Retaining corporate business income creates a powerful tax deferral, but can it lead to other problems?
By Sean Rheubottom
Many readers will know that carrying on business through a corporation allows access to a lower rate of taxation on active business income (ABI). In 2020 in Saskatchewan, the first $500,000 of ABI gets the most preferential tax rate, 11% (that’s federal and provincial tax combined). ABI between $500,000 and $600,000 is taxed at 17%, and above $600,000, the rate is 27%.
Let’s focus on ABI taxed at 11%. If you paid the after-tax amount to yourself as a taxable dividend, you would pay tax at the “non-eligible” dividend rate of up to 40.37%. At that point, you and your corporation have together paid a combined or “integrated” tax rate that is very close to the tax you would have paid had you not incorporated, or had you paid all the profit to yourself as a salary. Salary is taxed at a maximum of 47.5%.
The big win is the tax deferral made possible by the 11% corporate rate. If you can leave the after-tax ABI in the corporation and invest it while it’s not required for lifestyle expenses, putting off the personal tax until later, that tax deferral quickly turns into absolute tax savings.
The power of a tax deferral
Alice’s corporation, ACo, earns $300,000 of ABI. She decides to pay the entire amount to herself as a salary and bonus. She pays 47.5% in tax, leaving her with about $157,500. If she extracted the money as an after-corporate-tax dividend she would have $159,212 to invest. So let’s split the difference and say she has $158,000 to invest. She invests it for 10 years in a well-managed balanced portfolio with a 6% return consisting of 1% interest, 1% dividends, 1% realized gains, and 3% deferred growth. After 10 years the $158,000 has grown to $254,791. She liquidates the investment, paying tax on some realized gains, and is left with $240,936.
Brad’s corporation, BCo, also earns $300,000 of ABI, but he invests the after-tax cash, $267,000, inside BCo, with the same plan to liquidate the investment after 10 years. After a decade at the same 6% growth rate, the $267,000 has grown to $434,914. Brad liquidates the investment, creating a capital gain, which is taxed inside BCo. The cash in the corporation is then paid to Brad as dividends, most of which are fully taxable, but he makes use of eligible dividend tax rates, refundable tax from investment income, and the tax-free capital dividend account from realizing capital gains. At the end of the day, Brad has $297,143 in his pocket. The deferral has become an absolute saving.
Similarly, a deferral is achieved if ABI taxed at the 17% or 27% corporate rate is retained and invested, because the 17% and 27% ABI rates are lower than the 47%-plus rate on income paid straight to the shareholder. The deferral takes longer to turn into absolute savings because the difference in corporate and personal tax rates is not as stark.
But don’t forget about good old RRSPs and TFSAs. An optimal mix of salary and dividends allows investment in these tax-deferred plans as well, with good long-term results.
More money, more problems?
So retaining after-tax business income can defer tax and create absolute savings. But an accumulation of non-business investments in your operating company (opco) leads to other problems that need to be addressed.
Purify to secure your capital gains exemption (CGE)
Canadian tax rules provide that each individual shareholder can shelter up to a lifetime limit of $883,384 (in 2020; indexed for inflation until it reaches the maximum $1 million) from the sale or deemed disposition at death of “qualified small business corporation” (QSBC) shares. Each individual’s lifetime limit is reduced by the amount of any kind of CGE they have ever used (including the CGE for qualified farm property and the general $100,000 exemption that was repealed in 1994). The lifetime CGE may also be reduced by other factors not discussed here.
For your shares to be QSBC shares, you must keep track of how much of the corporation’s assets are “active” business assets and how much are “passive,” such as excess cash and investments. The rules are complex, but one main requirement is that, at the time shares are sold, the corporation must meet a 90% active business asset test. Excess cash and investments don’t qualify. There’s also a 50% active asset test that must be met for a period of, usually, two years before a sale.
Fortunately there’s a solution: you can stash corporate dollars by setting up a separate corporation (holdco) that can receive the after-tax business income from your opco as tax-free dividends. Your opco’s 90% “purity” is maintained. We call this “purification” of your opco. The powerful tax deferral is preserved. Another benefit is that your savings account is protected from potential creditors of your opco.
Purify to avoid corporate attribution
Maintaining 90% purity also helps avert a “corporate attribution” problem that can arise if you have a structure that includes your spouse as a shareholder. The new tax on split income (TOSI) rules make income splitting more difficult in any event, but you still need to consider corporate attribution because it can have a negative effect even if you’re not actually paying dividends to your spouse.
Passive investment income may reduce the small business limit
Your holdco’s investments will generate investment income such as interest, portfolio dividends, and taxable capital gains (passive income), and the powerful tax deferral will work as described.
But since 2019 there’s a new problem to contend with: a new tax rule that may reduce your opco’s access to the $500,000 small business limit that gets the 11% tax rate. The small business limit will be reduced by $5 for every $1 of passive income over $50,000, until your holdco’s passive income reaches $150,000 and the small business limit is reduced to zero.
If you think of a well-managed balanced portfolio that produces 3% passive income (with 3% deferred as capital growth), you’ll realize that it takes a fairly large investment account to start grinding your small business limit. If you might be nearing that level of passive income, it could be time to consider strategies such as investing outside your corporate structure, an Individual Pension Plan, or tax-deferred insurance based investment options.
First published in the June 2020 edition of The Business Advisor.