent insurance policies as power tools rather than holy water. If used correctly and regularly maintained, they can do wonderful things, but they are not the solution for all of life’s ills. Moreover, just like a chain saw or electric drill, if you use the wrong tool for the job or fail to regularly maintain and service, owning a permanent life insurance policy can certainly go very, very wrong.   Stay tuned for next time, when I talk about what you can do to manage your existing and future permanent insurance policies to take some risk off the table and to learn about new investment offerings inside insurance policies intended to help you do just that.

Estate Planning Basics

Check out my latest article on estate planning as seen in The Costco Connection.

Estate Planning Basics

Proposed Changes to Small Business Taxation – Levelling the Playing Field?

level-playing-field

Introduction 

In my last article, I outlined some of potential changes to the rules set by the Federal Government regarding the following issues that will affect small business owners, including:

  • How they can spread dividend income from their companies to different family members in order to lower their overall tax bill as a family;
  • How they can increase their tax relief upon selling their companies down the road by having different family members own shares of the company in a trust or under age 18;
  • How money retained in the company that is invested in passive investments rather than plowed back into the business will be taxed in the future.

The basic premise behind these changes is that the Federal Liberal government wants to level the playing field between the tax bill an employee pays on income and subsequent investment gains outside of registered plans and what a company owner and all shareholders and family members not working for the company or heavily invested in it would pay collectively up front and in the future on money not invested back into their business.

The information released by the government goes to great lengths in explaining their take on why they think the suggested changes are “fair”. A lot of their math is based purely on a straight comparison of an employee making a set salary and a company earning that same amount in profits. But are the proposed changes fair to company owners or even a fair comparison? In the end, this is one of those questions that is based more on values and principles rather than math and high finance. Each of us will come to our own conclusions, but, here are some considerations that I don’t think have brought to the table. For the discussion to follow, I will be comparing an employee earning $200,000 per year to a company generating that much in profits that are taxed as income in the hands of a single shareholder, as will be common under the proposed rules.

What About Employee Benefits? 

Most employees have a benefit package that includes extended health and medical, disability, pension plans or Group RRSPs as part of their compensation that is essentially not taxed. Sure, they get a deduction on some of these expenses but, at the end of the day, it’s far better to get a tax-free benefit than to have a tax-deductible expense. As a result, if proposed changes do not take this into account, it is arguable that company owners will actually do worse under the new rules than their salaried compatriots since they won’t have these benefits or have to pay for them themselves with personal or corporate dollars so that to be left with $200,000 in taxable income, they would have had to earn perhaps 20% more than this in order to pay and deduct the benefits that salaried employees get as a matter of course or do without.

CPP, EI, WCB and other Employee Benefits 

In addition to the traditional benefits package offered to most employees, there are also other government-mandated benefits that employees receive. In particular, a company must pay about 5% per dollar in salary per employee into their Canada Pension Plan up about $2,500 per person, as well as Employment Insurance and WCB Benefits. Although the employers do benefit by paying into WCB by ensuring that they can’t be sued by workers injured on the job, the employees benefit by knowing that they have coverage if injured on the job regardless of who is at fault. Ultimately, I would suggest that any comparison between salaried employees and company owners needs to also factor in these hidden taxes. Even if a one-person company, which might mean not having to pay for WCB benefits and EI, business owners still need to pay both the employer portion of their CPP pension as well the equal portion both they and employees pay into the plan. Again, although these expenses are deductible but it is still far better to get things for free than merely at slight discount. In the end, if these extra costs are viewed as taxes, then business owners earning $200,000 in salary after the dust settles are actually paying more to the government than employees. For a business with many employees, the business owner may have paid far more in taxes when the total bill paid by the company for all employees is added to the income tax deducted from the remaining $200,000 paid to him in salary. As an added insult, the owner is most likely not to qualify for EI if the business ever goes belly up.

Earnings History 

By the time many smaller businesses earn the $200,000 per year in profits noted in my example, they have probably had to endure many lean years along the way to get to that point, compared to employees. In particular, many professionals with their own shops may make significantly less for many years than employees with similar qualifications before catching up and potentially surpassing them. Until then, the salaried employees have hopefully been able to pay down debts and both invest and compound investment gains towards their retirement. In other words, many business owners are stuck playing catch up compared to their salaried friends. Not only would it help them to be able to income-split profits from their business during the lean years with their spouses and older family members, income splitting and the ability to stockpile extra profits inside their companies when they finally do get their businesses in high gear allows them to start catching up quicker. The new proposals would make it harder for starting businesses to survive during the lean times by preventing him from sharing profits with other family members and make it far harder to catch up when business is booming.

