My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with BDO. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. My posts are blunt, opinionated and even have a twist of humour/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, November 30, 2020

Tax-loss planning for the COVID stock market

Last year I cut with tradition and did not post my annual tax-loss planning/selling blog. However, because of COVID, my client’s portfolio returns and realized capital gains/loss positions are “all over the place.” I have never seen such disparity in my career, so I am again posting a tax-loss planning/selling blog. Consider it part of your required tax considerations during these uncertain times.

The reasons for the disparity I note above are as follows:

1. With the 35% or so drop in the stock markets at the beginning of COVID, some people “bailed” or sold off certain holdings to go to cash. Those that held their positions (and noses) or added to them likely do not have any realized capital losses this year, unless they sold selected stocks that were hit during COVID.

2. Certain conservative portfolios fared worse this year than in a typical market dip, due to precipitous declines in transportation, entertainment, preferred shares, or real estate REITs.

3. Those who held technology, medical or pharmaceutical stocks, and certain food-related stocks were rewarded with astronomical gains in 2020.

If you fall into category #1 or #2 or have realized capital losses this year, I suggest you review your capital gain/loss situation early this year. In the good old days, I suggested you undertake this task before you get busy with holiday shopping, but many people won’t go much further than their computer to shop this year. So, you can probably do both simultaneously.

While most investment advisors and managers are pretty good at contacting their clients to discuss possible tax-loss planning/selling, I am still amazed each year at how many advisors do not discuss the issue with their clients. If you have an advisor, ensure you are in contact to discuss your realized capital gain/loss situation and other planning options by next week.

If you are a DIY investor or maybe even if you have an investment advisor, you may wish to set aside some time this weekend to review your 2020 capital gain/loss situation in a calm, methodical manner. You can then execute your trades on a timely basis knowing you have considered all the variables associated with your tax gain/loss selling.

I would like to provide one caution about tax-loss selling. You should be very careful if you plan to repurchase the stocks you sell (see superficial loss discussion below). The reason for this is that you are subject to market vagaries for 30 days. I have seen people sell stocks for tax-loss purposes with the intention of re-purchasing those stocks, and one or two of the stocks take off during the 30-day wait period—raising the cost to repurchase far in excess of their tax savings.

Thus, you should first and foremost consider selling your "dog stocks" that you or your advisor no longer wish to own. If you then need to crystallize additional losses on stocks you still wish to own, be wary if you are planning to sell and buy back the same stock. Your advisor may be able to "mimic" the stocks you sold with similar securities for the 30-day period or longer or utilize other strategies, but that should be part of your tax loss-selling conversation with your advisor.

One additional note: While I don’t comment on rumours and conjecture, there are many tax commentators who feel there is a good chance the capital gains inclusion rate will increase from 50% to a higher rate in a future budget. If you are in that camp, you may not wish to crystalize your capital losses in 2020 but rather save them for the future, so that you deduct the losses at a higher inclusion rate.

Reporting capital gains and capital losses – The basics


All capital gain and capital loss transactions for 2020 will have to be reported on Schedule 3 of your 2020 personal income tax return. You then subtract the total capital gains from the total capital losses and multiply the net capital gain or loss by ½. That amount becomes your taxable capital gain or net capital loss for the year. If you have a taxable capital gain, the amount is carried forward to the tax return jacket on Line 127. For example, if you have a capital gain of $120 and a capital loss of $30 in the year, ½ of the net amount of $90 would be taxable and $45 would be carried forward to Line 127. The taxable capital gains are then subject to income tax at your marginal income tax rate.

Capital losses


If you have a net capital loss in the current year, the loss cannot be deducted against other sources of income (unless you are filing for a deceased person. In that case, get professional advice as the rules are different). However, the net capital loss may be carried back to offset any taxable capital gains incurred in any of the three preceding years, or, if you did not have any gains in the three prior years, the net capital loss becomes an amount that can be carried forward indefinitely to utilize against any future taxable capital gains.

