The ability for lawyers in some provinces to incorporate is opening new tax planning doors for those looking to sell their practice. But not enough lawyers are taking the time to properly plan their estates and take advantage of such changes.
Between 20 to 30 per cent of the bar has been practising 26 years or more, depending on the province, according to statistics from the Federation of Law Societies.
Many lawyers will continue to disregard the ageist conspiracy of a fixed retirement age, asserting their right as self-employed professionals to keep working as long as their bodies and minds hold out — and perhaps longer if they can get away with it.
Nevertheless that time will come. It is as sure as death and taxes. And the only consolation is this: even though there is nothing you can do about death, there is no shortage of advice available for minimizing your taxes when you retire.
Jason Safar, for example, a tax partner at PricewaterhouseCoopers LLP in Mississauga, Ont., says lawyers can now look forward to an exciting new opportunity for tax relief — “something that is fundamentally changing the way that a lawyer can sell his practice, which is his biggest asset and a key to retirement planning.”
It involves using the new provisions that now enable lawyers in several parts of Canada to form professional corporations and it takes advantage of what Safar calls “the big home run” in tax planning — the lifetime capital gains exemption.
Safar explains that traditionally the way a retiring lawyer gets revenue from his practice is to have the other lawyers who are taking over from him pay what amounts to a trailer fee for the ongoing work they do with his clients. This money comes in gradually as the retiring lawyer transfers his clients and it comes in the form of taxable income, most likely taxed at the highest rate.
A new method of payout that Safar suggests is for the lawyer to incorporate and run his practice as a corporation. He or she can then sell the corporation to the lawyer who is taking over. The proceeds from this sale are not considered income, but a capital gain. Capital gains are taxable, but tax rules grant a lifetime capital gains exemption of $500,000 to people who sell shares representing 90 per cent of the ownership of a privately held Canadian corporation.
A lawyer can sell his or her professional corporation to another lawyer and claim this exemption, says Safar. The retiring lawyer can save money on taxes and give the purchaser a break on the price of acquiring the practice. For example, the retiring lawyer might anticipate getting $200,000 as his share in the fees from his former clients under the traditional formula. Instead, he could sell his shares to his successor for $150,000 and still be better off because it’s tax free.
“You have an individual for whom the greatest part of their value is their ability to practise law. Now, he can sell this thing and get the proceeds tax free,” explains Safar. He cautions, however, that the rules are quite detailed as to who qualifies and how, so it is always important to consult a tax specialist for specific advice about how you can apply this strategy to your own specific situation.
Safar admits that this strategy is so new and so bold that it makes many cautious lawyers more than a little nervous. “A year or two ago, when I went out and talked to lawyers about this, they looked at you as if this is some type of scam. But in the last couple of years, we are starting to see people do it. They’re seeing that it’s not a scam, but a legitimate tax planning arrangement, something every business in Canada has been accessing since 1970.”
Nevertheless, he says, lawyers are still asking him, “Are you sure that I don’t have to pay tax on that?”
And they have every right to be cautious, he adds. “They’re the ones bearing the risk. If they get audited, they get stuck with the bill.”
Safar and other tax advisers note that a professional corporation also provides lawyers with ongoing tax deferral opportunities, since a small business can earn up to $300,000 at a low tax rate (17 per cent or less in most provinces). Individual income tax will have to be paid on this money eventually, when shareholders get it out of the company. But, in the meantime, it can be invested and earn interest.
Stuart Bollefer, a partner with Aird & Berlis LLP, says it is “unfortunate” that lawyers in Ontario do not enjoy the same opportunity that new legislation is giving to doctors and dentists to appoint shareholders in their corporations who are not active members of their profession. Lawyers in some other provinces are allowed to do this and it means that they can have spouses or family trusts named as shareholders, thus allowing them excellent income-splitting opportunities that are currently denied to Ontario lawyers.
Bollefer notes that there is, however, one drawback to letting assets sit in a professional corporation. These assets are potentially available to anyone who might have a claim against the lawyer, he says.
