In Canada, corporations can play a key role in personal financial planning.
In this article, we share tips for small business owners to make smart use of their corporation to optimize their tax bills.
Paying yourself efficiently
As a small business owner, how you choose to pay yourself can have significant tax implications.
Consider these questions:
- Do you pay yourself a salary, dividends or both?
- Do you spend every single dollar you earn in your small business or do you have an annual surplus?
- What are the tax implications of leaving a surplus in your company versus withdrawing it?
Imagine your small business generates a profit of $300,000. You can choose to pay yourself this full amount as a salary or to leave some of it in the corporation as retained earnings.
|Profit||Salary||Retained earnings||Tax (approximate)*||After-tax balance|
|Example 1||$300,000||$300,000||$0||$124,000 personal income tax||$176,000|
|Example 2||$300,000||$150,000||$150,000||$46,000 personal income tax
$22,500 corporate income tax
* Assumes the small business owner is an Ontario resident paying the top marginal income tax rate.
Although this is a simplified example, there can clearly be significant differences in your overall tax bill (corporate + personal) depending on how and how much you choose to pay yourself from your corporation.
Any surplus funds you leave in your corporation can be used to run or expand your small business, but you can also choose to invest this money.
Your corporate investment portfolio can then earn passive income for you in the form of interest, dividends, rents, royalties and capital gains. This passive income will be taxed within the corporation, which may result in a lower tax bill compared with holding the same investments in a personal capacity.
Planning for capital gains at death
No matter how successful they are in running their corporation, many small business owners have a blind spot: what happens when they die?
In general, your estate will face a tax bill for capital gains upon your death. There are many variables that go into calculating these capital gains, but the calculation is premised on the idea of your assets being sold at fair market value when you die.
If your corporation is worth, say, $1 million at the time of your death, this could result in a capital gains tax bill of approximately $250,000.
Even if you have this much in cash sitting inside the corporation, the challenge is that the capital gains tax is owned personally and must be paid by your estate, not your corporation.
The corporation could pay a dividend to your estate to pay the capital gains tax, but this would then be subject to a separate dividend tax of potentially up to 50%.
To avoid this double tax hit, it’s important as a small business owner to plan for capital gains at death. One tax-efficient way to do this is with a corporate-owned life insurance policy.
Maximizing tax efficiency with corporate life insurance
Corporate-owned life insurance can be a powerful tool for boosting the tax efficiency of your small business.
Here are two ways it can help maximize the value of both your corporation and estate:
- A participating whole life insurance policy consists of a fixed death benefit and a variable cash value component that participates in the insurance company’s investment pool. When this investment pool grows, so does the cash value of your corporate life insurance policy – tax free! With compound interest, the tax-free growth of your policy’s cash value can offer a significant advantage compared with other types of investments held within your corporation as income generated from these is taxed annually.
- Upon your death, all the money inside the policy (including all the growth) will be paid out tax free to your corporation. This money can then be transferred either completely or mostly tax free from the corporation to your estate. With proper planning, this insurance payout can be used to cover the tax on capital gains at death owed by your estate, potentially resulting in significant tax savings compared to withdrawing money from the corporation as a dividend.
Estate planning advantages
As a small business owner, you want to pass on as much of the hard-earned value within your corporation as possible to your loved ones or other beneficiaries.
In addition to minimizing the impact of taxes on your estate upon your death, corporate-owned life insurance offers two other key advantages related to estate planning:
- Confidentiality. The beneficiaries of a life insurance policy are confidential, allowing you to leave money to others while keeping this information private.
- Speed. Life insurance proceeds do not need to be processed through the estate or pay probate fees, so they can usually be paid out within a few weeks of your death. In contrast, winding down an estate can sometimes take years.
Tax planning for small business owners
For small business owners, understanding Canada’s tax laws can result in enormous savings both during their lifetime and upon their death.
By making smart decisions about how you pay yourself and using tools like corporate-owned life insurance, you can have more money to enjoy during your lifetime and more wealth to pass on to the next generation.
To discuss how tax planning can benefit your small business, contact us at firstname.lastname@example.org to schedule a call with a Rubach Wealth advisor.