Grow and Save

“This is a frustrating time for us,” Raymond O’Brien said. “We seem to be in a sweet spot in our business, and yet we’re not able to exploit it properly.” Ray is CEO of Glendon Consulting Engineers, a successful firm with a professional staff of 20.

“Before tax and bonuses,” Ray said, “the company earns about $1.3 million. Typically, we bonus out $1 million to the four partners. That leaves us retained earnings of $300,000. After tax that’s about $240,000 — not enough to allow our business to grow.”

I said, “Some firms ask partners to lend the after-tax amounts of their bonuses back to the company. If you did that, the company would receive advances of about $500,000 back from the founders.”

“We did that for several years. The problem is that nowadays we’re likely to have personal cash needs that make it difficult to lend all the money back. Dave had a divorce settlement, Arnie has a son with a disability, and Fred remarried and now his wife’s expecting.”

“What about you?” I said.

“I’m mostly worried about retirement,” Ray answered. “I’m putting away as much money as possible because I didn’t save when I was younger. Meanwhile, I want the company to grow quickly. Then I want to sell my shares to someone in the younger generation.”

“It sounds as though for different reasons, all the partners are in a similar situation. You all want to take out the maximum from the business, but have enough working capital to grow the company.”

“Yes,” Raymond said nodding. “That’s about it.”

“There’s a vehicle that could help you out,” I said. “It’s called a Retirement Compensation Arrangement. Usually it’s referred to as an RCA.”

“Never heard of it.”

“It’s not very well known at present, but as people grow to understand it better, it will become more popular. It’s designed to be a non-registered pension plan. It works like this. The company makes a contribution to the RCA and receives a tax deduction for it, similar to the way bonuses are treated. In Glendon’s case, that would give the RCA $1 million. The RCA then divides its cash into two equal funds, an investment fund and an account with Revenue Canada.”

“You mean the RCA pays Revenue Canada $500,000?”

“Yes. That’s similar to what happens when you receive your bonuses: about half goes to Revenue Canada. But now it gets interesting. With the $500,000 it still has, the RCA can make about any investment it wants — including lending the money back to Glendon. In addition, several banks will lend the company up to 90% of the total amount contributed to the RCA. It means that by using an RCA, the company can receive a cash infusion of $1.3 million. It would about double your working capital.”

“True,” Ray said. “If we can maintain our return on assets at our traditional 20% level, it would give our profits a real boost.”

“Exactly. The company will grow as long as your return on assets, or “ROA,” is greater than your cost of capital. And that will soon mean larger bonuses. When you retire, the funds paid to Revenue Canada are refunded to the RCA, but the payments out of the RCA are taxable. You pay tax on the withdrawals at your usual tax rate, as you would if you had a pension or if the payments came from an RRSP. If you become a non-resident of Canada, the withholding tax on a lump sum payment will be 25%. If you become a non-resident and receive periodic payments over at least a 10-year period, the withholding tax may be reduced to 15% under some tax treaties. But you might have to pay tax on your receipts in your country of residence.”

“This is an interesting idea,” Ray said. “Is it very complex to set up?”

“There’s some legal work to do. The banks require collateral agreements of course, and they’ll look carefully at what you’re going to use the money for. Many users build a life insurance component into the deal as a way of protecting the equity value of the partners. There are ways of structuring the arrangement that could make the insurance premiums tax deductible.

“Instead of robbing your future growth in order to fund a retirement scheme,” I said, “the RCA may help you grow and save all at once.”

Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto, e-mail: hbulmash@bulmashcullemore.com