Canadians like to complain about high taxes and the CRA, but despite these grumblings, there are some legitimate tax-planning strategies and opportunities for business owners.
Although each case is different, the following are some of the most common ones advisors may employ in order to minimize taxes on their business-owner clients’ business income.
One note of caution: Advisors should always recommend their clients seek formal tax advice to ensure all the t’s are crossed and i’s are dotted when employing these strategies.
One of the main options for business-owner clients to reduce tax on current business income is to incorporate and retain profits in the corporation that aren’t needed to fund lifestyle expenses.
The first $500,000 of active business income is taxed at about 16% (although this varies by province) and income above $500,000 is taxed at about 31% (this, too, varies by province).
This higher rate will decrease over the next few years. The incorporated business owner or professional can defer tax for many years until the retained earnings are paid out of the corporation as dividends.
An income-splitting opportunity that business owners have is the ability to pay reasonable salaries to family members (even minors) for services rendered.
If family members are adults, the corporation can pay them dividends either as direct shareholders or beneficiaries of a family trust that owns the common shares of the business.
Unlike salary income, adult family members receiving dividends don’t have to work in the business. So, adult family members with no other income could potentially earn $30,000 to $50,000 of dividend income from the corporation tax-free, depending on the provincial rates and whether or not the income in the business was taxed at the small business rate.
Undertaking an estate freeze transaction is another common tax- and estate-planning strategy for limiting and deferring taxes at death and multiplying the $750,000 capital gains exemption with other family members on a share sale.
Flow-through investing and charitable giving
Flow-through investing and charitable giving apply equally for business owners. Donating appreciated publicly traded stock or flow-through investments in kind through a corporation allows an additional increase to the capital dividend account due to the 100% exemption for capital gains.
Individual pension plans
As an alternative to RRSPs, business owners can also set up an individual pension plan (IPP) to reduce current corporate taxes.
IPPs offer business owners the ability to accumulate retirement savings through their own defined benefit pension plan. IPP contribution limits for owners over age 40 are higher than those for RRSPs. Large initial past-service IPP contributions can also be made by the company for owners who have earned T4 income from their corporation for many years.
A couple of other interesting features of the IPP not offered by RRSPs are: All IPP expenses, including investment fees, are fully tax-deductible; and the actuarial growth rate for IPP assets is 7.5%. So, if the IPP earns less than 7.5% (and many did in 2008 and 2009), then the company can top it up with further tax-deductible contributions to bring the plan back up to tracking 7.5% per year.
Some tax specialists argue an IPP can be beat through retaining funds in the corporation in a taxable account and dividend sprinkling in retirement. That’s still up for debate, and all depends on the assumptions used to crunch the numbers.
But an IPP does offer a creditor-protected pool of retirement capital that grows by 7.5%, and this structured retirement program can provide some peace of mind and retirement income diversification to the business owner. Given the IPP has annual contribution limits, there’ll still likely be some other funds accumulating in the company.
Holding companies and tax-exempt life insurance
Common strategies for the business owner to minimize tax on future investment income are similar to executives – TFSAs, tax-effective asset allocation, prescribed rate loans to a family trust and tax-exempt life insurance. But the business owner has one extra structure where significant money will accumulate: The holding company. With low, active income corporate tax rates, there’s an incentive for the business owner to retain funds in the corporation, and then move them tax-free into the Holdco for creditor protection and reinvestment.
That’s the good news. The bad news is investment income earned in the holding company is taxed at a flat corporate investment tax rate that’s slightly higher than the top personal tax rate. There could also be a large tax bill upon death related to the deemed disposition or windup of the holding company shares.
This provides a compelling argument to reallocate some Holdco investments (particularly lower-yielding, fixed-income investments) into tax-exempt life insurance. The result: tax-sheltered growth, a tax-free death benefit paid into the company, and the ability to distribute insurance proceeds from the company to the estate tax-free via the capital dividend account.