Sunday, December 11, 2011

Structuring Your Business

There are 3 traditional ways to operate a business in Canada;

i) a sole proprietorship
ii) a partnership
iii) a corporation

I’ve alluded to incorporating in my past but not provided any basic information. While there isn’t much in the way of unconventional wisdom in this post, I have found new entrepreneurs approach this whole discussion with fear & trepidation. I hope the following discussion will assuage those apprehensions. It really isn’t a big deal and no matter what you do you can’t cause irreparable damage with your choices

Technically as soon as you sell something, you are in business. This is a sole proprietorship and any profit you make is reported on your personal income tax return. The degree to which you grow from that point is just a measure of desire. You can stay at that level if you want. Of course CRA doesn’t spend too much time chasing people who have a garage sale or somebody selling quilts & crafts to friends. In fact, if your revenue is under $30,000 they don’t even expect you to charge GST. To be blunt, you’d be considered a nuisance more than a source of tax revenue.

Since you report any income from a sole proprietorship on your personal tax return there are two impacts, one is bad and the other is good.

Firstly, the bad one; your profits will be taxed at personal tax rates. For those who haven’t been paying attention to my previous posts, the reason it is bad is because governments charge much higher taxes to individuals than to businesses (but that’s another post).

The second impact is the good one. As a sole proprietor you are still considered in business so you will be recording all your business related expenses and deducting from your business income just like any other incorporated or partnership business.

The sweet spot is that if your business expenses exceed your business income in any given year you are allowed to deduct those leftover business losses from income on your personal tax return, specifically employment income! In other words CRA allows people to “grow” into their business as a part-time activity while still maintaining their regular 9-to-5 job. I recommend this option as a risk mitigation strategy.

The survival statistics on start-up businesses are not good. It can take a number of years of investing in these losses before a business can have all the pieces working well to make it successful. So CRA views this allowable support for a few years as a smart thing to help you out. Of course, don’t expect to run up continual losses over many years without any taxable profit. CRA is not that stupid.

To operate a simple part-time service as a sole proprietor doesn’t require much at all. You may need to get a municipal licence, or other certificates & approvals depending on your line of business. These may include registering physical store-front premises, parking, health & safety, employees and other considerations.

The one thing I recommend from Day 1 for any size business is to out-source your accounting and taxes to a good bookkeeper and/or accountant.

I won’t dwell on partnerships much. In some respects they are taking the limitations of a sole proprietorship and layering on the complexities of multiple decision makers. Many entrepreneurs often get started with peers and associates. Teamwork & collaboration is instrumental in building a successful business. However, I just think a partnership requires more skill and leadership to manage than a corporation. Many inexperienced entrepreneurs are intimidated by the concept of incorporating and feel a partnership is “simpler & easier”. I’ve seen many potentially good businesses flounder because the owners are spending so much time on the politics & stress surrounding management of the partnership instead of applying their efforts to decisive, proactive leadership in the business. I suggest you avoid the aggravation and start your venture yourself. If you need certain skills you can initially bring in those same people as vendors & suppliers to your business. Gain some leadership and business management skills first. Allow yourself the opportunity to see how things perform in an entrepreneurial environment before you hand over the keys. You can always invite additional people to join you as an equal or subordinate peer later. I would add a special caveat to family members and spouses. The stress of managing a business together can sometimes ruin good family or marital relationships.

Once you have a good understanding of business and acquired solid leadership skills there are some benefits of partnerships that are worth investigating, but for new entrepreneurs I recommend you start your journey with either of the simpler options; the sole proprietorship or the corporation.

Don’t let the word, the concept or your own fears prevent you from considering this. Once you start to seriously grow your business; once you are beyond being a dabbler for beer money; once you think you need help to keep up with sales; once you leave your employment position to work full time on your fortune; you should incorporate! In my opinion the benefits far outweigh the drawbacks. I prefer to discuss the drawbacks in worst case scenario; in other words; “Why wouldn’t you incorporate?”

The costs - this is often trotted out as a good reason not to incorporate. The truth is you can incorporate anywhere in Canada for $500 or so. There is a myriad of online services, including the federal government’s own website that can set you up as a corporation in hours or even minutes. The annual fee to keep them going is in the neighbourhood of $25 a year to file a piece of paper. So if your whole business venture is a flop, you are out-of-pocket $500. That is a throw-away cost. I would guess you probably burn that much running your car for a month. If anybody can afford to incorporate, then it isn’t much of a downside risk. What else could it be?

The financial record keeping - In my opinion anyone in business (excepting perhaps the handmade crafts people) have to pay taxes whether you’re incorporated or not. Anyone who has looked at paying taxes knows good financial record-keeping is essential to minimize tax. So whether you’re incorporated or not you should still have a bookkeeper and/or accountant handle that part for you. So paying an accountant to reduce your taxes is the same whether you are a sole proprietor or a corporation; that can’t be the reason.

