In This Issue
- Small Business Focus: Why it might not make sense to invest profits in your RRSP
- Tax Planning: No major changes in federal budget, but ‘tweaks’ could take a toll
- Retirement Planning: Lottery bonds not a wise retirement saving tool
Why it might not make sense to invest profits in your RRSP Costs
Many of our clients who are small business owners ask whether they should invest their profits inside or outside of their corporation. This can be a complex question, and the answer will depend on several contributing factors. Investing inside a corporation can be highly tax-efficient, but it must be structured properly, and so specialized advice is required before proceeding.
Canadian small business owners may be better off in retirement if they invested excess cash inside their corporation rather than paying out a salary merely to make a Registered Retirement Savings Plan (RRSP) contribution or to invest in a non-registered investment account. To begin with, we must reassess the age-old maxim that Canadian small business owners should always pay themselves enough salary or bonus to ensure they can maximize their RRSP contributions each year.
Take what you need, leave the rest
We argue that to the extent that the business owner needs cash personally, it will be preferable to extract the cash from the corporation in the form of salary or dividends (a separate topic for discussion) and forgo the excess withdrawal for investing in an RRSP or non-registered account. An absolute tax savings coupled with a tax deferral may be realized by having income that is earmarked for savings taxed inside the corporation at the small business tax rate (currently a flat rate of 15.5% in Ontario) rather than having the corporation pay excess income to be taxed in the hands of the individual at their marginal tax rate even if deducted as an RRSP contribution by the business owner.
The dividend payout strategy
When surplus funds are invested in a diversified portfolio inside the corporation, the invested capital may generate interest income, Canadian dividends, and/or capital gains. Interest income is fully taxed each year, whereas Canadian dividends from portfolio investments are also taxed in the year received. Only 50% of capital gains are taxed and only when they are realized.
The after-tax corporate investment income (including the 50% taxable portion of capital gains) can then be paid to the business owner as a taxable dividend and taxed at his or her personal dividend rate. The 50% non-taxable portion of realized capital gains can be paid out to the business owner as a tax-free capital dividend.
Corporate investment vs. RRSPs
It’s important to note that interest income, dividend income, and capital gains are not taxed at the favourable small business tax rate of 15.5% (in Ontario) but, rather are taxed at much higher corporate rates. Fortunately, a portion of the corporate tax paid on this income is refundable to the corporation when it pays out a taxable dividend to the shareholder, i.e., at retirement. As a result, in most provinces, the total tax paid on investment income earned (and capital gains realized) in a private corporation is only slightly higher than if the investment income was earned (and capital gains were realized) by the small business owner personally.
One must remember, however, that the initial “seed money” for the investment inside the corporation is taxed at 15.5% as opposed to the taxpayer’s marginal tax rate – a significant advantage.
Additionally, when one compares investing in a corporation with investing in the tax-sheltered environment of an RRSP, one might believe that the RRSP will significantly outperform the unsheltered environment, primarily because income tax is not paid immediately on investment returns, leaving more capital to be reinvested. However, it is important to remember that the traditional advantages associated with earning capital gains (taxable at 50%) or Canadian portfolio dividends (eligible for the dividend tax credit) are completely lost when this type of investment income is earned inside an RRSP, while these tax advantages are preserved when earned inside a corporation.
RRSPs do have a key advantage over corporate investments. RRSPs can provide business owners with an effective method of creditor protection. The federal bankruptcy laws were amended a number of years ago so that RRSPs and RRIFs are protected from creditors upon bankruptcy, other than contributions made within the final 12 months prior to bankruptcy. Investments inside a corporation do not enjoy the benefit of creditor protection. However, some measure of protection may still be available by holding corporate investments in a holding company or sister company rather than the operating company itself.
Generating tax-free dividendsh3>
At retirement, instead of withdrawing funds from an RRSP or Registered Retirement Income Fund (RRIF) to live on, the business owner would sell corporately-held investments and extract the after-tax proceeds as a dividend. As many of our good clients already know, at present, the first $40,000 of dividends (approximately) paid out by a small business to adult shareholders (over the age of 18) on an annual basis (including adult children) are tax-free if there are no other sources of income.
Most retirees will have other sources of income in the form of CPP and OAS. So, if, for example, our business owner had an additional source of income in the form of CPP equal to $10,000 at retirement, then she could declare and pay a dividend of $30,000 to herself as opposed to $40,000 ($40,000 = $30,000 dividend + $10,000 CPP). The dividend would be received tax-free for the current personal tax year.
If the business owner’s spouse had part-time employment income of $8,000 and CPP income of $9,000, then a $23,000 dividend could potentially be paid tax-free to the spouse.
Lastly, if the business owner had an adult child who required financial support, an additional dividend could be paid to the child. Assuming the child had no other sources of income and as long as the child is a shareholder (and the company share classes were organized properly), a dividend equal to $40,000 could be paid and received by the child on a tax-free basis.
For owners who have other sources of cash to fund personal living expenses during their working years and do not need to extract any funds from the corporation, the advantage of the tax deferral can be even greater. In these cases, we normally advise such owners to have all the business income taxed in the corporation at the preferential small-business rate (15.5%) and reinvested inside the company.
Leave surplus funds in the corporationh3>
In summary, business owners will have more after-tax cash available if they leave surplus funds inside the corporation instead of paying enough salary to maximize an RRSP contribution. There are three reasons for this conclusion:
- There is simply less tax paid by having the initial income taxed in the corporation at 15.5% and eventually flowing it to the shareholder as a dividend tax-free.
