In episode 4 of our Talking Real Estate with Peter and George video series, George Dube and Peter Cuttini discuss the pitfalls of DIY set-up of your personal real estate corporation (PREC). Learn what realtors need to know.
Peter Cuttini:
Hello, everyone. Welcome to episode four I believe of the Talking Real Estate with George and Peter. Today, we’re going to be talking about, can you set up your own PREC? And so if you’re a realtor here in Ontario, you all know that you’re able to incorporate it effective October 1st. Does it make sense for you to just go online and set up a cookie cutter basic corporation, or just go to your lawyer and get the off-the-shelf cookie cutter simple corporation? So George, I’ll open the floor up to you. Does that make sense?
George E. Dube:
It’s not that somebody can’t do it. It’s more, I think the consequences of doing that which may be minimal in some cases, for sure, but they’re taking some pretty big risks I would suggest at least from a tax perspective. One of those big risks, I think that people probably don’t fully appreciate is that from a tax perspective, when we’re changing how we’re moving or operating from a proprietorship or a partnership to a corporation, any fact we’ve really sold that for tax purposes. We’ve sold our business to the corporation and we’ve sold it for fair market value.
And as you’re aware, whenever Revenue Canada hears that somebody has sold something for fair market value. I mean, they’re licking their chops. They’re wringing their hands thinking, this is fantastic. We’re going to get our hands on some more taxes right away. And so somebody kind of jumping into that scenario of creating that own corporation without any alternative advice and filing and et cetera, et cetera, they could surprise themselves with an ugly little bill from Mr. and Mrs. Revenue Canada down the road.
And as another quick little comment on that is to say that one of the easiest things for Revenue Canada to do when we filed that first corporate tax return, there’s a particular schedule on there that basically identifies where did everything start off from and what transfers occurred between the shareholder and the business. And so, in other words, if they see the personal real estate corporation has a bunch of revenue, a natural question would be, well, how did it magically start with all this revenue? There must’ve been something, some meat and potatoes to start it off. And for most people, for most realtors, that’s going to be what I’ll call intangible assets. Some of the goodwill, if you will, client lists, things of that nature that allowed the realtor to get up there in terms of an income level.
Peter Cuttini:
So I’ve heard of a few potential issues. Maybe you can expand on them, George. Is there an HST implication for this transfer?
George E. Dube:
Potentially. So again, one of the little things that Revenue Canada of course loves to see is GST and HST. So if we are going to be in a position where the argument is, there’s no value to the corporation. Then again, the GST and HST on zero is going to be remarkably close to zero, not a big deal. We’re going to have a number of clients that are going to take what I’ll call a protective stance. In other words, if they have some revenues, I’m going to throw out a number and let’s say they have a profit of $150,000. Revenue Canada could argue that there’s some value to that business. And I’m not sure what number they’re going to use, but let’s say they claim that of that 150,000 in my example, 50 of that represents kind of earnings beyond what they would otherwise pay the shareholder, the owner operator.
And so maybe they say something to the effect of, well, maybe we’re going to apply a five times earnings multiplier as a rough number to calculate what the value of the business is. So now all of a sudden that realtor businesses, in my example, were $250,000. So one is to say, we can file a tax selection that allows us to not pay tax at that point in time. We can defer the tax until another event, typically is sale of the business or death or redemption of shares. But we had to do everything correctly. We had to have the legal agreements, we had to have an appropriate business valuation, and we had to file the actual tax election. And then this starts to swing around too, to the GST and the HST to say, well, depending on what that value is that we’ve determined now there’s GST and HST consequences.
So if it’s something where we initially said, we just want to file this tax election. Because part of that tax election, it has what we call a price adjustment clause and provided we’ve made a reasonable attempt at doing the valuation, which is where we try to get our clients to consider why don’t you have the BDO’s CBV team, essentially their business valuation team come in so that if Revenue Canada challenges the value, we’ve got something to stand on. Whereas if we just kind of took a guess at that number, it’s quite possible Revenue Canada rejects the tax election, and then they deemed the entire transaction to be at fair market value. So on the income tax side, a disaster on the GST and HST side, now we have a problem as well, because now potentially we had to have that GST and HST on a good chunk of value.