Planning preparation


I suggest you should start your preliminary planning immediately. These are the steps I recommend you undertake:
  1. Retrieve your 2019 Notice of Assessment. In the verbiage discussing changes and other information, if you have a capital loss carryforward, the balance will be reported. This information is also easily accessed online if you have registered with the CRA My Account Program.
  2. If you do not have capital losses to carry forward, retrieve your 2017, 2018 and 2019 income tax returns to determine if you have taxable capital gains upon which you can carry back a current-year capital loss. On an Excel spreadsheet or multi-column paper, note any taxable capital gains you reported in 2017, 2018 and 2019.
  3. For each of 2017, 2018 and 2019, review your returns to determine if you applied a net capital loss from a prior year on line 253 of your tax return. If yes, reduce the taxable capital gain on your Excel spreadsheet by the loss applied.
  4. Finally, if you had net capital losses in 2018 or 2019, review whether you carried back those losses to 2017 or 2018 on Form T1A of your tax return. If you carried back a loss to either 2017 or 2018, reduce the gain on your spreadsheet by the loss carried back.
  5. If after adjusting your taxable gains by the net capital losses under steps #3 and #4 you still have a positive balance remaining for any of the years from 2017 to 2019, you can potentially generate an income tax refund by carrying back a net capital loss from 2020 to any or all of 2017, 2018 and 2019.
  6. If you have an investment advisor, call your advisor and request a realized capital gain or loss summary from January 1 to date to determine if you are in a net gain or loss position. If you trade yourself, ensure you update your capital gain or loss schedule (or Excel spreadsheet, or whatever you use) for the year.
Now that you have all the information you need; it is time to be strategic about how to use your losses.

Basic use of losses


For discussion purposes, let’s assume the following:

  • 2020: total realized capital loss of $30,000
  • 2019: taxable capital gain of $15,000
  • 2018: taxable capital gain of $5,000
  • 2017: taxable capital gain of $7,000

Based on the above, you will be able to carry back your $15,000 net capital loss ($30,000 x ½) from 2020 against the $7,000 and $5,000 taxable capital gains in 2017 and 2018, respectively, and apply the remaining $3,000 against your 2019 taxable capital gain.

As you will not have absorbed $12,000 of your 2019 taxable capital gains ($15,000 of original gain less the $3,000 net capital loss carryback), you may want to consider whether to sell any other stocks with unrealized losses in your portfolio so that you can carry back the additional 2020 net capital loss to offset the remaining $12,000 taxable capital gain realized in 2019. Alternatively, if you have capital gains in 2020, you may want to sell stocks with unrealized losses to fully or partially offset those capital gains.

Identical shares


Many people buy the same company's shares (say Bell Canada) in different accounts or have employer stock purchase plans. I often see people claim a gain or loss on the sale of their Bell Canada shares from one of their accounts, but ignore the shares they own of Bell Canada in another account. However, be aware, you have to calculate your adjusted cost base on all the identical shares you own in, say, Bell Canada and average the total cost of all your Bell Canada shares over the shares in all your accounts. If the cost of your shares in Bell is higher in one of your accounts, you cannot pick and choose to realize a loss on that account; you must report the gain or loss based on the average adjusted cost base of all your Bell shares, not the higher cost base shares.

Creating gains when you have unutilized losses


Where you have a large capital loss carryforward from prior years and it is unlikely that the losses will be utilized—either due to the quantum of the loss or because you are out of the stock market and don’t anticipate any future capital gains of any kind (such as the sale of real estate)—it may make sense for you to purchase a flow-through limited partnership. (Be aware: although there are income tax benefits to purchasing a flow-through limited partnership, there are also investment risks and you must discuss any purchase with your investment advisor.)

Purchasing a flow-through limited partnership will provide you with a write-off against regular income pretty much equal to the cost of the unit; and any future capital gain can be reduced or eliminated by your capital loss carryforward.

For example, if you have a net capital loss carryforward of $75,000 and you purchase a flow-through investment in 2020 for $20,000, you would get approximately $20,000 in cumulative tax deductions in 2020 and 2021, the majority typically coming in the year of purchase. Depending upon your marginal income tax rate, the deductions could save you upwards of $10,700 in taxes in Ontario—as an example.

When you sell the unit, a capital gain will arise. This is because the $20,000 income tax deduction reduces your adjusted cost base from $20,000 to nil (there may be other adjustments to the cost base). Assuming you sell the unit in 2022 for $18,000, you will have a capital gain of $18,000 (subject to any other adjustments), and the entire $18,000 gain will be eliminated by your capital loss carryforward. Thus, in this example, you would have total after-tax proceeds of $28,700 ($18,000 + $10,700 in tax savings) on a $20,000 investment.

