Friday, September 21, 2018Canada's Leading Online Business Magazine

Retained Earnings: Your Business Keeping Your Stuff

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By Mark Borkowski

Time and again we hear business owners speak of their businesses much like spouses, or second spouses. These allusions to the owner-company relationship as a marriage bear no resemblance to reality. At best they are delusions rather than allusions. The end result generally involves complacency and your company keeping your stuff.
Steve Southern leads the client outreach function for Ogilvie Daugherty Business Profit Solutions. They serve the owners of successful private companies, ensuring their clients pay themselves (or pull profits) from their companies using the one optimal solution. Ogilvie Daugherty has found, through their practice that virtually all business owners are losing wealth to avoidable tax erosion.

Many lifestyle businesses and owners become highly intertwined. The business’s and owner’s lives start to meld. The owner drives a company car; and the owner’s actual spouse also drives a company car. Many vacations are at least partially also business trips. And often a few suppliers to the company do a few odd jobs around the owner’s home and maybe do not charge all that much for these services. The list goes on and on. Our firm does not advocate many such arrangements, but everyone knows they happen.

All of this warm and cozy back and forth can start to seem like a very tight relationship, perhaps even a marriage. Let us break that myth now. A marriage includes the concept of shared/joint ownership. Within a marriage there are concepts like ‘marital property’ and ‘separate property’. Marital property is jointly owned. When the marriage ends, the marital property must be somehow divided.

When it comes to your business, there is no joint ownership and there is no marital property. You own your stuff. Your business owns its stuff. And when the relationship ends, that is when you no longer own the company; you each keep your own stuff. There is no joint stuff.

This hits hardest in that innocuous retained earnings entry on your company’s balance sheet. The retained earnings line is, in theory, your stuff, earnings that could have and arguably should have been distributed to shareholders (i.e. to you). That sounds great, but because that stuff which you consider to be your stuff sits in your company’s retained earnings line, legally, it still belongs to the company. So either you get your stuff back before you sell your business, or it will be gone forever.

So why has your company retained your stuff? To answer this question we must first break the question down. When we say ‘your company’, we are actually referring to a decision made by the chairman of the board of directors of your company, and that is likely you. So we are really asking, why did you (acting on the advice of your advisors) decide to have your company retain your stuff?

The answer generally falls to the dire implications of income taxation and a lack of considered alternatives. The earnings were retained in the company because it was going to be too expensive (i.e. taxation) to pay them out. And so the company retained the earnings and used them to buy trucks or machinery or computers or the like. The cash became assets. The company retained your stuff.

Unknown to virtually all business owners and their advisors, there exist very simple, highly proven and reliable mechanisms to move these excess sums out of the operating company and into a holding company, and to do so tax-free. Inside the holding company one can apply tools to ensure the sums grow within a tax-sheltered environment and yet remain entirely accessible, if needed. Should the company in fact need these earnings to purchase assets or for other necessities, the owner can choose to lend the money back to the operating company. There are also many other benefits to these strategies, but they go beyond the scope of this article.

This represents one small aspect of the work we do in our firm. We see far too many clients whose companies have retained massive sums of money. Even worse, we see far too many businesses with an actual fair market value pegged at far less than the retained earnings line. Some business owners actually believe there is value in the retained earnings line. That is generally not true, and there is generally no corresponding cash in the business either.

The retained earnings line is simply a tidy cumulative accounting of your stuff that your business has thus far kept. Do you remember that hedge trimmer that your neighbour borrowed years ago, you know, the neighbour that moved to another province last year? Do you think you will ever see it again?

Get your stuff out! If your business needs some of your money, then you can establish a loan to your operating company. But first ensure that you pull your money out of your operating company on an ongoing, year after year basis, ideally using the tax-sheltered and highly efficient mechanisms noted above. At least then you will both benefit from a loan agreement that stipulates that the loan exists.
And you will not lose your stuff!  

Mark Borkowski is president of Mercantile Mergers & Acquisitions Corporation. Mercantile is a mid market M&A brokerage firm. You can reach Mark at

www.mercantilemergersacquisitions.com

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