Successful private corporations face significant investment decisions as their surplus grows
A common tax planning technique for incorporated business owners is to leave profits within the business. Since money paid to an owner from the business is a taxable event, it is typically prudent for the owner to withdraw only the amount they require to live off, and everything extra remains in the corporation. The corporate tax rate on active business income (more on this below) is lower than the income tax a business owner would pay personally on receiving the income, hence the effectiveness of this strategy. Note: the phrases “businesses” and “corporations” refer to Canadian-controlled private corporations (“CCPC”).
What are the downsides to this approach?
1. Business owners pay a whopping 50.67% tax rate on passive income earned in a corporation. The intention of this high rate is to encourage business owners to not shelter excess profits in a corporation or, alternatively, to reinvest in business operations, not investment portfolios.
2. A further downside was introduced in 2019 for corporation’s earning excess passive income, beyond the high tax rate mentioned above. As a recap, Canadian businesses pay a lower tax rate on their first $500,000 of active business income, called the small business deduction rate. Between federal and provincial taxes, the rate is reduced from 27% to 11%. Looking at $500,000 of income, that equates to $135,000 of income tax without the small business deduction vs. $55,000 with the deduction.…an $80k difference. However, after the 2019 legislation, businesses earning more than $50,000 in passive income begin to have their small business deduction clawed back on a 5:1 basis – it gets completely wiped out once $150,000 of passive income is hit. So, not only has the corporation paid over 50% tax on the passive income, they have paid another $80,000 in tax on the active business income.
3. The lifetime capital gains exemption (“LCGE”) can shelter nearly $1m of capital gain when a business owner disposes of their company shares. In order to qualify for this exemption, a number of criteria must be met, one of which being the majority of corporate assets must be used for active business purposes. In other words, a sizeable passive asset in a corporation, such as an investment portfolio, can disqualify the business owner from the LCGE upon sale of their shares.
Solutions
The solution is NOT to start withdrawing every penny from the corporation and paying high personal tax rates. The solution is to allocate passive assets into a tax-exempt, cash value insurance policy. Why does this work as a tax-planning, wealth building strategy?
1. There is no annual tax reporting for an insurance policy’s cash value growth. These are tax-exempt policies, so no tax is paid while the policies grow, avoiding the 50.67% pitfall mentioned above. Cash value can be accessed three ways (more on this in the next section).
2. In addition to tax-deferred investment growth, the small business deduction clawback is avoided since these are tax-exempt policies (no annual income reporting).
3. To protect against the potential LCGE clawback, the policy should be owned by a holding company, which also provides creditor-protection against the business’s creditors.
For more information or to get started with this concept, contact Jeff Graham at (604) 363-7549 or jeff@firstoakfinancial.ca.
DISCLAIMER: this commentary is provided for general informational purposes only and does not constitute financial, insurance, investment, tax, legal or accounting advice. The numbers projected can fluctuate based on a wide variety of factors and approval for an insurance policy is not guaranteed. Always seek advice from your tax and/or legal advisors prior to implementing these strategies.