At a conference many years ago, an industry veteran noted that a good advisor knows the rules, but a great advisor anticipates where the rules are going. The very best advice looks beyond the client’s present situation toward what it will be in future.
Case in point: the challenges posed by recent tax changes for corporate investments. The fact that it could have been much worse than where things landed may not be much solace to affected business owners, but it’s also not the end of the world.
Rather than pursuing the investments themselves (as one convoluted proposal did), the federal government settled on limiting access to the small business rate. In brief, the annual $500,000 threshold for the small business deduction comes down $5 for every $1 of passive income over $50,000, until it is completely lost at passive income of $150,000.
This bad news may, ironically, offer the benefit of being a canary in the coal mine. Significant passive corporate income may be a warning sign that owners could face even greater ultimate tax cost if they don’t have a plan for extracting corporate money.
While there are many ways shareholders may legally enjoy (some) use of corporate assets, the bulk is waiting to be taxed on eventual distribution to those shareholders.
That brings up the topic of integration: the concept and procedure for protecting against double taxation when income runs through a corporation. The two-stage gross-up/tax-credit procedure reconciles how much tax has been paid at the corporate level when calculating a shareholder’s tax on dividends.
Take the example of a sole proprietor in Ontario who would net $465 for every $1,000 earned at the top bracket. Alternatively, the business could be run through a corporation using either the 12.5% small business rate or the 26.5% general corporate rate. After gross-up and tax credit on the dividend, that would be $455 or $446, respectively, in the hands of that same person as shareholder.
Of the two corporate rates, that’s less than a 1% difference in favour of the small business rate, which, for practical purposes, achieves integration either way. The main issue is timing, with more tax due earlier if the general corporate rate applies.
Who it affects
But let’s get back to why we’re looking at integration. It’s against the backdrop of a corporation that has more than $50,000 of passive income.
Using the government’s own example in the 2017 proposals, that’s $1 million of passive assets earning 5% interest. But if we’re talking about an investment portfolio consciously structured to defer income (and tax) recognition—read that as unrealized capital gains—you could be talking a multiple of that.
There’s no question that leaving assets in a corporation allows more dollars to be invested than if paid as dividends into personal hands. Keep in mind, though, that integration rates on corporate passive income emulate what a top-bracket taxpayer faces and are sometimes even higher, so it’s not clear how much further ahead one may be. For example, a top-bracket taxpayer pays 53.5% on interest income, but if that went through a corporation then the net rate to that person after dividend would be 57.7%.
Future-minded client advice
Regardless, there may come a point when passive corporate assets are so large that high-bracket rates on dividends become unavoidable. Wouldn’t it have been nice to have taken some out while at the lower bracket if you knew this was coming?
Aware of these tax issues, an investment advisor can have a deeper financial planning conversation with the client: How long will the business continue? What stage of life is the person at? What are the spending needs?
Taken together, the answers to these questions can help align the drawdown with actual need, rather than leaving the person exposed to higher taxes due to excessive deferral. By guiding the conversation in this direction, the advisor can better serve the client’s interests, both presently and in the future.
Doug Carroll is practice lead for tax, estate and financial planning, Meridian Credit Union.