Donation of marketable securities


If you wish to make a charitable donation, a great way to be altruistic and save tax is to donate a marketable security that has gone up in value. As discussed in this blog post, when you donate qualifying securities, the capital gain is not taxable and you get the charitable tax credit. Read the blog post for more details.

Superficial losses


One must always be cognizant of the superficial loss rules. Essentially, if you or your spouse (either directly or through an RRSP) purchases an identical share 30 calendar days before or 30 days after a sale of shares, the capital loss is denied and is added to the cost base of the new shares acquired.

Disappearing dividend income


Every year I ask at least one or two clients why their dividend income is lower on their personal tax return. Typically, the answer is, Oops, it’s because I sold a stock early in the year that I forgot to tell you about it. Thus, if you manage you own investments; you may wish to review your dividend income being paid each month or quarter with that of last year’s to see if it is lower (of course this year it may be lower due to COVID related dividend cuts). If the dividend income is lower because you have sold a stock, confirm you have picked up that capital gain in your calculations.

Creating capital losses - Transferring losses to a spouse who has gains


In certain cases, you can use certain provisions of the Income Tax Act to transfer losses to your spouse. As these provisions are complicated and subject to missteps, you need to engage professional tax advice.

Settlement date


It is my understanding that the settlement date for Canadian stock markets in 2020 will be December 29, as the settlement date is now the trade date plus two days (U.S. exchanges may be different). Please confirm this date with your investment advisor, but assuming this date is correct, you must sell any stock for which you want to crystallize the gain or loss in 2020 by December 29, 2020.

Corporations - Passive income rules


If you intend to tax-loss sell in your corporation, keep in mind the passive income rules. This will likely require you to speak to your accountant to determine whether a realized loss would be more effective in a future year (to reduce the potential small business deduction clawback) than in the current year.

Summary


As discussed above, there are a multitude of factors to consider when tax-loss selling. It would therefore be prudent to start planning now, so that you can consider all your options rather than frantically selling at the last minute.


The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.

Monday, November 16, 2020

How do I reduce my fixed costs?

COVID-19 has been a revelation when it comes to tracking our costs. For many of us, it has provided absolute clarity on what are our true fixed costs are and how much we spend on discretionary items. I think many of us have been stunned at the level of discretionary savings we had when COVID hit initially and still have in large part. These discretionary savings came from four areas in general: entertainment, restaurants, clothing, and travel.

Many of my clients and friends have said they plan to temper some of their “excessive” pre-COVID discretionary spending in a post-COVID world (which hopefully arrives sooner than later). Whether or not we revert to our old discretionary spending habits once we feel safe will be an interesting experiment in human nature.

But how about our fixed costs? Is there anything we can do about them? Today, I review four of the larger fixed costs and discuss some considerations for reducing these fixed expenses.

Automobile Costs


Every year after News Year’s, I print a summary of my yearly spending, and every year I’m shocked once again by the money my family (and I’m including myself) spends on car-related expenses such as leases and financing, gas, and insurance. I always say to myself, I could replace my car for one half off the cost and would lose nothing except prestige (or in my case, possibly the loss of a convertible top) and maybe some unnecessary higher end performance.

Assuming ego and car performance are primary drivers of your choice of vehicle and you can overcome both these obstacles—can you reduce your fixed costs if your lease is not coming due or you are unable to sell your car due to financing constraints?

Cutting car costs


To be upfront on this, I am not a car expert or car nut, so you will have to do some homework on your own. But a couple people I know have moved off their previous cars and have shared their win-wire with me, so let us discuss some considerations.

Firstly, to make the savings worthwhile, as noted above, you need to park your ego, which means moving off your mid to higher end car for a less sexy model (i.e., you need to drop your lease a few hundred dollars). In most cases, dropping your mid to higher end car will also result in significantly lower fuel and insurance costs.

