Justin Trudeau has vowed to increase taxes on the wealthiest of Canadians – many of whom have achieved their status by building businesses. These business owners could one day find themselves facing a tax-strategy dilemma: Should they leave money in the business, take it as income, or do something completely different?
Those are common questions for tax and financial advisers, who say that a little planning goes a long way.
Incorporating a business offers benefits that help soften the blow, says Ross McShane, director of financial planning services at McLarty & Co. Wealth Management, based in Ottawa. Those advantages are tax deferral (retaining funds inside the corporation and paying tax at the personal level later) and income splitting (paying dividends to family members who are in lower personal tax brackets).
While tax rates vary by province, they can take a serious toll on a business’s bottom line. As of this year, for example, the marginal tax rate in Ontario for salary or other income higher than $220,000 is a staggering 53.5 per cent – a 4-percentage-point increase over 2015 rates. For non-eligible dividends, the rate is 45.3 per cent, more than 5 points higher than last year.
Mr. McShane says he’s urging clients to think twice about withdrawing funds from their corporations if it means pushing their personal income above the $220,000 mark.
“They might have a mortgage or a line of credit held at the personal level, which carries a low rate of interest given today’s low-rate environment,” he says. “It might be more beneficial to avoid accelerating the paydown of debt through corporate withdrawals and, instead, carry the debt, and retain the funds in the corporation.”
Instead, he says, the funds can be retained in the business and invested and withdrawn at a later date – retirement – when the taxpayer is likely in a lower tax bracket.
If the taxpayer is fortunate to have RRSPs or non-registered capital held outside of the corporation, he adds, these funds can be drawn on to augment cash-flow needs rather than corporate funds.
“The message we’ve been giving business owners is, if they’re earning income in their corporations and they don’t need it to live on, it’s best to leave it in the business,” says Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth Management.
“Either reinvest it in the business or, if the business doesn’t need the capital, invest it in a portfolio of securities inside the business, or alternatively in something like a corporate-owned life insurance policy.”
Mr. Golombek says that this approach is especially logical for small-business owners, who continue to benefit from a low tax rate in their corporations because of the small-business deduction. Even though Mr. Trudeau has vowed to tax the rich, this deduction was spared in the most recent Liberal budget.
“Initially you pay a very small rate of tax on the first $500,000 of active income of 10.5 per cent,” Mr. Golombek explains. “The rest of the money can sit in there forever until you need it, and you don’t pay tax until later on, until you withdraw it as a dividend.
“That’s why we’re not surprised to see many companies and small business owners with huge pools of cash or investments sitting inside their private companies,” he adds. “The question is, how do you get it out?”
One tax-savvy approach is the purchase of a corporate-owned universal life-insurance policy. Jennifer Black, senior financial adviser and certified financial planner at DFS Private Wealth in Mississauga, Ont., says that when the business owner dies, money is paid out through the capital dividend account (CDA). “That’s usually tax-free to beneficiaries,” Ms. Black says.
She notes, however, that business owners should consider this strategy before the end of the year. Regulatory changes will take effect in 2017. “That’s going to lower the amount of the tax-free portion that can come from an insurance policy and flow to beneficiaries through that CDA. … If you purchase policies this year, then they are grandfathered to the old rules.”
Another approach for business owners to consider, Ms. Black says, is setting up an independent pension plan (IPP). “When you make contributions to a IPP, it’s a contribution from the company and it’s deductible.
“Essentially, if the business owner is taking a salary, then they’re able to contribute more to a pension than they would an RRSP,” she explains. “So it gives them additional deductions, and the deductions are at the business level so they can save tax.”
Another advantage here is that business owners can move their RRSPs into the pension so that they can be fully credit-protected. Another bonus? If they’re paying a fee to a financial adviser to manage that RRSP, that fee can be deducted as a business expense, something that can’t happen with a personal RRSP, Mr. Black says. And the ability to do income splitting with the pension starts at age 55, unlike with a registered retirement income fund, which starts at age 65.
No matter which options business owners choose to mitigate their taxes, Mr. McShane says that it’s worth having or revisiting a comprehensive financial plan, which should be able to project what an individual’s tax bracket would likely be at retirement.
“The plan should also determine what the dependency is on the corporate assets,” he says. “For instance, the individual or couple might have a surplus of funds in the corporation that will eventually go to their beneficiaries. Increasing dividend payments to adult children could very well result in a lower tax hit than if the individual made the withdrawal today.”