With free advice, you often get what you pay for. It’s been a long time since I’ve been surprised by clients or colleagues telling me about the latest tip that’s shared around the barbeque. What strikes me is the blind faith put in these comments. Understandably, in the world of finance, easy answers have always been sought after, but are there really easy answers when it comes to deciding on your remuneration strategy? Or whether or not to incorporate your business? Or on choosing between a fixed or variable interest rate for your mortgage? The answer is: there are no easy answers.
The individual circumstances, along with personal preferences, need to be considered when making these decisions. What’s right for one person is not necessarily right for another, and to allow these decisions to be made for you based on some blanket statement that doesn’t reflect your situation isn’t just naïve, it’s risky. What follows are a number of topics on which I’ve consistently heard the “right way to go”. What makes them even more interesting is in most cases I’ve heard BOTH sides of the coin argued as to which is in fact the “right way to go.”
Lease Versus Buy
Fortunately, when it comes to where you live, this decision is typically not made lightly, even if there is much debate over the choice in light of today’s real estate market. When it comes to the car you drive, arguments tend to be a lot more one-sided. I hear this question often and just as often we hear how leasing is a no-brainer, or that buying is the obvious choice. The fact is the two options present very different scenarios with varying pros and cons.
Advocates for the lease typically argue it’s cheaper, which is typically true from the perspective of monthly cash flow. Furthermore, if you’re leasing a car for a three or four year period, you won’t incur any significant maintenance costs since warranty coverage, along with the fact that the vehicle is relatively new, should result in no major repair bills. Finally, if you’re a fan of driving a new car every three or four years, leasing does present a much more favourable option.
On the flip side, you can buy. Yes, your monthly payment is higher, but at the end of the finance period, you actually own something and in all likelihood it has tangible value that you can cash in on if so desired. You’re also stuck with any post-warranty repair costs, which can be expected to increase in the vehicle’s later years, although proper maintenance throughout the life of the vehicle should help to keep these bills in check.
So what’s the answer? Lease or buy? The answer is another question: what do you prefer? If you want a new vehicle every few years and to keep the monthly payment low, then lease. If you’d rather build equity and ultimate ownership in an asset, and enjoy periods of no monthly payment (between paying off one vehicle and buying another), purchasing is the better choice.
Buy Personally Versus Buy in the Company
Another common opinion revolves around who should pay the bill for an upcoming purchase. This can be for a variety of investments, from something as significant as a rental property to as small as a new computer. While the repercussions may not be as substantial on the computer, decisions on real estate or a new car shouldn’t be made on a whim.
Proponents of the corporate purchase will argue that it’s cheaper to buy with the pre-tax dollars of the company as opposed to the after-tax dollars of the individual owner. While this is true, there are significant other considerations to be made first. With respect to real estate, the long-term plans for the investment play a critical role in deciding how to structure the acquisition. Buying property in a company immediately eliminates the principal residence exemption for capital gains available only to individuals on the sale of their principal residence.
While you can’t have more than one principal residence in the same year, there is some flexibility on which property you designate as your principal residence in a given year. There are also sales tax implications to consider when buying real estate, as well as consideration as to whether or not the property will be rented out in the future.
The purchase of a vehicle should also not be made in haste. Automobile expenses remain a popular area of audit so business owners hoping to save money by purchasing a personal use vehicle in their company beware. Taxable benefits are a common result of ATO inquiries and can be an unwelcome surprise. The documentation for supporting business vs. personal use of vehicles has become much more cumbersome in recent years. The short answer to this decision can often be made by evaluating how much the vehicle will actually be used for business purposes. If it’s not a significant amount, buy personally and charge the company for business use (but still remember to keep the mileage log!).
Fixed Versus Variable
In today’s world of rock bottom interest rates, this has been one of, if not the, hot topics in finance in the last few years. Hindsight is 20/20, and anyone will tell you that recently variable rates have been the clear cut winner. It’s much more challenging, however, to decide what to do in the future. The general consensus is rates have nowhere to go but up. The questions become when and by how much?