Here are a couple of ways to do this:
  1. There is a huge demand for used cars right now, so your first step may be to talk to your car dealer. While typically this will not work because the breakage fee will be too high (meaning, when they compare the buyout to the appraised value, it will be a large penalty that most people would not want to pay), I know that in at least one case, that is how someone moved off their car. Again, I am not a car expert, but there would be no downside to see if your dealer has any interest or if they could make it a win-win.
  2. The second and more likely way to move off your lease (it may be possible for financed cars, but I am going to deal here with leased cars) is to use a lease-breaking company. While you win by moving off your expensive lease, the person taking on the lease wins by lowering their lease costs as they benefit from your initial down payment on the lease or because you incentivize them to take over the lease. It may also allow them to lease the prestige car they desire at a lower price. There is substantial due diligence required for both parties. If you are moving off your lease, you need to understand the transaction, transfer fees, timing (so you do not get stuck with two final lease payments). If you are taking over the lease, you need to understand the lease terms you are assuming, the current wear and tear, the kilometres driven, and lease conditions related to the kilometres at the end of the lease.
As noted, I am not an expert in this area. I am just pointing out options to lower your auto costs, but you need to educate yourself of the pros and cons of taking over a lease, if that is of interest to you.

Mortgages


Mortgage costs are typically the largest fixed cost for most people. The main issue with refinancing is the penalty to break your mortgage (check your mortgage to confirm its terms). Penalties are dependent upon whether you have a fixed or variable mortgage and where you are in your mortgage term. Typically to break a mortgage you would pay some permutation of three months' interest, plus the associated legal costs (you may want your lawyer to assist you at the outset in understanding the legalities of your mortgage).

Whether it is worthwhile to refinance is a math exercise that is far beyond the scope of this post. There are many free calculators on the web that let you plug your current mortgage into a calculator to determine the savings under a refinancing. Very simplistically, you would then need to compare those savings to the penalty and legal costs.

As with a car lease, you need to be careful and undertake substantial due diligence and possibly get financial and legal assistance.

Insurance


Another large fixed cost is insurance. I have written before about reviewing your life insurance coverage, and while that post was intended to ensure you have the proper amount of life insurance, you should review all your policies (including other types of insurance, such as disability and critical illness) to confirm they are still required to meet your insurance needs.

Many people at some point in their lives were sold a policy of some sort that may have not been required or is duplicate or excessive coverage. If you have a trusted financial advisor, you can pass your coverage by them to get their opinion on whether you have any policies not really required to protect yourself.

Other costs (or, How many streaming subscriptions do you need?)


We all have multiple fixed plan costs, for phones, internet, music, TV and streaming services, and newspaper and magazine subscriptions. My suggestion is to note all these down, and see if any should just be eliminated because they’re unnecessary (do you really need cable, Netflix, Prime, and Apple TV? Do you need both Sirius and Spotify?). And if you still need or want them, see if you can negotiate the costs down.

The above list does not necessarily include all your fixed costs. However, the point of this post is that you may be able to reduce not only your discretionary costs but also some of your seemingly fixed costs. Feel free to spread the lesson throughout your financial affairs.


The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.

Monday, November 2, 2020

Tax Planning Silver Lining for Small Business Owners during COVID-19

As my colleague Jeff Noble notes in this excellent May 2020 guest blog post on The Business Owner’s COVID Contemplation, small business owners have had a herculean task navigating thorough COVID-19 for a myriad of reasons—ranging from lost revenue to keeping staff employed to accessing relevant government programs.

Some small businesses have been fortunate to occupy sectors that have thrived during COVID, including technology, health care, and some retail segments (the grocery chains and big box stores). However, many more have suffered during COVID, which in turn has caused their business to lose financial value and, as consequence, likely caused many business owners to delay the sale of their business until they can regain their value post-COVID.

As discussed in this BDO Tax Alert (see the final heading, “Tax Planning when the business value has declined”), this decline in value may have provided a silver lining in that you can potentially reduce your tax liability at death through either an estate freeze or re-freeze, or an estate thaw, where you have previously undertaken an estate freeze.

Estate freeze

As noted in the Tax Alert, “an estate freeze is a process where you take steps to ensure that the future growth of your estate accumulates in the hands of your intended beneficiaries in a tax effective manner. By freezing the value of your estate, you will effectively lock-in the tax that will arise on your death (subject to changes in future tax rates).”

