As a full-time farmer or small business owner you may face high levels of taxable income when it’s time to wind down or transfer your operation. There are strategies available to lessen the tax impact of selling your farm or business assets, but they take advance planning.
As a full-time farmer or small business owner you may face high levels of taxable income when it’s time to wind down or transfer your operation. There are strategies available to lessen the tax impact of selling your farm or business assets, but they take advance planning.
If your business is incorporated this is another tax-minimization strategy you might consider at the time of sale or transfer. A retiring allowance is defined as “an amount received at retirement in recognition of long-term service or as compensation for loss of employment.”
If your business is not incorporated you cannot pay yourself a retiring allowance, but you still can to your employees, including family members.
Retiring allowances are treated as employment income for individuals who receive them. The advantage of having such payments classed as a retiring allowance, however, is that recipients can transfer a portion of the amount for years of service prior to 1996 to their RRSP without affecting their RRSP deduction limit and without immediate taxation.
Key factors to consider in using a retiring allowance as a tax minimization strategy are, first, the maximum allowed for transfer to an RRSP and, second, the amount that is reasonable based on length and type of service to the business.
The maximum amount of retiring allowance that can be transferred to an RRSP for any given year is $3,500. This number comprises $2,000 for each full or partial year of service prior to 1996, plus an extra $1,500 for each year of service before 1989 – provided you are not entitled to receive any benefits from contributions you made to a registered pension plan (RPP) or deferred profit sharing plan (DPSP) for those years.
For years between 1989 and 1995 the limit is a straight $2,000 per year of service, regardless of whether you are a member of an RPP or DPSP. No amounts can be added for years of service after 1995 (when tax rules were changed).
You cannot transfer the eligible part of your retiring allowance to your spouse’s RRSP. It must be transferred to your own RRSP. By transferring directly to your RRSP, you avoid immediate withholding tax on that income.
The rules are somewhat different for the non-eligible amount of a retiring allowance. You can contribute it directly to your own RRSP without withholding tax, provided you have enough unused contribution room to use the full amount as an RRSP deduction in the tax year of the transfer. Or you may contribute to your spouse’s RRSP. You include the amount in your income, but then take an offsetting deduction for the contribution to your spouse’s RRSP.
The second important issue in paying a retiring allowance is to make sure the amount is reasonable. Otherwise the Canada Revenue Agency (CRA) may not accept it as a deduction against farm or business income for tax purposes. The amount of an allowance must realistically account for the recipient’s years of service to the business, the amount earned while working for that business, and the type of work actually performed.
The number of years of employment with your business need not be continuous, and there is no restriction on the length of the break between periods of service. The CRA “reasonableness” rule of thumb for a retiring allowance is 2.5 times an employee’s average annual salary for the last 5 years of employment, less any RRSP, RPP or DPSP amounts received.
Usually, an employed spouse also qualifies for a retiring allowance. Prior to 1980, however, an unincorporated business owner was not allowed to deduct (as a business expense) remuneration paid to a spouse. So a few years ago, CRA was asked to comment on a situation where no salary had been paid to a spouse prior to 1980.
Could services provided by the spouse prior to 1980 be considered eligible for contributing a retiring allowance to an RRSP? CRA indicated that, in a particular case, it might be possible to prove the existence of an employment relationship even without remuneration. CRA also noted that where an employment relationship existed but remuneration was very low or non-existent, a payment on retirement might constitute deferred compensation.
One can reasonably assume that this position could be expanded to include similar post-1979 low- or non-remunerated years of service for a spouse or other family members where a bona fide employment relationship existed.
It’s always prudent to talk with your tax advisor before implementing strategies like a retiring allowance. Professional advice can help you maximize the tax benefits for your business, yourself and/or your employees.
For another strategy, read how you can draw on your RRSP savings accounts while avoiding clawback of Old Age Security payments.