After business owners decide whether to pay themselves using salaries or dividends, they must choose where to invest excess cash: in a personal account or in the corporation. The corporate option is complicated by the fact that investing inside a corporation generates passive income.
Passive income earned inside a corporation is subject to higher rates of tax than active business income (ABI). Tax on passive income has two components: non-refundable and refundable. The corporation pays the non-refundable tax regardless of whether or not the passive income leaves the corporation via a dividend to a shareholder. The corporation pays the refundable tax in the year the taxable passive income is earned, but the tax is refunded when the corporation pays that income to a shareholder as a dividend.
The tax rates and non-refundable/refundable tax breakdown vary by province and type of passive income. For Ontario in 2019, the tax rate on interest and foreign income is the same, at 50.17%, though the breakdown between non-refundable and refundable tax differs: interest is 19.5% non-refundable and 30.67% refundable; foreign income, assuming a 15% non-resident withholding rate, is 31.4% non-refundable and 18.77% refundable.
The tax rate for eligible dividends is 38.33% (0% non-refundable, 38.33% refundable) and 25.08% on capital gains (9.75% and 15.33%).
Effectively, capital gains are taxed at half the rate of interest because only half of a capital gain is taxable. Should these gains be paid out to a shareholder, it can result in two dividends: one that is tax-free, called a capital dividend; and one that is taxable to the shareholder personally.
How AAII factors in
The federal small business deduction (SBD) limit of $500,000 is reduced based on the previous year’s adjusted aggregate investment income (AAII), which is by $5 for every $1 of AAII that exceeds $50,000. Once $150,000 of AAII is earned in a year, the SBD is eliminated.
The corporate tax rate in Ontario is 12.5% on the first $500,000 of ABI; the rate jumps to 26.5% on ABI above this threshold. The resulting impact is twofold:
- A reduced or eliminated SBD will accelerate the application of the higher corporate tax rate (26.5%) on ABI, which in turn may lead to a review of the compensation decision between salary and dividends.
- Funds invested corporately for personal use in the future will experience a lower deferral of personal tax. Frances — the owner of a software corporation that generates $200,000 per year in active business income (ABI) described in my previous column — would see her current tax deferral lowerered from 11.7% (24.2% marginal tax rate on salary minus 12.5%) to -2.3% (24.2% minus 26.5%). This may influence her decision on whether to invest corporately or personally.
While Frances is not likely concerned about the SBD clawback at this stage, her business’s prospects could change.
The numbers in action
To see how taxes impact Frances’s investment options, we can compare her RRSP contribution with a TFSA, non-registered account and corporate investment (Table 1). Recall that Frances would contribute $10,332 to her RRSP if she chose salary compensation; TFSA, non-registered and corporate accounts reflect after-tax beginning values. In all cases, we use a 5% pre-tax rate of return and assume that her personal marginal tax rate at the beginning and end of 20 years is 24.2% (13.6% for ineligible dividends). For the taxable accounts (both personal and corporate), we will assume that 25% of the annual return is taxable.
The RRSP and TFSA provide the best after-tax results, thanks to their tax treatment. Since Frances’s tax rate is the same after 20 years, the values for both accounts are identical.
The difference between the corporate and non-registered accounts lies largely in the deferral of personal tax. This gave the corporate investment a head start. Despite higher rates of corporate tax on the investment income, the non-registered account couldn’t close the gap.
Each business owner’s situation is different and dynamic. Tax rates could change, businesses could grow and results can vary. Table 2 offers other considerations for small-business-owner clients’ personal investments.
|Table 1 — Personal and corporate investment options|
|Value after 20 years||$27,414||$20,780||$20,294||$23,987|
|Personal tax on withdrawal||($6,634)||$0||($1,175)||($2,656)|
|Table 2 — Other considerations for business owners|
|Upfront tax deferral||Yes, corporate|
|Owner’s compensation||Salary (dividends only if owner has carry-forward room)||Salary and/|
with retained earnings
|Subject to contribution limits||Yes||Yes||No||No, but be mindful of AAII|
|Accessible to corporation||No||No||No||Yes|
|Withdrawal taxable||Yes (fully taxable personal income)||No||Yes (taxable personal capital gain)||Yes for ineligible dividends;|
Yes for eligible dividends;
No for capital dividends
Curtis Davis, FMA, CIM, RRC, CFP, is senior consultant for tax, retirement and estate planning services, retail markets at Manulife Investment Management