If your business-owner client is affected by the new tax rules for passive investment or split income, you’ll want to ensure they have effective planning in place. That planning could include an individual pension plan (IPP).
Trevor Parry, president of TRP Strategy Group (consulting) and a tax and estate planning advisor with Raymond James Canada in Toronto, Ont., says there are about 13,000 standard IPPs in Canada and might soon be more, considering the passive investment income rules.
An IPP could help keep passive investment income within thresholds that the federal government imposed beginning this year. Access to the small business deduction is limited beginning at $50,000 of passive income and eliminated completely at $150,000. Income earned in the IPP doesn’t belong to the corporation so isn’t included in the calculation for passive income. Also, IPP contributions are tax-deductible to the corporation.
The extended rules for tax on split income (TOSI) could also highlight the use of IPPs, says a report authored by Parry, Lea Koiv and Peter Merrick. Koiv is a tax, pension and retirement expert at Lea Koiv & Associates in Toronto, and Merrick is the author of The Essential Individual Pension Plan Handbook and the Canadian Securities Institute’s course on IPPs. Their report was presented last year at the annual conference of the Society of Trust and Estate Practitioners.
For example, where a spouse or child previously received dividends but, in response to the new TOSI rules, now receives a salary working for the corporation, the spouse or child can be added to an IPP. Employment income is key when establishing an IPP because it’s required to calculate pension accrual (dividends don’t qualify for pensionable earnings). The ability to implement an IPP in this situation thus adds a silver lining to any loss of dividends. (Note that an IPP recognizes only employment income from the professional corporation, not past self-employment earnings or partnership earnings, for example.)
IPPs also offer benefits including tax savings under pension splitting rules, creditor protection, predictable retirement income (IPPs are defined-benefit plans) and a method to catch up on retirement savings—especially for baby boomers, who are facing their retirement years, Parry says. That’s because IPP funding is age sensitive, reaching about 29% of pensionable earnings at age 64, versus 18% for RRSPs, allowing for greater tax deferral.
At younger ages, IPPs might not make sense, Koiv says, noting that IPP funding surpasses RRSPs’ 18% funding after about age 38. She says that IPPs, which have annual costs, generally make sense when clients are around age 50, when the service funding is approximately 23%, and also when clients have relatively high wages and substantial earnings. (The RRSP contribution limit for 2019 is $26,500, representing prior-year earned income of $147,222.)
IPPs also might not work for clients living in expensive regions with high housing costs or with dependants and lots of expenses, Koiv says, because the corporation requires liquidity to continue to fund the plan. (Ontario has funding requirements, but not all provinces do.)
The business should be well established with consistent, positive cash flows, says Todd Sigurdson, director of tax and estate planning at IG Wealth Management in Winnipeg. Startups or companies aggressively re-investing profits in the business might not be good candidates. “You don’t want to be in a rush to establish an IPP,” he says. “You can always make the past service contributions for your prior years of service.”
Ultimately, every client situation is unique, so deciding if an IPP is appropriate requires an objective review of the client’s situation, Parry says. For example, business owners who pay themselves a salary might be good IPP candidates even if they sometimes paid themselves dividends in past years. If the client has worked long enough, pension accrual can be substantial, he says, because it’s based on indexed wage history, not just current salary.
Salary can go as far back as 1991 (when modified tax rules gave rise to a rebirth of the IPP) and can extend up to year-end when a client reaches age 71. For family corporations (i.e., connected persons for tax purposes), accrual is based on the calculation for indexed average wages (for more about the calculation, read Why IPPs can help more business owners than you’d expect).
An actuary must set up the plan and explain it to the client, in step with federal and provincial rules, Parry says.
It costs about $2,500 to set up the plan and about $1,500 annually, he says, and administration and investment management fees are tax-deductible to the corporation. More complicated commuted-value IPPs could cost at least $5,000, Koiv says.
