Why should unincorporated client incorporate their businesses?
Recently I was teaching a course on executive compensation. The topics covered were the importance of linking compensation with a corporation overall strategy.
At the end of the class, a student asked me to discuss the main differences between a financial planner and a business executive benefits consultant. I explained that traditionally a financial planner/ investment advisor/ insurance agent focuses exclusively on his/her clients’ personal side of their balance sheets. This could include a client’s personally owned RRSP, investment and real estate portfolios, life insurance, disability insurance, critical illness insurance, and long term care insurance. In essence, the traditional financial planner assists with a business owner’s personal financial affairs separate from the source that created his/her client’s wealth, that of the client’s business.
On the other hand, a business executive benefits consultant creates solutions that deal with the business side of a client’s balance sheet that assists his/her clients to achieve five main glorious outcomes. These outcomes are wealth preservation, tax minimization, creditor proofing, wealth accumulation, and wealth distribution.
Successful business people want their trusted financial advisors to show them ways to keep their wealth. In essence, successful people want their financial advisors to provide them with financial, tax, succession, and estate planning solutions. Business owners are different from the rest of Canadians. If for no other reason, the Income Tax Act favors people who work for themselves. There are numerous advantages available to those who own their own business, who take the risk and have the creativity and fortitude to do something on their own. These people are compensated for it.
In the future when you speak with your clients about the value of incorporating their businesses to maximize the tax minimization and deferral treatment of their hard-earned money, here are ten reasons that illustrate the effectiveness of a corporation as a financial tool.
Reason one: Tax deferral opportunities.
The difference between the corporate tax rate and the personal tax rate on income earned by an individual compared to small incorporated businesses across Canada is approximately 26%. For every $1,000 income retained in an incorporated business, your client gets to keep an additional $260 than what they would have had to pay in income taxes had they declared it personally.
Reason two: Income splitting.
Pay a reasonable salary and bonus to family members including spouses and children for services they rendered to your client’s business. Prepare a job description for the services they each render. Pay a dividend to family members. While the payment of a family salary must meet the “reasonableness” test, this does not apply to dividends, which means your client can pay a $100,000 dividend to a shareholder who does not provide any services to the company.
Reason three: Tax advantage of the capital gains exemption.
Here in Canada we still have a wonderful tax break to reward successful entrepreneurship – the $ 500,000-lifetime capital gains exemption which allows an incorporated business owner to enjoy a tax-free capital gain provided an individual holds the stock in a private company for at least two years.
Reason four: Paying capital gains instead of salary.
Clients who own incorporated business can structure their cash withdrawals as capital gains rather than salary or dividends. Capital gains are only taxed on one-half of the income earned. So an individual who has used up his or her lifetime capital gains exemption who pays him/herself $300,000 in capital gains and who has a Ontario personal marginal tax rate of 46% will pay $69,000 of tax as compared to taking the same amount out as regular income that would require your client paying CRA $138,000 in personal taxes.
Reason five: Individual Pension Plan and Retirement Compensation Arrangements.
If your client is a business owner over the age of 50 and employed by an incorporated business, your client should consider creating a “super-sized RRSP,” i.e. an individual pension plan (IPP) or a retirement compensation arrangement (RCA).
Contributions to these two vehicles will exceed maximum allowable registered retirement savings plan (RRSP) limits, meaning your client can save a great deal more money for his or her retirement in a tax-efficient way. Both are fully deductible by the sponsoring company and are non-taxable benefits for the individual. Increases in the total value of the assets held are tax-deferred until withdrawn.
Reason six: Corporate-owned universal life insurance (UL)
Universal life insurance allows tax-sheltered growth within your client’s policy. A corporate-owned life insurance contract can tax shelter much of your client’s retained earnings in the cash-value portion of a policy, provided the premiums are not deducted. As an incorporated business owner, your client can access these funds for business or personal use throughout his or her lifetime by collateralizing the policy through loans from a bank. For example, your client might borrow funds annually in order to increase his or her retirement cash flow.
Make sure your client has the appropriate documentation and guarantee fees in place to avoid a personal benefit (which forces your client to play a lot of unnecessary personal tax). Any related bank loan would be repaid automatically upon your client’s death from a portion of the policy proceeds. At the same time, a credit to the corporate capital dividend account (CDA) would be created equal to the full policy proceeds.
Reason seven: Employee Profit Sharing Plan (EPSP)
An EPSP is a special purpose trust that allows the beneficiaries of the plan to share in the profits of a company. The allocation to an EPSP is taxable in the hands of an employee and a deductible expense for an employer. An EPSP is a non-registered savings plan in which the employer contributions are computed by reference to a company’s profit. Advantages of an EPSP are:
- They attract neither Employer/Employee Canada Pension Plan or EI contributions.
- They allow for more control over retirement assets.
- They are treated as pension and /or RRSP eligible earnings.
- Source deductions and withholdings are not required by the EPSP trustee or employer.
- They allow for income splitting opportunities.
- All amounts paid from an EPSP to an employee are not subject to a reasonableness test, unlike salaries.
- The “kiddie tax” rules should not apply to income received by minor children from an allocation from an EPSP if they are bona fide employees of the business.
- Contributions to the EPSP can be made up to 120 days after a corporate year-end.
Reason eight: Health spending accounts.
A health spending account (HSA) is a corporate bank account with deposits available exclusively for healthcare expenses. Having an HSA allows you to convert healthcare expenses into 100 percent business deductions equal to the annual deposits into the HSA. Payments of these expenses are treated as a non-taxable benefit to you. You’ll determine the contribution amount each year and also how to spend the benefit dollars. Unlike traditional medical and dental plans, if the deposits are not spent in the current year, the funds remain in the account, available for future use.
Reason nine: Loan money to children for education and succession planning.
The basic principle behind the loan arrangement is to shift the income needed to pay for education from the high-tax-bracket parent to the low-income child. The child reports the loan as income when in the low tax bracket, and receives a deduction when in a high tax bracket. Suppose your client’s corporation lends $60,000 to his daughter, including $40,000 for law school tuition. The daughter pays $7,000 tax. When the lawyer daughter takes over the business from your client she repays the $60,000, she can deduct the payments from the earnings, generating a total net saving of $24,000.
Reason ten: Writing off your mortgage
If your client has a mortgage on his or her home and has capital in his or her corporation, consider having them writing a cheque from the business to themselves, depleting this capital balance. After using this money to reduce or eliminate their home mortgage your client then goes to the bank for a personal investment/ business loan and invest the money back into his or her corporation. This strategy converts the non-tax deductible interest you pay for your mortgage into a tax-deductible investment loan, plus it can also “creditor proof” your money.
There are many more benefits to incorporating a business. The best professionals to help a client determine whether it is time for an individual to incorporate their business is you, the client’s trusted advisor.