And yes, in theory, the PREC should be able to receive a refund of the GST and HST paid, the ITCs, assuming that we’ve identified it in time, et cetera, et cetera, and make the claim, but for the individual, the proprietor or the partner, they will have missed paying that GST and HST. So now there’s going to be some interest and some penalties on top of everything. And just the normal kind of that in theory, it balances out, but in practice, it won’t, if we didn’t file correctly in terms of elections on the income tax side, and there’s a GST and HST election, which gives us kind of a get-out-of-jail-free-card provided we’ve gone through all the proper steps.
So it’s a long-winded way of saying, yes, there’s some potential implications there, and it doesn’t mean that everyone’s going to be subject to them, but that’s kind of the value of sitting down with the advisor to see what’s applicable in my situation.
Peter Cuttini:
Okay. So if I were to go out and just set up a PREC by myself, I’m the shareholder. Is that who’s the only person who should be a shareholder? Like who should be a shareholder?
George E. Dube:
A great question in the sense of depending on what somebody’s business situation and family situation are, that answer’s going to change. So certainly the regulations for the realtors have requirements or restrictions may be a better word, that define who can and cannot own the shares and what types of shares they can own, but they also give us the ability to indirectly own those shares. So in other words, it’s possible to potentially put in place a holding company, for example, or maybe there’s a couple of holding companies.
Maybe we should be, I guess, in probably the most common situation, sharing ownership between spouses and ensuring that we’re one meeting the rules from the regulation standpoint, from professional body in terms of [inaudible 00:08:13] are requiring, and then start to delve into what, what makes sense from a tax perspective, because if I’m starting to save more and more money in terms of this tax deferral, how am I going to get the best use out of that money? How am I going to redeploy the funds? And there can be tax advantages of different types of structures. And it also will depend on, like if we’re investing in real estate, perhaps. If we have other business activities, maybe the spouse has another business activity. Now let’s start to integrate that so we’re not losing money in between the gaps, if you will.
Peter Cuttini:
So you’re basically saying the cookie cutter might not work for everybody.
George E. Dube:
In fact it could be a real disadvantage. I mean, yes, there’s still going to be at the end of the day, the opportunity to defer the tax on the income that’s left at a corporate level, or maybe have the ability to do some income splitting. So it’s not like it’s a complete disaster ignoring that initial conversion, if you will, and perhaps unexpected taxes on the value of the business, but we’re just not peeling out as much of the opportunities from a tax perspective, if we’re just going plain and simple, which might be the best solution for some people, I’m not saying otherwise, but I think for far more families, they’ll find there’s some more planning opportunities there that given an opportunity we can help with.
And even and I appreciate the exceptional, vast majority of lawyers who are going to do a great job in terms of the articles of incorporation, et cetera, but did they include everything that we’re looking for from a tax perspective? And certainly some will. Probably the majority will, but as accountants, we probably all have our idiosyncrasies, of course. And I like mine done a little bit differently than Billy Bob or Betty Sue, et cetera, et cetera. Even our partners will do things slightly different. It doesn’t mean that one’s necessarily right or wrong, but let’s make sure that the overall plan is going to fit for what we’re hunting down. And so if that means a couple of clauses that we want to see in our articles, well, I want to ensure that they’re available, so I can do the planning with my clients that way.
Peter Cuttini:
You mentioned type of shares, George. Are all shares the same or are there differences?
George E. Dube:
There are differences. So I guess the majority of people, when they’re thinking of shares, they’re going to be talking about the common shares of the business. And these are typically thought of as the shares that are going to grow in value, they’re appreciating if you will. And those are the shares that again, most of us are considering, but on the other hand, we also have something called special shares. Some people will use the term preferred shares. And with these special shares, they can be critical for in particular, the initial tax selection. But the special shares also give us an ability to be a little bit creative in terms of what we’re going to do with those shares. So for example, we may or may not have voting shares in a common situation, although with the PREC they’re going to have to be non-voting.
We can define what the values are. We can give them some characteristics that allow us to work with this tax selection and help ensure not guarantee, but help ensure that there’s a debate with Revenue Canada, this concept of the price adjustment clause that I mentioned. Again, if we have everything in place, ultimately this price adjustment clause says something to the effect of maybe we put a value. We meaning BDO’s valuation team of half a million dollars onto the business, but it turns out a couple of years after the fact that Revenue Canada thinks the numbers should be 750,000. And if we can show we made a reasonable attempt at valuing the business and all the other steps are completed, we can retroactively adjust our special shares value from $500,000 in my example, to $750,000 without paying any additional income tax, assuming that we haven’t otherwise transferred to redeem some of those shares.