The extra legal paperwork & administration – To keep your corporation running, the government only wants three things; i) you must pay your taxes ii) you must file your tax returns so they can confirm you are paying your taxes and finally iii) a piece of paper (& fee of course) that provides contact information in case they want to chase you for not paying your taxes! Do you see the common theme? Your accountant will look after i) and ii) leaving you with iii). You’ll spend longer waiting in your dentist’s office every year than filling out that form and mailing it with a cheque. The incorporation service or lawyer you selected for getting the corporation set up will have probably given (or charged ) you a little binder. It contains all the legal & administrative paperwork. In most cases, it is put in a drawer that day and will never again see the light of day. In theory, you are supposed to hold a meeting with yourself once a year and write some things down (meeting minutes and resolutions etc). In all practicality, I can’t think of anyone who would want to review those meeting minutes. My suspicion is you will go to your grave with that binder still in the drawer. The only exception will be those partnerships where one partner or spouse is suing the other for breach of their partnership agreements. In those cases you need to have all these documents formally kept up to date… primary proof that partnerships are more complicated than corporations!

The benefits of incorporation are numerous. The primary benefit is the provision of specific legal protection from liability. Corporations live forever; so if your business holds assets in United States, you will simplify the issue of US estate taxes. Corporations allow you to income split between family members who are shareholders; significantly reducing taxes. Corporations allow you to determine specific dates for payment of income to yourself to further reduce taxes. In my PHSP business alone, a corporation has unlimited room for eligible deductions whereas sole proprietorships have CRA-specified limits. In 2011 that limit is $1500 per adult.

And as for closing corporations down, you just have to ensure you’ve paid your last taxes and let them die. You can file paperwork and pay a fee to have them dissolved, or if you don’t file the paperwork for a period of time, they are simply placed on the defunct list. Done!

I have opened and closed dozens of corporations in my little empire. They are cheap, fast and easy to utilize. I don’t see any significant risk in a worst case scenario and they have significant upside.

Of course, when you are setting up your business you should talk to a credentialled expert in this field. My unconventional wisdom suggestions fit my risk profile but may not fit yours.

Thursday, December 1, 2011

Trans Border Credit & Financing

This is a longer post than usual because the steps are so annoyingly elaborate for what is a relatively simple process. My business partners and I are investing in US real estate during the 2008-2010 recession. This is what we did to handle the finance side of it. I streamlined some of the steps and eliminated those steps we took that resulted in a dead end. So you are already benefiting from our experience.

1. Start doing some research about candidate city & state in which you would like to invest. Continue doing this for some time but you eventually need to decide to make a purchase at some point. Nothing is perfect. We selected Dayton, Ohio in 2007 because
a. The GM plant had closed over a year prior so the bad news was behind us
b. There is a major US Air Force base and two universities there to provide some stable baseline employment
c. It is a significant city but not a major metropolis so deterioration of urban infrastructure was not overwhelming
d. It is close enough for commuting to two major cities – Cincinnati and Columbus
e. It is not a tourist destination with fickle rental markets

2. Open a personal Royal Bank of Canada bank account; separate from any other account you have. This is your US property investment account. It will morph into a business account.

3. At the same time set up a US account at RBC Bank USA through the same Royal Bank branch. This is not a simple US dollar denominated Canadian account. It is a bona fide US bank account with US cheques encoded for processing in the US cheque clearing system. You will be selecting a physical branch in the US where the account will exist. Wells Fargo is the only other financial institution that offers this to normal Canadians, as far as I know.

4. Link the two Royal Accounts to move money seamlessly and immediately

5. Initially, get the RBC Bank USA cheques personalized in your name with your CDN home address on the face. They will take some time to arrive. Only order the minimum

6. Deposit a token amount of money in your Canadian Royal Bank account

7. Transfer a little money to your RBC Bank USA account so you have funds in each account

8. Over the next few months make more deposits and transfers. Don’t worry you will need your funds in US dollars for the property purchase so start sending it down now.

9. This activity will also generate monthly statements so you can confirm all the bank correspondence arriving at your home address from both accounts is switched to online. You cannot be receiving paper from the branches, as you will be changing the mailing address in later steps.

10. Incorporate a company (I will call it Alpha Co.) in your CDN province with you, your family and/or your business partners as shareholders. If you don’t know how to do this I’ll be putting up a blog post in the near future.

