Many business owners incorporate because they want to pay less tax.

 

The money you save on tax can be invested through your corporation.  

 

When you leave this money in your corporation, you can invest it in various assets such as stocks, bonds and mutual funds. These assets will generate investment income, typically in the form of interest, dividends and capital gains.

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This is called “passive income” to distinguish it from practice income or “active business income.”  Passive income does not get the same preferential treatment as practice income, which benefits from the small business tax rate.

In fact, the taxation of passive income can get quite complex. Your corporation pays high tax rates on the investment income (interest, dividends and/or capital gains) it reports each year; and when this money is distributed to you (and other shareholders), it is taxed again.

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However, to make sure that the same investment income doesn’t result in both high corporate tax rates and high personal tax rates, some of the corporate tax is refunded to the corporation when dividends are paid.

Canada’s tax system uses a concept called tax integration so that, all else being equal, it shouldn’t make a difference whether income is earned personally or through a corporation. The tax should be about the same.

One of the biggest financial benefits of incorporating your practice is access to the low small business tax rate on your practice income.

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The Income Tax Act (Canada) uses “notional accounts” to help preserve tax integration for corporations.

1. Eligible and non-eligible refundable dividend tax on hand (ERDTOH and NERDTOH)

Corporations often pay tax at the top rate on passive income; however, some of the tax paid on passive income is refundable. When taxable dividends are paid to a shareholder, the corporation is eligible for a refund of this tax. ERDTOH is recoverable through the payment of eligible dividends while NERDTOH is recoverable through the payment of non-eligible dividends. This refundable tax mechanism helps to preserve tax integration.

1. Capital dividend account (CDA)

Half of realized capital gains earned on an investment are not taxable, regardless of whether this capital gain is earned in a corporation or by an individual. To ensure that the tax-free portion of capital gains earned by a corporation can flow through to shareholders, this non-taxable portion goes into the corporation’s CDA and can be paid out tax-free to shareholders as capital dividends.

1. General rate income pool (GRIP)

Eligible dividends are personally taxed at lower tax rates than non-eligible dividends. Canadian-controlled private corporations, like most professional corporations, can pay eligible dividends to the extent of their GRIP account. Generally, the GRIP is a notional pool that consists of active business income taxed at the basic corporate rate as well as eligible dividend income received by the corporation.

 

Each of the three different types of passive income — interest, eligible dividends and capital gains— has its own tax implications for your corporation and you personally.  Interest is generated from fixed income investments, such as bonds. It is generally the most secure type of income, but also the most highly taxed. Because of this last fact, it makes more sense to hold it in registered accounts like registered retirement savings plans (RRSPs) which provide some tax-sheltering benefits. Holding fixed income investments in a corporate account is not tax-efficient.

Eligible dividends earned in your corporation are attractive because the corporate tax has already been paid by the company issuing them. Personal tax still applies, though, so the benefits of eligible dividends will depend on your personal tax circumstances.

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Capital gains only trigger tax when the gain on your investment is realized (i.e., you sell the investment). Realized capital gains have a 50% inclusion, which means only half your capital gains are subject to tax. Capital gains on investments held in a corporation are taxed at a lower rate than eligible dividends.

As a general rule, you should hold relatively more equities — which can generate capital gains — inside your corporation, and relatively more fixed income in registered accounts, where it can be sheltered from the high tax on interest.

If your focus is on growing your investments to provide income in retirement, you are best to focus on investments that generate capital gains, rather than dividends, in order to defer tax. But later in life, when your focus switches to drawing on the funds retained in your corporation, eligible dividends may be more attractive than capital gains.

 

The amount you leave in your corporation can be invested in various assets such as stocks, bonds and mutual funds. And, as we saw earlier, these assets will generate passive investment income.

When too much passive income is generated in a corporation, it can result in reduced access to the small business tax rate on your practice income. (Note that this is a federal tax rule, and not all provinces have replicated it at the provincial taxation level.)

How much passive income is too much? For every $1 over $50,000 in passive income you earn in a given year, the amount of business income eligible for the small business tax rate drops by $5 in the following year.

The business income exceeding your limit would be taxed at the general corporate rate, which is about 28% (varies by province/territory), compared with the small business tax rate of roughly 12% (also varies by province/territory).

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Using your RRSP and TFSA to manage the passive income effect

As we’ve seen, the amount of passive income being earned in your corporation can affect your access to the small business tax rate. Your RRSP and TFSA can help control this effect — and reduce taxes.

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RRSP: When you pay yourself a salary (versus dividends) from your corporation, you reduce the amount of active business income in your corporation. The corporation’s active income is a key factor in the passive income rules, and reducing it can mitigate or even eliminate the passive income effect.

With a salary, you also create the ability to contribute to an RRSP. You will get a tax deduction on your contributions, and your investments can grow tax-deferred inside the RRSP, where they aren’t contributing to corporate investment tax challenges. Contributions to a spousal RRSP, where applicable, can split income and further reduce overall taxes.

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TFSA: One way to reduce the passive income being earned in your corporation is to take funds out of the corporation— and contribute them to your TFSA. Although you will pay tax upfront to distribute the money from your corporation, there is no tax payable on income generated in your TFSA.

The latter benefit is often greater than the upfront cost (especially in retirement, when that upfront cost will be lower if you are in a lower tax bracket). So generally, it’s smart to maximize your TFSA this way.

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Other ways to add value to your corporation

Life insurance: A life insurance policy bought with corporate funds can have several benefits. The lower tax rate applied to those funds makes this a more efficient way to pay for the insurance. If you name the corporation as beneficiary, the death benefit is tax-free to the corporation and could be used to pay your final tax bill, donate to charities, etc. And because corporate-owned permanent life insurance has an investment component, you can use it to transfer excess trapped corporate surplus to your heirs. Access to life insurance depends on your health, with costs increasing as you age, so don’t wait if this strategy applies to you.

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Individual pension plan (IPP): IPPs provide a defined benefit pension that’s funded by the corporation but separate from it. This means that income earned in the IPP doesn’t belong to the corporation, so it doesn’t add to passive income and reduce your corporation’s ability to benefit from the small business tax rate. The IPP may allow for higher contributions than an RRSP, as well as pension splitting. The benefits of an IPP need to be weighed against the setup and ongoing actuarial and administration costs.

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The main goal of carefully managing the assets in your corporation is to optimize your corporation’s tax efficiency so you can accelerate your savings and asset growth. There are several proven strategies to consider that can make good use of your corporate assets while preserving access to the very valuable small business tax rate.

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No matter what type of business you own, consider speaking with MapleTree advisor to aim at making your company operate tax-efficiently.