Why Tech Millionaires Should Start Businesses

For employees exercising stock options or hitting RSUs vesting cliffs, you’ve probably paid much more tax over the last few years than you’re used to. We review hundreds of taxes returns every year, and It’s not uncommon for us see tax returns showing over $500,000 taxable income, especially for tech employees.

When you exercise stock options, the difference between the grant price and the exercise price is reported in box 38 of your T4 under security options benefits. The total of Box 38 is added to Box 14 displaying employment income. If your company’s share price grew significantly within the last few years, you may have noticed Box 14 has a number well above the highest tax bracket of ~$221,000[1] even if your salary is under $100,000.

Once your income reaches $221,708, the next dollar you earn is taxed at 53.53%. Most Canadian are aware of the tools available to defer this income, like RRSPs, but there is less common strategy to reduce your taxable income while building for your future; Start your own company! I know what you’re thinking “my job is already super demanding, and you’re telling me I should start a company, I don’t have time for that.” The first thing to know is that it doesn’t have to be a full-time commitment. The idea is that you can create a sole proprietorship, ideally in an asset light industry, meaning it doesn’t require real estate or lots of inventory. For example, with ecommerce, you don’t necessarily have to hold inventory, instead your business facilitates delivery directly from a manufacturer to the customer. The skills required are branding and marketing as opposed managing a store. There are many reputable resources on how to build an ecommerce company, (and even more not so reputable), but the main point here is that it doesn’t have to take a lot of time or money when you’re just starting.

How the Tax works

There are many reasons why starting a business can be a great idea for employees with temporarily high income, but it’s a perfect combination of the following:

1. If you’re building wealth quickly through equity compensation, while working very hard, there may come a day when you want to quit, because the salary doesn’t motivate you to stay in your job. This happens all the time. It’s called “calling in rich” .
2. With the help of technology, it’s never been easier to start your own business.
3. You may only be in the top tax bracket for a few years before you exercise your stock options. When you are in the highest tax bracket, any business expenses of the sole proprietorship will reduce your total taxable income, meaning you will save 0.53 cents for every $1 you can reduce your income. This is the equivalent of getting a 53.53% discount on any business expenses for your new company courtesy of the CRA.
    

What to Expect

Most businesses take a few years to grow their customer base, but you don’t need the business to be profitable right away because you have a full-time job to support your lifestyle expenses. At the beginning, the business will likely have high expenses and low revenue. There will be several expenses like website creation, costs for freelancers to design logos or write copy. You may need to take a course, obtain a license, purchase software or hire a part-time employee. If you’re well into the highest tax bracket, you will get a 53.53% discount on all these expenses. If the business is cash flow positive right from the beginning, even better, but the more likely outcome is that it won’t be profitable right away. It may take some time to see traction if you’re investing in SEO and marketing, but if you’re executing well, word of mouth will spread and business will eventually pick-up, coinciding perfectly with exiting your regular job, which won’t be as scary because you will have already prepared your parachute over the last few years. Keep in mind that taxes are important, but saving tax alone isn’t a reason to start a company. Hopefully, this is something you already wanted to do.

We’ve all heard stories of entrepreneurs taking crazy risks to build incredible companies, and sometimes having no other choice can be a great motivator to build a world-changing company, but there’s also advantages to starting a business from a place of financial strength and security. It can give you the freedom to optimize for long-term instead of making less than ideal decisions in haste just to cover your basic needs.

You don’t have to wait until your income is greater than $220,000 to start a business, but if you’re anticipating a temporarily high income from stock options, and you’ve got an entrepreneurial itch, here are some key points to remember before you start:

• The business should be structured as a sole proprietorship, not a corporation. The reason is that losses of the sole prop can be used as deduction against personal income whereas corporations’ expenses are separate and can only be used to offset income in the corporation. There may be other reason to structure your business as a corporation that you should looking into before starting.
• Capital costs like vehicles and hardware cannot be deducted all at once. Capital assets follow a specific depreciation schedule allowing you to deduct a certain percentage of the purchase price every year.
• January is the ideal time to start to the company since it gives you the entire year build up expenses as you build the company’s infrastructure.
• The business must have a profit motive; you can’t start a design business just to create art for yourself and deduct your art supplies cost from your income.

There are many advantages to starting a business when you’re in a high tax bracket, but before you do, hire a good accountant and lawyer. These professionals will be able to help you set up the sole proprietorship and file tax returns correctly, giving you two less things to think about as you build your empire!