There are myriad ways for advisors to keep their clients’ taxes low, but if your clients are professionals, you might want to think about having them incorporate.
“The premise behind [tax planning] is there’s a very high cost of taxation that reduces investment returns,” says John Stacey, director of taxation at NexGen Financial. Stacey spoke on the topic at the Knowledge Bureau’s Distinguished Financial Advisor conference. “Maybe as much as 28% of the return or more can be taken away through taxation, so the objective is to try to become more tax efficient.”
Incorporations allow people to pay less tax and use different strategies to keep tax payments down.
Stacey points out that in Ontario the top personal tax rate is about 48%, but business income in a private Canadian company is taxed at around 18% up to the first $400,000, and 36% above that figure. “You see, there’s a very significant benefit that the policy has provided to small- or medium-sized business owners,” he says.
The idea is that clients will reinvest their savings into the business. With that in mind, Stacey says, about 26% is “essentially a tax-deferred amount.”
This tax savings can also be put into an incorporated investment portfolio, as long as it’s within the company. “In this way, significant amounts of tax-deferred income can be used as a means of wealth accumulation.”
It’s important to keep any money that’s generated from investments, or saved through a tax deferral, within the company because as soon as it’s taken out, the individual will be taxed the top personal tax rate. Therefore, Stacey suggests that advisors counsel clients to keep their cash in the corporation for as long as possible. “Leave the money within the company so you can continue to keep that tax-deferred advantage,” he says.
One issue surrounding investment portfolios—whether incorporated or not—is that returns are always taxed at the highest personal rate. To prevent the returns from taking a tax hit, Stacey says to defer taxation onto the investment return. “You need something that provides compounded growth without any distributions,” he says. “You keep it invested and essentially defer the taxation on that return for as long as you want.”
Another tax strategy is to distribute income from the company to the client’s family. Stacey says incorporated clients might be able to give their family cash at a lower rate of tax or even no tax. Family members own shares in a trust, and the client can move “significant” amounts of dividends to them, especially if their other sources of income are limited.
“It makes sense to structure businesses properly early so you can reduce capital gains by splitting gain among family members,” adds Larry Frostiak, a tax partner at Frostiak and Leslie Chartered Accountants.
Frostiak says transferring incorporated businesses correctly can save clients a lot of tax dollars. First of all, clients can utilize the $750,000 lifetime capital gains exemption in order to mitigate any gains that might be incurred during the transfer of wealth.
Clients should also understand the difference between selling assets and selling shares. “When you sell assets, very often there are two levels of tax,” he explains. “The company has to pay tax on the sale of assets and then, to get money out of the company, the shareholders have to pay tax.”
If you sell shares, he says, there’s usually only one level of tax—on the shares. Add the capital gains exemption, and, Frostiak says, there’s a “huge benefit” to selling shares rather than assets.
In the end, there are myriad tax strategies that advisors can use to help alleviate their clients’ tax pressures and help build real wealth. Stacey says advisors should acknowledge that investment returns erode once taxation and inflation are taken into account. “When you look at interest-bearing investments, you’re probably close to zero return after tax and inflation,” he says. “Becoming more tax efficient in this area will be of significant value to most investors.”