The decision becomes a question of one’s risk tolerance. Those riding the variable rate wave (hardly a wave of late, interest rate variability has been more of a still pond in the last few years) argue that increases aren’t on the immediate horizon and when they finally come they will likely be quite tempered. The risk with waiting is an increase can actually happen at any time and when it does the switch to a fixed rate will no doubt be costlier than it is now.
A recent study of Accredited Mortgage Professionals showed 85% of those buying a home in the last 18 months have done so with a fixed rate, a proportion over 15% higher than current mortgage holders. The spread between fixed and variable rates is so low that, coupled with the security of locking in for the next five years, choosing a fixed rate is a comfortable decision.
This is a decision that should not be made lightly. For those rolling the dice on variable rates, be wary. Countless other studies talk about how highly leveraged Canadians are in today’s economy, and an increase in interest rates can literally break the bank for those who are already stretching cash flow to its limits.
Salary Versus Dividend
Dividends aren’t the secret they once were. Most business owners understand they have options when it comes to their remuneration. The issue, are they asking themselves the right questions in order to arrive at the decision that best suits them? The tax system works under the concept of integration, whereby an individual should be tax neutral whether they receive their compensation in the form or salary or dividends. It isn’t perfect, but it’s not too far off.
Simply put, dividends are cheaper than salary, to the individual recipient. What gets lost in the analysis is that dividends are paid out of a company’s after-tax profits, so the business has already paid tax at the corporate level before the individual shareholder then pays tax on the dividend. When you combine the taxes paid by both the company and the shareholder, it’s fairly consistent with the tax that would have been payable by the individual if he or she had just drawn a salary from the company.
So what to do? It depends on your personal circumstances, franking account balances, other employee wages (ie Payroll tax threshold).
Incorporate Versus Sole Proprietor
Of all the debates discussed above, this one is probably made with the least professional counsel when the advice is most important. Online tools have made incorporating a business both easy and affordable, which has ultimately led to quite a few incorporations that probably weren’t necessary. There are several questions to be asked and answered before making this decision. Some of the primary benefits of incorporating are tax deferral and income-splitting. There are many others to consider, but these are two of the biggest from a financial perspective.
A tax deferral is achieved when an individual is making more money than they need for their day-to-day spending. Earning their income through a company allows them to have the excess taxed at a much lower rate than it otherwise would be if all of the income was earned personally. The top marginal tax rate on personal salary is 47%, which is more than the corporate rate of 27.5%. Note that the individual shareholder will still pay tax on the dividends eventually distributed by the company; hence it is a tax deferral and not necessarily a tax savings. Presumably the owner may be in a lower tax bracket in his or her later years, so there may in fact be a tax savings achieved in the long run. In order for this deferral (and potential savings) to be realized, again, the individual has to be making more than they are spending. If every dollar earned goes to pay for the mortgage, the car, the kids and all of life’s incidentals, there is nothing left to leave in the company. A thorough budgeting exercise should be undertaken to determine if the tax deferral is in fact a benefit to incorporating.
Income splitting is generally available when there are family members that are inactive in the business and in a lower tax bracket then the sole proprietor. The result is a tax savings by being able to take income out of the higher tax bracket individual and putting it in the lower income earners hands. This works well when there are spouses or non-minor children, especially those going to university or college, who don’t work or have minimal income. Conversely, if you don’t have a spouse or children or if your spouse is in a high tax bracket already, these income-splitting opportunities can disappear.
The decision of whether or not to incorporate should always be closely examined. Professional advice is well worth the investment. Furthermore, if the decision is to incorporate, having a professional evaluate your situation will lead to setting up the right structure for you. As often as I’ve seen individuals incorporate unnecessarily, I’ve seen others who should do it do it ineffectively.
It’s easy for a professional to answer a question with a list of other questions, but the fact is these debates don’t have simple answers that can be applied to every situation. A good advisor will ask the questions based on your needs and circumstances and then offer a course of action tailored to those specific objectives. If you’re co-worker who writes computer code all day is telling you the best way to structure your financial decisions, you might want to get a second opinion and contact the office on 0359 11 7000 or firstname.lastname@example.org
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