11. Incorporate a second company (I will call it Bravo Co.) in your CDN province with Alpha Co. as the only 100% shareholder. This is to avoid having Alpha Co. declared a sophisticated company because of an ownership of foreign US stockholding. It allows Alpha Co. to retain its qualification for the small business tax deduction (lower tax rate) as it will earn active income from this company rather than from being a passive asset owner. Money will move through Bravo Co. but never remain in it as it would be taxed at a higher rate. You can later sell or transfer shares in Bravo Co. to investors or family members without affecting any property ownership (land transfer taxes), US estate tax, or deemed income tax implications. You may want to do this to raise cash from outside investors or redirect your income streams. Never sell more than 49% so you always retain control and the ability to roll-up the revenue to your master company.

12. Incorporate an LLC (I will call it Charlie Co LLC) in the state where you will be doing business as a landlord – use an online service or a local lawyer.
a. Pay for it using your RBC Bank USA account
b. Have the only shareholder as Bravo Co.

13. Pass Director’s Resolutions in all the corporations to agree you will use the personal accounts for business purposes to reduce costs and facilitate low cost transfer of funds. All transactions between companies will then be accounting entries.

14. Now you can go shopping for US rental properties – We bought houses at first but found small apartment buildings more effective. It gives you diversification in the revenue stream

15. When you make the purchase, file the title in the name of Charlie Co LLC

16. Hire a property manager with whom you can work – This is tedious trial & error process or perhaps a referral if you’re lucky. You want someone who does it full time; not a realtor who does property management as a sideline. They need to provide reliable and credible monthly financial reports and have a capability for advertising, evictions & screening tenants as well as maintenance monitoring.

17. Get property insurance on your property

18. Arrange with the Property Manager to transfer the balance of your income to RBC Bank USA account each month. This will be your gross operating earnings; it is net of their fee, the float held in their account, and any other expenses

19. Set up automated withdrawals from your personal Royal account for
• Municipal taxes on your property
• local utilities on your property
• property insurance on your property
• any loans you used to acquire the properties

20. If you used an online incorporation service, ask your property manger to be the registered representative of your company in the state. You want to have a physical address in the US where you can have mail received if anything ever comes up. If you used a lawyer, it is likely included in his fee.

21. You will need to run like this for a while, say 6-12 months, until you are reasonably satisfied with your property manager. You are about to establish a strong link with him so be absolutely sure before you start changing the physical addresses.

22. Apply for an Employer Identification Number (EIN) so Charlie Co LLC will become an entity with the US IRS for taxes – don’t try to avoid US taxes.

23. Once the EIN is approved file the conversion to a Type “C” corporation from an LLC

24. By now, you should have confirmed online banking and no documents come to your home address each month. With your property manager’s permission, switch your bank account physical and mailing address to be your property manager’s physical address in the US.

25. Once your RBC Bank USA account has been open awhile, fly to your bank branch for a personal visit. (Ours is in Naples, Florida and the trip is a business expense!)

26. Ask to open a companion business account in corporate name with the same physical address as your personal bank account (i.e. remember the address is the same as the property manager). This may not work for you so you have to be creative about a physical US address.

27. Apply for a credit card in your personal name (or preferably business name if possible) to establish some business credit history in the US

28. Apply for a small LOC on your business name. (if possible) to establish more credit history

29. Transfer all automated debits & credits from your personal account to your business account.

30. One your first annual property visit you’ll be fly to your state. Purchase a cell phone for your business locally in that state. Register your address as the property manager physical address but have the cell bills sent to your online email address

31. Have that business phone forward to your cell phone in Canada with some sort of low rate plan

32. Set up a 1-800 number for your business terminating to that cell phone in your state; establishing more business credit.

33. You are now well on your way for credit building for future mortgage capability so you can purchase assets in the US directly. You will have credit bureau account references to your business name with a physical address (your property manager) from the following entities:
• Bank
• Credit card
• Civic municipality
• Electric power utility
• Gas heat utility
• Water utility
• Property insurance company
• Property manager
• Cell phone provider
• Toll free provider

34. Get your DUNS number from Dunn & Bradstreet

What you will have at this point is:
• A tax friendly Canadian corporate structure in which you can change ownership with your investors of any components of the enterprise without generating a costly transfer of physical property assets in the US
• The physical investment property will be forever owned by Charlie Co LLC meaning US estate taxes and any land transfer taxes are eliminated.
• You have limited your liability through the Charlie Co LLC corporate entity in your state where your properties are located to protect you from lawsuits
• You have a US Internal Revenue Service account with an EIN; it will be filing regular tax returns as a full bona fide C corporation
• A Business Bank account in the US with US cheques to facilitate payments in the US banking system and you can pay for any services you need in the US with US cheques
• You can now move money between countries without fees (other than exchange rates).
• You own a business in the US linked to a US physical address with a US business phone number
• You have some credit history in the US with which you can at least approach some lenders for mortgage financing directly within the US