For example, say your business was worth $2 million pre-COVID. If you did not undertake an estate freeze and therefore died without a freeze in place, the tax on your death would have been based on the $2 million value (If your leave the shares to your spouse there is no tax until your spouse passes away). In Ontario, for example, this works out to about $535,000 of personal tax if the entire value is taxed as a capital gain at the highest marginal rate. As noted in the Tax Alert, the “freeze will allow you to pre-determine the taxes that will arise on your death so that you can ensure that cash will be available to pay that tax (for example, by taking out sufficient life insurance).”

If you undertake an estate freeze during COVID when the value of the business is depressed, you can reduce the tax liability upon your death. Using the example above, say your business value has fallen during COVID from $2 million to $1.3 million. If you “freeze” your shares now, the $535,000 tax liability on death would be reduced to approximately $350,000.

When you freeze your shares, your strategy will usually be to redeem these shares over time. The proceeds received from the redemption of the freeze shares will be treated as a dividend for tax purposes. As shares are redeemed, this will lower the value of the shares you would hold on death.

If you are interested in learning more, I have previously written on this subject here, here and here.

It is critical to understand that by freezing your shares, you are giving the “bounce-back” and future growth in your business to your children. So if the value of your company bounces back to say $2.3 million by the time you pass away, you have effectively deferred tax on $1 million of value to your children ($2.3 million value less freeze value of $1.3 million).

Finally, it is very important that the freeze share value, your yearly salary and your other assets will provide you more than you need for your retirement, or the freeze may not make sense. 

There are many tax complexities in undertaking a freeze, please ensure you obtain professional advice.

Revisiting a freeze: The estate re-freeze and estate thaw

But let’s say you already executed an estate freeze. Now you are faced with a business the value of which has declined – at least in the short term. Is there a way to undo that freeze to take full advantage of the current economic downturn?

There is, and more correctly there are – two ways. One is an estate re-freeze; the other is an estate thaw.

As noted in the Tax Alert on estate re-freezes, “If you have already undertaken an estate freeze, but the value of your business has declined in the current environment, it is worth considering whether the freeze could be ‘undone’ and you should ‘re-freeze’ your business at the current value of your business. This could make sense if the value of your business is less than its value at the time the original freeze was undertaken, and therefore the value of the fixed value shares you took back on the original freeze is more than the value of the business. A re-freeze would allow you to reset the freeze at the value of your business today and further reduce the amount of taxes your estate would have to pay on your death.”

 Using the example above, assume you had frozen your shares for $2 million in 2007. If the value of the corporation has dropped to $1.3 million, a re-freeze will save you the tax on the $700,000 drop in value, or around $185,000.

Again, you must keep in mind the re-freeze value and your other assets will need to provide you more money than you need for your retirement, or a re-freeze may not make sense. 

An estate thaw works a bit differently.

“You may also decide that you want to undo an estate freeze done in the past due to the decline in value," says the Tax Alert. "Known as an estate ‘thaw,’ this would be possible if you or your spouse are beneficiaries of the family trust that own the common shares of your business. Implementing a thaw would mean that you would transfer the common shares out of the trust to you or your spouse. Whether this makes sense depends on your own situation, and the interests of the other intended beneficiaries.”

Estate freeze vs. estate thaw


As noted above, a thaw is different from a re-freeze. In a re-freeze you just reset the value of your initial freeze shares, lowering your tax liability on death and allowing the future growth from the lower freeze value to accrue to your children. In a thaw you are reversing some or all of the original estate freeze and possibly, depending upon the circumstances, effectively nullifying the prior estate freeze, such that the freezor is put back in the same position as they were before the original estate freeze. Under a thaw, you now lose most if not all the benefit of any bounce-back in the shares going to your children.

Re-freezes and thaws are even more complex than an estate freeze and for all these transactions, I reiterate, you need to seek professional advice.

Fair market value of shares


Determining the fair market value of shares for a freeze or re-freeze during COVID is complex. I would suggest it is mandatory that you engage an independent certified valuator to determine the revised value of your company.

COVID has provided little good news to small business owners. However, if your business has been affected, you may want to speak to your tax advisors about the benefit of a freeze, re-freeze or thaw.

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.