Each week, I share Live Well, Stay Rich, Never Retire strategies directed to business owners and senior professionals. But too often, I underestimate one of our most important but very silent business partners: the CRA.
Tax planning and paying your taxes are critically important in your financial planning and cannot be overlooked. So let’s review the role the CRA plays in your financial plan as a business owner.
I would consider the CRA a somewhat devious partner…
It shares in our profits but doesn’t participate in our losses. It’s not around when we need help landing a new client or have trouble paying the rent. Yet somehow, we have a partner that takes approximately 50% or more of everything we earn.
Given the impact our business partners can have on our Stay Rich principle, it makes sense to examine our relationship with the CRA and find ways to reduce or defer their portion of our money.
I am not suggesting that business owners enroll in advanced tax planning courses on weekends. Instead, I’m encouraging you to acquire a general understanding of how businesses are taxed. This information is readily available from books, blogs or listening to podcasts. Including this one!
Ask yourself this question: “If a business expense was approximately 50% of your net income, how much time/money would you allocate to reduce that expense or at least become more efficient with its usage?” Compare your answer to how much time you spend in tax planning.
From my experience working with business owners like you over the last 25 years, you might be too busy, a touch complacent, or lack the right advice. Which means you may just default to paying whatever your advisor calculates.
Dear business owners: I challenge you to be deliberate and allocate enough time to tax planning.
So for the next four weeks, I will examine ways that you—and also senior professionals—can reduce or defer CRA’s take-home pay.
Please note that these blogs are for informational purposes only. I won’t and can’t cover every possible scenario, so please speak with your advisor to determine if these strategies are useful for your specific situation before implementing.
1) Tips for mature businesses
After years of working long hours in your business, missing family events and some weekends, many of you may have accumulated savings in your corporation. I’m referring to funds over and above the cash requirements of operating your business.
First, if you are in this situation, congrats!
You’re on your way to achieving financial independence. But at the same time, you have made your silent partner very happy.
Historically, when owners of Canadian Controlled Private Corporations (CCPC) earned funds in excess of personal needs, they were inclined to leave the surplus funds within their CCPC (usually limited to the first $500,000 of surplus funds).
This strategy allowed business owners to pay tax on the first $500,000 of active income at the small business tax rate, which in Ontario is currently at 12.5%. Additional taxes would be paid when funds were distributed to the shareholders.
This strategy allowed for a tax deferral opportunity for those with excess corporate earning.
In 2018, CRA passed new rules that causes business owners to lose some of or the entire benefit connected to the small business tax rate on the first $500,000 of active business income when their corporation earns more than $50,000 per year of passive income.
The rules here are somewhat complicated but in simple terms, if the corporation earns between $50,000 to $150,000 of investment income (i.e. passive income), then the small business deduction limit is reduced from $500,000. For example, $150,000 of investment income reduces the small business deduction limit to zero.
Simply put, if a business owner earns more than $50,000 in passive income, the benefit of leaving annual savings in your corporation and deferring the tax over many years is significantly reduced.
My suggestion is to speak with your advisors and evaluate ways to reduce your passive income.
Here are a few ideas to get you started:
- Consider investments that increase in value rather than distribute interest or dividend income. For example, consider non-dividend paying stocks or real estate that generate zero net rental income.
- Consider withdrawing sufficient funds to maximize your RRSP and TFSA contributions. Given sufficient time, RRSPs and TFSAs would outperform corporate investing when earnings come from interest, eligible dividends, or annual capital gains.
- Consider repaying shareholder loans, which are tax free withdrawals from your corporation. For example, if you loaned your corporation funds and the corporation no longer needs the loan, consider repaying the loan to the shareholder.
- Determine if your corporation has a balance in its Capital Dividend Account (CDA). If so, this portion may be distributed to shareholders tax free. Consider establishing an Individual Pension Plan (IPP). Since the corporate contributions are not owned by the corporation, any income earned within the IPP has no effect on the small business deduction limit. As well, the annual contribution limit to an IPP is generally higher than the limit available to a RRSP. Remember, higher annual contributions may lead to higher tax-deferred accumulation.