- There is more “seed money” left to invest in the corporation when personal tax is not paid immediately on cash not needed currently by the owner.
- The preferred tax treatment afforded to capital gains and Canadian portfolio dividends is not available when the investments are in an RRSP.
Proper planning is essential
Although this strategy can be highly lucrative and very tax-efficient, it is complicated. So proper planning and organization is required in advance to ensure this type of strategy does not run afoul of Canada Revenue Agency’s rules.
Proper planning and preparation will ensure the most tax-efficient result for small business owners. That’s where we can help. Give us a call, and we can help you maximize the many tax advantages of small business ownership.
No Major Changes In Federal Budget, But ‘Tweaks’ Could Take A Toll
By Marc Lamontagne, CFP, R.F.P., CIM
Finance Minister Jim Flaherty delivered the 2014 federal budget on February 11 in Ottawa. Unlike prior years, this year’s budget doesn’t have any major changes that impact the majority of Canadians. Still, there were a few tweaks here and there that you should know about. So here’s a summary.
The government increased the adoption expense tax credit to $15,000 from $12,000. And there’s a new tax credit for search-and-rescue volunteers similar to the one for volunteer firefighters. Those with diabetes will also be able to claim their diabetes service animals.
There are no major alterations to tax rates or to contribution rates for major programs like the RRSP, RESP, RDSP, or TFSA.
Still, for people with higher incomes, business owners, and new Canadians, there are some targeted tax changes. These include the following:
Kiddie tax tightened. Attempts by business owners to split income by paying dividends to minor children in lower tax brackets have already been thwarted by taxing those dividends at the highest marginal rates rather than the lower ones available to kids.
This year’s budget widens the kiddie tax lens to include business and rental income earned through a trust or a partnership structure. This means that business owners will no longer be able to make a minor the beneficiary of a trust that earns income generated by the work of adult partners. The change is effective immediately.
Graduated tax rates in trusts. This change, which takes effect in 2015, eliminates graduated tax rates for testamentary trusts, which essentially allowed income splitting after death, after a reasonable period of administration of 36 months.
This is a major change that impacts estate planning for higher net worth Canadians. There are still numerous other uses of a testamentary trust that are non-tax related, as well as some notable graduated tax-rate exceptions, so please don’t hesitate to discuss this with us.
Immigration trusts eliminated. Ottawa had long granted newly arrived Canadians to place money in offshore trusts for a period of five years at no tax. In an unexpected move, the Finance Minister announced that this loophole has been closed, effective immediately.
Donations-on-death rule changes. Current rules make a donation through a will claimable in the year of death and in the prior year. This will change in 2016 when the estate will be able to claim the donation for the year the gift is made and for any prior year.
Heirs also will retain the option of using the current system. For some, especially estates that remain open and continue to earn income, this option may add some flexibility at tax time.
Pension transfer limits. Starting 2011, Ottawa introduced relief for people who had to commute underfunded pensions to RRSPs, RRIFs, or other savings vehicles. The 2014 budget extends that tax relief.
If you’d like to discuss how these or other items in the federal budget might affect your personal or business tax situation, your estate plan, or your retirement plan, give us a call. We’d be happy to answer your questions and address any concerns you might have.
Marc Lamontagne, CFP, R.F.P., CIM., is partner at Ryan Lamontagne Inc. and is an expert in the area of personal and corporate tax planning, specializing in comprehensive financial planning and wealth management for executives, business owners, and emerging affluent families.
Lottery Bonds Not A Wise Retirement Saving Tool
by Jocelyn Verdon
When you consider the number of people who say that they are counting on a lottery win to fund their retirement, there would likely be quite a number of people who might find lottery bonds appealing.
Lottery bonds are unknown in North America, but many European countries issue them, and with great success too. The UK Lottery Bond Fund, for example, holds the equivalent of over C$70 billion.
Lottery bonds are a type of government bond in which some randomly-selected bond serial numbers earn a bonus interest payment. But the coupon rate on the lottery bond is minimal to begin with, and most people don’t “win” enough to even cover the cost of inflation on their money. There are many variations of these bonds, but in all cases, the appeal is in the amount of the potential “bonus” payments.
In a typical month, the UK Lottery Bond Fund awards one £1,000,000 prize, five £100,000, eight £50,000, and 1,836,000 smaller prizes of amounts ranging from £25,000 to £25. The odds of winning the grand prize are staggering, but the much better odds of winning one of the lesser prizes is what keeps things interesting. It is really a perpetual lottery ticket that can be cashed if the need arises.
Interestingly, it has been shown that the more money you have invested in lottery bonds, the greater your chance of earning a decent return. For high-income earners, then, lottery bonds can be a viable investment if the principal amount is large enough. For low income earners, they are really no more than a secure way of dreaming, “secure” only because the bond is guaranteed by the government.
Would lottery bonds encourage people to save more? The shift from lottery tickets as an expense to lottery tickets as an asset may indeed result in an increase of personal savings, and people might buy more bonds/tickets than they usually do. But because they pay almost no interest and are subject principal to the ravages of inflation, for 19 out of 20 people, a lottery bond would not be a good way to fund retirement.
Jocelyn Verdon, is the assistant to Thomas Ryan and team leader at Ryan Lamontagne Inc.
