The Problem:
We are now five years into the 2017 tax changes and small business owners continue to be placed under increased scrutiny in how they save for their business. In particular, the tax landscape is more punitive when you’re a business owner of a Canadian Controlled Private Corporations (CCPCs) that retain profits and accumulate passive investments. Without careful monitoring of active business income and passive investments held in their CCPC’s, business owners run the risk of having their CCPC small business deduction clawed back.
The following information reviews how income earned in a CCPC is taxed, discusses how recent tax changes impact the small business deduction for CCPCs accumulating passive investments, and examines how corporate life insurance can be used as an investment strategy that preserves the small business deduction while providing a tax shelter for corporate passive investments.
Corporate Taxation Review:
When a corporation qualifies as a CCPC, income is earned and taxed in one of the following two ways. The first $500K of active business income is taxed at a combined Federal and Ontario rate of 11.5% while passive income earned on investments is taxed at a combined Federal and Alberta rate of 50.2%. The key difference is that active income is earned through expelling energy while passive income are earnings accumulated and retained by the corporation from investments in passive assets.
Once dividends are declared to the shareholder, there is a relief provision that recovers a portion of the high rate tax paid by the corporation through a refund mechanism (the refundable dividend tax on hand). Up to 30.67% of the high rate tax can be recovered, leaving the final corporate tax burden at 20%. In order to accomplish the refund, the shareholder will pay personal income tax on the dividends received at their personal marginal income tax rates.
Recent Federal Tax Changes – Preserving Your Small Business Deduction:
When you use your corporation as your investment vehicle, the growth generates passive investments. Once these investments begin generating more than $50,000 annually or 5% on $1,000,000, your savings will begin to reduce the small business deduction on active business income. Eventually, the small business deduction will be clawed back in its entirety as passive investments earn more income.
The chart below demonstrates this relationship:
* SBD – Small Business Deduction
Corporate Life Insurance Strategy:
Owner-managers should consider reallocating passive investments into a corporately owned exempt life insurance policy. Premiums invested by the corporation should be paid with after-tax corporate dollars into the policy cash value account. Investment earnings inside the cash value account are considered tax-exempt and are not subject to either high passive income tax rates or reduce access to the small business deduction.
During retirement, the accumulated investments can be used to fund personal income requirements of the CCPC’s owner-manager. In addition, the funds drawn from the corporate policy should not adversely affect income-tested benefits, such as OAS, received by owner-managers. Corporate Life insurance will also boost estate values and the majority of the proceeds will flow through the corporation as a capital dividend when paid out.
Pay enough income to maximize registered plans:
RRSP contribution room is based the amount of earned T-4 income paid out to the shareholder. When paying out increased salary, 18% of annual income or prior contribution room can be deducted against the income drawn from the corporation.
TFSA accounts do not provide a tax deferral on a personal level but investment growth is done tax-free. Withdrawals are also considered tax-free when taking income from their accounts.
Individual Pension Plans (IPPs) are contributions made by the corporation into a personal pension plan. Corporate contributions are tax-deductible to the corporation and growth is tax-sheltered within the investment account. In many cases, past service can allow the corporation to back-fill contributions and allow for a larger tax deduction.