The report says medical doctors in particular might be well-suited to the IPP because they typically don’t have pensions and they rarely sell their professional corporations, as dentists often do.
With the new rules for passive income, doctors have also lost their unique opportunity, relative to other professionals like accountants and lawyers, to split income with family members.
The following client example uses a medical corporation to demonstrate IPP funding.
Dr. Eshan Gupta and Radhwa Gupta
Consider Dr. Eshan Gupta and his spouse Radhwa, ages 50 and 47 (who are not real people). They’ve decided to implement an IPP in response to the new tax rules and to fund their retirement.
They both have income beginning in 2005 from the medical corporation where they work. Eshan’s earnings history allows him to accrue the maximum pension possible from 2005 onward (calculated using indexed average wages), so that as at Jan. 1, 2019, accrued liability for Eshan’s 14 years of income is $464,440.
Radhwa’s earnings are less, at $30,000 annually as an office manager, with accrued liability of $102,818. Total accrued liability for the couple is $567,257 (see Table 1).
Eshan has maximized his RRSP since 2005, resulting in a qualifying transfer of $364,821 from the RRSP to fund the IPP, leaving a remaining funding liability of $99,619.
Because that remaining liability isn’t in the plan on Jan. 1, the CRA allows an interest adjustment on the amount. Assuming mid-year funding, the adjustment is $17,416. If the IPP were implemented in the latter part of 2019, the adjustment would be larger.
As shown in Table 1, the corporation’s maximum IPP contributions for 2019 are $151,454 for Eshan and $53,924 for Radhwa, the report says. The minimum contribution for 2019 would be $44,904 and $11,042. This includes the current service, which is the annual contribution that must be funded in the year, as well as a “going concern special payment,” which is funding for past service. This payment can occur over 15 years.
Table 1: Medical corporation’s potential IPP contribution for 2019
|Maximum IPP contribution for 2019||Incorporated doctor (Eshan)||Spouse (Radhwa)||Total|
|Accrued liability Jan. 1, 2019||$464,440||$102,818||$567,257|
|Less: transfer from RRSP||($364,821)||($59,200)||($424,021)|
|Unfunded liability Jan. 1, 2019||$99,619||$43,618||$143,237|
|2019 current service funding||$34,418||$6,451||$40,869|
|Minimum IPP contribution for 2019|
|Going concern special payment (funding of 2005-2018 liability over 15 years)||$10,486||$4,591||$15,078|
Source: Individual Pension Plans—A Technical Guide by Lea Koiv, Trevor Parry and Peter Merrick, with updated figures for 2019
If the corporation chooses maximum funding, the IPP will have assets of $516,274 to fund Eshan’s pension, as shown in Table 2. Eshan will have accrued a pension of $42,358 as at Jan. 1, 2019, Parry says; Radhwa, $9,921. Projected total pension amounts at age 65 for Eshan and Radhwa, respectively, are $87,741 and $19,200 (in current dollars).
Current service contribution for Eshan is about 23% of wages; for Radhwa, about 22%. Those percentages will increase as they reach age 64.
Table 2: IPP total assets
|IPP contribution||Doctor (Eshan)||Spouse (Radhwa)||Doctor + spouse|
|Corporation’s maximum contribution for 2019||$151,454||$53,924||$205,378|
Source: Individual Pension Plans—A Technical Guidecby Lea Koiv, Trevor Parry and Peter Merrick, with updated figures for 2019
Other considerations for business owners
An IPP is typically wound up when a corporation is sold, says Sigurdson. The buyer doesn’t want the liability, and the seller wants to keep it as part of their retirement plan. The business owner can purchase an annuity or commute the plan, subject to maximum transfer value rules.
IPP contributions can no longer be made after age 71, so business owners who continue to work must consider their compensation structure for tax purposes, such as salary and dividend mix, Sigurdson says. When converting the plan, most business owners choose the commuted value, instead of an annuity or pension payment, he says: “They’re used to taking risks; they want to manage their money.”