So basically those special shares and common shares, they’re just tools again, to allow us to do different things from a tax perspective, from non-PREC corporation so when we’re setting up, perhaps the investment holding company with our realtors, there’s also some other, I guess, advantages that we can play into with those special shares.
Peter Cuttini:
Is there anything else that, George, that you see people, whether it’s realtors or other people that just when they get the off-the-shelf cookie cutter, is there anything else that they make mistakes on or any general guidance you can give them?
George E. Dube:
One of the big things, and this is certainly subject to debate, but one of the big things in my mind is who between spouses will be owning the shares. Often, we’ll see someone, one of the spouses who’s for the lack of a better word, the business operator as the only shareholder of the company, or they’ll think, Oh, I’ll just change it down the road, add my spouse. And it’s something that in theory sounds really, really simple, but actually Revenue Canada is not very keen on spouses exchanging common shares of a business or for that matter special shares.
And certainly it’s not that it’s not impossible to do. I’m not suggesting that, but there are unquestionably is a line of court cases that show even where fair market value has been paid for those shares. It’s possible that if those shares are changed, something we call attribution can come into play where the recipient intended. So let’s say for example, spouse A is the realtor and spouse B is the other spouse. Then if we started off all with spouse A and then spouse B gets involved after the fact, well, now there’s an argument to be made potentially that spouse A has given to spouse B the right to earn dividend income and Revenue Canada can, if a dividend of say $50,000 was paid to spouse B, attribute that $50,000 back to spouse A.
And of course that’s going to be found after the fact and probably after a court case, or certainly some arguments. And now all of a sudden, it’s not only the tax that spouse A is going to end up paying, but now there’s interest and penalties. And we’re hoping that Revenue Canada will remove the dividend from spouse B, which is not a guarantee. So yes, there are other things that we’re trying to be careful of. Now I’ve given kind of a bit of a nightmare scenario, but I can certainly point to some court cases to show it’s happened. And unfortunately, most people kind of walking unaware of that.
A lot of things we can fix, Peter, in the sense of something’s not quite done right and hopefully if somebody has gone and perhaps they have set up a corporation online. As long as they haven’t done the entire transaction yet, we can get in there and we can help them. We can get things fixed up in a perfectly legal tax efficient way, but it is important that we’re, or a qualified advisor has that opportunity to jump in as soon as possible. It’s just so much easier if we could get in right at the beginning before it really started, but it’s not the end of the world necessarily if we’re a little bit after the fact, but we certainly don’t want to be too late.
Peter Cuttini:
So my understanding and correct me if I’m wrong, it appears that from your talk, you should do it right upfront. And if you wait too long, it could cost you a whole bunch more money down the road.
George E. Dube:
That’s the simple explanation, and we’re not necessarily allowing them for the full benefit of that PREC. In other words, we’ve got that initial value that we talked about, the difference in personal tax rates versus corporate tax rates, but there’s so much more sitting there in terms of income splitting, being able to use those after-tax funds now for re-investment regardless of how they’re reinvested, but let’s do it tax efficient. Let’s consider, should we be using a family trust? Should we be using the holding companies, investment companies? That’s all part of the parcel, or maybe what we’re trying to do is kind of create a five-ish year plan where initially stage one is creating the PREC itself. And maybe we’re going to stage two or three when certain thresholds or conditions are met, but let’s plan that out because it may be a lot less expensive to just do it right the first time as compared to grow it over time that way. Again, pros and cons that just will depend on the taxpayer’s unique situation.
Peter Cuttini:
Fair enough. So, could I summarize it to you using more of a realtor language? They never recommend that you buy or sell your house yourself. Really we shouldn’t be recommending, they set up the corporations themselves. It’s the same advice, isn’t it?
George E. Dube:
It’s absolutely same. I agree completely. And it costs relatively little to do it right the first time. Just do it.
Peter Cuttini:
Yeah. Fair enough. Unless you have anything else, George, I’m going to say have a great day, everyone. Thank you for listening.
George E. Dube:
I think that’s again, covers off what we’re hunting.
Peter Cuttini:
Take care, everyone.
George E. Dube:
Thank you, everybody.
To contact Peter or George you can email pcuttini@bdo.ca or gdube@bdo.ca.
Tags: PREC
