Personal Benefits of Your Business or Professional Practice

Various tax rules have been introduced over the past decade to limit the personal benefits of corporations – the latest is the proposed increase to the capital gains inclusion rate from one-half to two-thirds. However, investing within your corporation remains an important tool to build personal wealth and many strategies continue to be effective. We will examine the overall tax framework of corporate investing and the strategies available to minimize combined personal and corporate tax.

Incorporating your business or practice has many advantages but one of the most important is the deferral of personal income. It allows you more control over your tax situation than a sole proprietor, partnership, or employee has.

At some point in your journey as a successful owner, you may reach the point where the profit your business is generating exceeds what is needed personally. We will examine how to allocate this cash in another article, but the following information is to help you understand how investing the funds within your corporation works.

The Flow of Corporate Investment Income

We previously examined how investment income is taxed personally in our article Maximizing After-Tax Wealth, but let’s look at how it is taxed in a corporation assuming it is not business related. To review, there are five types of passive investment income your corporation may receive from investing:

1. Canadian interest
2. Canadian dividends
3. Foreign non-business income
4. Capital gains
5. Return of capital

The source of the investment income can be from direct investment in stocks and bonds or indirect investment through mutual funds or exchange traded funds (ETFs). The following chart shows how the flow of the income works.

It is very important to consider the amount of passive income generated in your corporation. If you still have active business income, your access to the small business deduction (lower small business tax rate) is reduced starting at $50,000 of passive income and is eliminated at $150,000. In other words, the $500,000 threshold is reduced by $5 for every $1 of passive income.

Integration of Personal and Corporate Taxes

Since the end goal of operating a business for the owner is to generate personal income, it is important to understand the basics of how investment income integrates from corporate to personal. The mechanics of the integration is largely through RDTOH and CDA which are “notional” accounts your accountant and CRA use – they are not bank accounts. This concept is like your shareholder loan account in that it is simply a way to account for money. The first one is the refundable dividend tax on hand (RDTOH). It is further divided into eligible (ERDTOH) and non-eligible (NERDTOH). The eligible portion applies when your corporation receives a dividend from a non-connected corporation where the earnings were taxed at the general tax rate (more than $500,000 active business income) – most dividends from Canadian stocks fall in this category. The non-eligible portion applies to all other income types. Your corporation receives a tax refund from the ERDTOH when an eligible dividend is paid to you or another shareholder. Your corporation receives a tax refund from the NERDTOH when a non-eligible dividend is paid to you or another shareholder.

Summary for ERDTOH:

1. Corporation receives an eligible dividend from a Canadian stock
2. Corporation pays refundable tax
3. Refundable tax is recorded in ERTOH
4. Shareholders declare an eligible dividend
5. Corporation receives refundable tax and shareholder reports an eligible dividend on their personal tax return

Summary for NERDTOH:

1. Corporation receives investment income other than an eligible dividend
2. Corporation pays tax at the highest personal tax rate, but part of the tax is refundable
3. Refundable tax is recorded in NERTOH
4. Shareholders declare a non-eligible dividend
5. Corporation receives refundable tax and shareholder reports a non-eligible dividend on their personal tax return

The second notional account of importance is the capital dividend account (CDA). CDA is simply a way to keep track of the non-taxable portion of capital gains, now reduced from one-half to one-third, and the non-allowable portion of capital losses. There are also other items that are tracked such as capital dividends and life insurance proceeds. CDA is very important because it allows shareholders to declare a tax-free capital dividend if the balance is positive.

Summary for CDA:

1. Corporation sells capital property such as a stock for a gain or loss
2. Corporation pays tax on two-thirds of the gain at the highest personal tax rate, but part of the tax is refundable OR offsets other gains with two-thirds of the loss
3. The non-taxable one-third of the gain is added to the CDA balance OR the non-allowable one-third of the loss is subtracted from the CDA balance
4. If the CDA balance is positive, the shareholders can declare a capital dividend
5. The CDA balance is reduced by the capital dividend and the shareholder receives the capital dividend tax-free

Evidently, careful planning and consideration must be made by you, your investment advisor, and your accountant to maximize the advantages of the investments in your corporation. Generally, it is better to distribute eligible dividends in the year received, but for other income types it may be better to reinvest in your corporation depending on your province and personal tax bracket.

Strategies to Consider

Given all the previous information, what strategies can we consider to maximize your after-tax wealth from your corporation?

• Asset location – The option of which accounts you hold which investments is an important decision. Interest income and foreign income have punitive tax treatment in your corporation, but Canadian dividends and capital gains are more favourable even with the changes to the capital gains inclusion rate. Interest bearing and foreign investments may be better held in your RSP
• Choice of investments – Due to the preferential treatment of the income they produce, you may want to consider Canadian stocks and foreign growth stocks (low or no-dividend) in your corporation. The result is mainly eligible dividends and capital gains as income. Additionally, a corporate class mutual fund may be a better option than a trust mutual fund due to the ability to offset income and losses within the structure of the former. Finally, your corporation may not be included for US estate tax making US based stocks a good option to hold in your corporation versus your personal non-registered account.
• Choice of investing strategy – The passive income threshold of $50,000 is critical for you if you are still operating your business. Therefore, lower income strategies may be a better option for your corporate investment account. This includes buy and hold versus active trading to limit the amount of capital gains triggered.
• Tax loss selling – Strategically triggering capital losses to offset capital gains can improve after-tax performance, but careful planning with your accountant must be made to avoid reducing the CDA balance at an inopportune time.
• Insurance – The use of insurance is not limited to protecting your business from unexpected events. It is also useful in sheltering investment income within your corporation and reducing the tax bill of your estate. The main benefit is the funding of the CDA balance with insurance proceeds that can be paid out to your heirs tax free.

With the above strategies in mind, it is equally important to consider your individual investment objectives and constraints.

If you are interested in discussing strategies you can use for your specific situation, please contact us today – we are happy to help.