Keeping assets safe from attack is an important aspect of any retirement planning strategy, according to Kay Gray, a tax and estate planning partner with Grant Thornton LLP in Vancouver. She notes that limited liability partnerships provide some protection in several provinces with British Columbia’s more recent regulations offering a better shield against claimants than is available to law partnerships in Ontario.
“But it’s all quite new. It hasn’t been tested in court and I wouldn’t like to be the first test case. So we say, ‘Err on the side of caution,’” says Gray, who recommends using family trusts to own assets where possible.
Asset protection is one of the advantages that Bollefer sees in a simple retirement planning strategy for moving assets into the hands of the spouse with the lower tax bracket. In situations where the lawyer’s spouse earns less and therefore has a lower tax rate, Bollefer suggests that the lawyer takes responsibility for all the family’s spending and bill paying, so that the lower earning spouse is able to save his or her money and invest it.
“A lawyer shouldn’t mind spending all his income and letting his wife save all of hers, because if there’s ever a problem with the lawyer’s practice or a claim beyond his insurance coverage, assets accumulated by the spouse from her income really should be untouchable by potential creditors,” Bollefer says.
Craig Jones, a partner at Felesky Flynn LLP in Calgary, suggests going a little further in protecting your assets, to the Cayman Islands, the Bahamas, or even the Cook Islands. These are examples of asset protection jurisdictions — countries that have laws making it difficult to pursue assets in a trust. Setting up an asset protection trust in one of those offshore jurisdictions can protect your retirement nest egg by having, as Jones puts it, “a discouraging effect on a creditor’s willingness to spend money pursuing those assets.”
“You would never do this if you have existing creditors because that would be fraudulent, “ Jones warns. He advises that lawyers should take great care in setting up such a trust to ensure that they are not undertaking any fraudulent transaction in contravention of provincial law society rules.
“The dividing line between what is ethical conduct and what is unethical conduct is unclear and shifts from time to time. It is important for lawyers above all others to appear not to be engaging in unethical planning conduct,” he says.
Michel Matifat, a partner with KPMG, says lawyers should also apply the basic tenets of retirement planning. Contributing to a Registered Retirement Savings Plan (RRSP), for example, is “a must, a no-brainer,” he says. But it is not enough. What he suggests is putting aside a portion of your income every year for a non-registered investment fund that will become “your second pension plan.” His idea is to begin drawing income from this or other assets, such the sale of your principal home as you move into a condo, as soon as you retire, and before you are legally required to start cashing in your RRSP at age 69. This way, you will let the tax deferred investments in your RRSP grow for as long as possible.
For lawyers looking for a cutting-edge tax reduction strategy, Bollefer suggests what he calls a “bond switch.” You set this up in the following way: You make a loan to a family trust. The trust opens up a brokerage account with a discount broker and you buy a bond fund with a medium duration risk. The bonds within the fund will be relatively short term so that interest rate fluctuations won’t be too great. Ideally you pick a bond fund that distributes income quarterly, rather than monthly.
A bond fund, Bollefer explains, usually increases in value until the day of the distribution then drops. On the day before the distribution day, you switch out of the bond fund into a T-bill or money market fund. This means instead of receiving income from the fund, you’ve realized a capital gain. You’ve just cut your tax rate in two, and because it’s a capital gain there’s no income attribution back to the lender so the tax liability remains with the trust. Then, you buy back into the bond fund after the distribution date.
“The downside is you’ve got to monitor it,” Bollefer says. That raises one of the key considerations that any retirement or tax planning strategy should address, which is the personality and inclinations of the individual lawyer, notes Arthur Fish, a partner in Borden Ladner Gervais LLP in Toronto. Some people may benefit from a sophisticated estate planning strategy, but won’t do it because they just don’t want to. “They can’t be bothered. They don’t want the complication,” he says. This is an attitude that any adviser must respect, he adds. Otherwise, you may end up on the phone with them years later, saying “Why did you ever talk me into this?”