Self-employed clients can be delightful clients for financial advisors. But these clients also can be terrifying. The delight comes from the passion they have for their work; the terror can come from their lack of basic business knowledge combined with a belief that they can and should do everything themselves.
“Self-employed clients tend to be outgoing, goal-oriented, driven and live for a purpose,” says Greg Hillaby, executive financial consultant with Investors Group Securities Inc. in Calgary. “Their weakness is that they are very stretched for time.”
Adds Jaime Power, consultant with Investors Group Financial Services Inc. in Guelph, Ont.: “Most self-employed clients are really good at something, but they don’t realize all the other things that are required to run a successful business.”
Cathie Hurlburt and Mike Berton, senior financial planners with Assante Financial Management Ltd. in Vancouver, work closely with self-employed clients. Berton lists common mistakes made by these clients: “They always use their own assets. They seed the business at the expense of their kids. They blur the line between them[selves] and the business.”
A problem, Berton says, is that many entrepreneurs “don’t understand the links among spending, cash flow and profits.” As long as revenue is increasing, he adds, many entrepreneurs think they can spend as much as they bring in.
Self-employment isn’t for everyone. It takes passion and a willingness to work hard — up to 70 hours a week, says Pieter Demeester, personal financial planning specialist with Investors Group Inc. in Toronto. “That takes a lot of time away from other priorities. To make [the business] work, business owners need the agreement of their spouse and children” so that they are OK with the sacrifices that will be needed.
The key to success in running a small business is planning. “You may make the best soap in the universe,” Hurlburt says, “but you won’t make money unless you have a sound business plan, keep careful track of expenses and make sure your liabilities and potential liabilities are covered.”
Here’s a look the main issues you should consider when advising self-employed clients:
Work As Part of a Team
A business owner typically needs a team of advisors that includes a financial advisor, an insurance broker, a lawyer, an accountant and a banker.
“These people will understand the self-employed client’s situation and what he or she wants — and can act as mentors and sounding boards. Business owners can get too deep in the detail,” says Adrian Mastracci, senior discretionary portfolio manager with Lycos Asset Management Inc. in Vancouver. Mastracci says he sometimes becomes the quarterback of such teams.
Once you develop a game plan — with the help of members of the advisory team — the plan should be reviewed and updated periodically, including capital projections.
“Sometimes, [entrepreneurs] need to be brought back to remember why they are doing what they’re doing and why it’s important,” Mastracci says.
Major issues that need to be discussed are the client’s goals, what he or she needs and how long accomplishing them will take. Capital requirements, for example, often are underestimated. Mastracci suggests having a meeting with all advisory team members, to ensure all are “on the same page” on this and other issues.
Expenses and Cash Flow
Estimating expenses for a self-employed client can be a challenge, says Jason Pereira, partner and senior financial consultant with Woodgate Financial Inc. in Toronto. For example, a client who left a salaried position to start a business can be shocked at the price of replacing employee benefits. A self-employed client who is earning $50,000-$60,000 annually may have to spend $10,000 to replace benefits such as health insurance and pension benefits that were part of a previous employment package.
Many self-employed clients don’t realize that a business owner has to pay both employer and employee portions of Canada Pension Plan contributions.
Another issue, Pereira says, is understanding what can be deducted for income tax purposes. Most self-employed clients assume they can deduct much more than is the case.
Then there is the issue of finding cash to pay bills in the event of a sales slump. “Most people can’t survive more than 30 days without income,” Pereira says, and loans are hard to get, as banks regard self-employed customers as higher risk than customers who are employees.
Cash flow is an important consideration. Self-employed clients should set up an emergency fund that can cover eight to 12 months of expenses, vs the three to six months recommended for other clients.
If a client owns his or her home, a home equity line of credit should be set up before the client becomes self employed, Demeester and Power suggest.
A common mistake among self-employed clients is to assume that having a business will eliminate the need for retirement savings. Most business owners overestimate the value of their business. In fact, Berton says, the business may be worth nothing if the founder is no longer involved.
That makes retirement savings a critical element of the client’s financial plan. The self-employed client should pay him- or herself a salary that will cover their personal expenses and, if the business is not incorporated, provide for RRSP or TFSA contributions, according to Mastracci. If the business is incorporated, the client can save inside the business at attractive tax rates.
But incorporation is not for everyone.
Incorporating a business can have many benefits, particularly regarding taxes and retirement planning.
For example, income left in a corporation is taxed at the small-business tax rate, which usually is lower than the business owner’s applicable personal income tax rate. For example, Hillaby says, in Ontario, the combined federal and provincial small-business tax rate is 12.5% on the first $500,000 of business income, while the top personal tax rate is 53.53%. Thus, much more can be saved in the corporation for retirement than by putting the money into an RRSP.
The figures are similar but not identical in other provinces, as small-business rates vary among provinces, ranging from zero in Manitoba to 6% in Quebec on eligible income of up to $500,000.
However, rushing to incorporate is not a good idea. An incorporated business is costly — not just to set up, but also to maintain, the latter of which involves managing the required separate tax filings and sets of books, plus preparing balance sheets and income statements. Hurlburt estimates that incorporation costs $3,000-$4,000 a year.
Pereira doesn’t think incorporation makes sense until a client’s business is making $100,000 and still has $20,000-$30,000 left after all expenses are deducted.
Power suggests a simpler approach: “[Let the client’s] accountant decide when incorporation would have benefits.”
The benefits of incorporation are creditor protection and attractive tax rates. But not everyone needs creditor protection and tax rates are relevant only when you have profits to be taxed.
Hurlburt notes that incorporating doesn’t make sense if the business has losses because those losses can be applied against personal income tax filings.
A self-employed client’s insurance needs can be extensive and costly.
All self-employed clients should have disability insurance as soon as purchasing it becomes feasible. Insurers will want a few years of self-employed tax returns before providing coverage, says Mastracci. Clients should show as much income as possible by paying themselves as much as they can. The amount of disability insurance your client qualifies for is based on what he or she has earned over a given period.
Before your self-employed clients are able to get disability insurance, Demeester suggests, they should get term and critical illness insurance (CI) to provide some protection for themselves and their families. CI is important for most self-employed clients as it provides cash both to replace lost income when the client is unable to work and to cover the additional expenses often incurred when the client is seriously ill.
Insurance is seldom an easy sell. Many clients prefer to think nothing bad will happen to them. Business owners’ most valuable asset isn’t their business: rather, it’s their ability to work and generate income — which must be protected.
Full insurance coverage may not be affordable when clients are building their businesses, but they should begin with some coverage. Clients can always add coverage when they have the cash flow.
Self-employed clients may eventually need other types of insurance as well:
Overhead insurance, which covers the cost of fixed monthly overhead expenses required to keep a business running until the insured owner returns from a period of disability.
Key-person insurance, which names the business owner and possibly other key staff as the insured and the beneficiary as the business.
Business interruption insurance, which compensates for lost income in the event of a disaster.
Professional liability, workers’ compensation and product liability insurance also may be considered. Home-based business insurance provides coverage for the things your clients may need to run their business, as well as items they stock or goods being held for sale.
Succession and Estate Planning
An important consideration for self-employed clients is whether they are building a business that can be sold and, if it is salable, how much it can realistically be sold for.
In addition, succession is a “massive issue,” Hillaby says: when there are partners in a business, a strong shareholder agreement is needed — one that spells out exactly how each partner can sell his or her portion of the business and how the value of a deceased partner’s share of the business is paid to his or her estate.IE