- Consider corporate-owned life insurance. In most cases, income earned from investments inside a life insurance policy is not considered passive income and will not reduce SBD limit. Be aware that this option should only be considered if there is a life insurance need AND a need to reduce the corporation’s passive income.
- Consider making an in-kind donation of publicly listed securities with unrealized capital gains. No tax is triggered on the accrued capital gain. The capital gain is not included in your investment income and, best of all, the entire capital gain is added to your CDA and may generally be withdrawn tax free.
In summary, if your business’s investment income reduces its SBD limit, resulting in a reduction in tax deferrals and consequently reducing the amount of money that is eventually withdrawn from your corporation, it’s time to speak with your professionals.
2) Tips for a start up
Two frequent questions I receive from new business owners is whether they should incorporate and, if so, whether they should draw salary or dividends.
As discussed above, corporations have a significant tax deferral on your business income (the national average is about 30%) if you earn active business income that qualifies for the Small Business Deduction (SBD). The tax deferral can provide significant tax savings that can be reinvested.
But before rushing into a corporation, ask yourself the following questions:
- Does the nature of your business revenue qualify for the SBD? For example, passive income in the form of rental income doesn’t qualify for the SBD, unless your entity is not considered a specified-investment business. (One way to avoid that classification is for the corporation to have more than five full-time employees throughout the year.)
- Is the business operating at a profit or a loss? If the business isn’t yet profitable, consider postponing the incorporation process and try to deduct the loss from other personal income. However, if the business is profitable or you anticipate significant taxable income in the future, then seriously consider incorporating.
If after careful consideration, you decide to incorporate, the next question is: “How do I take money out of the corporation to pay for my lifestyle expenses?”
Generally, there are two options: salary or dividend withdrawals.
Lets examine both options:
- Salary is taxable as employment income to the owner and is taxed at the graduated rates in the province in which the owner lives. Also, salary creates RRSP contribution room for the owner and for the corporation, and the salary is considered a business expense. However, salary creates payroll taxes, CPP and EI considerations for the corporation.
- Dividend income doesn’t create RRSP contribution room and is not an expense for the corporation but can be more advantageous for the shareholder because it generally results in lower personal tax.
The question of salary or dividends depends on the needs of the owner and the corporation. The optimal mix is typically a combination of the two, and business owners should consult a professional to find that balance.
In conclusion, financial independence for a business owner involves recognizing and minimizing your silent partner’s share. This includes acquiring a general understanding of how our corporate tax system works and participating in deliberate tax planning with your professionals.
Don’t assume accountants include tax planning when computing your annual tax returns. This is generally not a moment when proper tax planning is accomplished.
Taxes are a big expense.
Make an appointment today with your professionals and start planning strategies for legally minimizing your tax burden and maximizing your returns.
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Ruth Bader Ginsburg (1933-2020)
Only the second woman ever to serve on the US Supreme Court, Ruth Bader Ginsburg was also—not surprisingly—one of only a few women in her class at Harvard Law School and then, later, at Columbia Law School. In fact, the Dean of Harvard Law once asked Ginsburg why she was taking the place of a qualified male student. She graduated from Columbia in 1959 first in her class, already married and the mother of a young child, and then faced barriers to employment as a woman when she was refused clerkship positions offered to fellow male students who had earned fewer honours. Throughout her career, Ginsberg fought for women’s rights under the law, arguing six landmark cases on gender equality before the Supreme Court in the 1970s. In 1980, President Carter appointed Ginsburg to the US Court of Appeals for the District of Columbia, where she served until President Clinton appointed her to the Supreme Court in 1993. With too many career milestones to enumerate, Ginsburg can aptly be summed up as a “tireless and resolute champion of justice” who never retired.
source https://richarddri.ca/how-to-maximize-tax-benefits-for-your-business/
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