Risk – Reward 

As suggested in the last paragraph, starting a business usually means accepting several years of tough times before the ship hopefully rights itself and all the hard work becomes worth it. Unfortunately, most businesses fail, which can mean financial ruin for the whole family. Hopefully, if the business really takes off, the business owner can make far more money than his salaried colleagues, along with the other lifestyle benefits that comes with working for yourself. For those business owners who merely catch up to salaried employees in income level, such as in the example I’ve provided, they’ve taken on far more risk than their salaried friends yet reaped none of the rewards. The ability to use the current tax rules to make their money go further is one way of rewarding company owners for taking on those risks. Ultimately, if you accept the premise that it’s good for the economy to encourage people to create their own jobs and even hire other people to work for them, then there has to be enough in it for these entrepreneurs to make it worth their while to roll the dice. Changing the tax system as the government proposes removes some of the biggest incentives to hanging out your own shingle. It is even arguable these changes are equal to changing the rules of the game half-way in for many businesses and may cause some business owners to regret ever starting their own business or to even trade in their companies for salaried jobs. People have budgeted for retirement, taken out mortgages or decided to start families based how much they could expect to have after paying taxes based on what their family as a whole receives from businesses after taxes and on how much their corporate investments can generate and pay out after taxes. The proposed new tax rules change all these calculations and will probably have the biggest impact on smaller businesses rather upon the higher net worth company owners who will probably have their tax bills increase more than their poorer colleagues but are also far more able to afford it.

Brain Drain 

One of my biggest worries about the impending changes is that they may drive many highly educated and talented people to leave the country to work in places with either lower taxes or more liberal income-splitting rules. The worry about doctors leaving for the U.S. is probably the most obvious example. Not only can physicians make significantly more down south – they can also jointly file taxes with their spouses and calculate their tax bills as a couple rather than looking at both of them separately. The current tax system in Canada offers enough of a benefit package to doctors currently practicing in Canada, along with all the other wonderful things that go along with living in Canada, for those self-employed doctors who live in the Great White North, or obviously they would not be here. Time will tell whether the effects of this tax hike. Obviously, many doctors will still stay on this side of the 49th parallel but some will not. Losing highly trained professionals to the south is certainly not in anyone’s best interests, except perhaps that of those migrating professionals.

Time Investment 

In addition to the time it takes to grow a business from an acorn to a tree, many business owners also have to invest incredible amounts of time along the way to both gets things up and running and to remain afloat. As I’ve learned the hard way, running your business can be like having several jobs at once – marketer, accountant, office manager and administrator in addition to your actual duties as a professional or executive, performing many of these ancillary tasks essentially for free, as they don’t generate business income. Accordingly, if the business owner has to spend more time per week in order to generate the same income as an employee who doesn’t have the same additional duties, is it fair that the business owner who earns the same amount in profits as the employee is left with less money after taxes under the new rules? Of course, this presupposes that all business owners have to work harder than employees, which is certainly not the case. Thus, of all the arguments I’ve expressed, I find this one the least convincing but it is worth considering all the same.

Economic Benefit 

The Federal Government will eventually have to answer the question of whether it is better for Canada as whole to have fewer entrepreneurs and business owners, but collect more tax dollars from these closely-held companies and their families or to collect fewer dollars for each combination of private company and shareholders’ families but to have more of them. The answer to this question should depend in part on how much our economy would benefit from keeping the status quo vs. changing the rules, and as a consequence, how much extra revenue the government would ultimately receive from the extra jobs a more entrepreneurial business climate provides. I cannot begin to answer that question, but the investment-focused part of me notes that the return to the economy of a single extra person who decides to roll the dice and start her own business because of the potential benefits offered under the current rules could conceivably generate 100’s of jobs down the road if all goes well would easily offset all lost taxes not collected from the business owner and her family, as well as many others. Even if she only employed 3 or 4 outside employees at a time at her peak, I would still expect our economy as a whole would still be the better for it.

Plugging Loopholes? 

I read an excellent article written in one of our national papers by Tim Cestnick a few weeks ago that expressed his take on the proposed changes. In it, he spells out the measures that are already part of our tax system to prevent income-splitting with minor children and to tax corporations on their passive assets, such as the tax rate on investment income in British Columbia of almost 50% on passive investment income and how business owners are incentivized to pay out investment gains from their companies by a refundable tax on part of this amount that the company gets back when it pays out taxable dividends to its shareholders.

In other words, although there are still huge tax benefits to company owners who retain business earnings inside their companies, our tax system already seems to be well aware of these benefits and is set up so business owners can take advantage of them. Although the proposed tax changes designed to prevent converting income to capital gains could properly be called closing a loophole, I cannot characterize most of the other changes in the same way, particularly those regarding how tax investment income will be taxed inside a company.

Although the government may ultimately decide that the current system provides an unfair advantage to business owners, I would submit that it is fair more accurate to describe the majority of the new rules as a change in tax policy rather than changes designed to thwart people from abusing the current rules. It seems rather harsh to so significantly increase the tax burden for business owners while at the same time seeming to vilify them as a bunch of fat cats taking who are perverting the tax system at the expense of everyone else. Although the government should be free to do what it believes in the best interests of all Canadians, I would suggest that trying to portray business owners as essentially wealthy freeloaders is simply not fair accurate, or helpful, except in potentially drumming up support from the non-business community to support or justify these changes.

Conclusion 

Although the government has done a good job in spelling out their rationale for changing the tax rules for small businesses, there is another side to the story. This article has outlined some of the reasons against making wholesale changes to the current system and also questions the premise that the proposed changes as currently suggested are entirely fair. In the end, this is one of those questions that depends on how you view the world and your personal values. Regardless of whether you are for or against the tax revisions, I would suggest that the situation is not as simple as it may appear at first glance.