While our thoughts this October weekend might be on the big bird in the middle of the table, we can also celebrate that October is both Financial Planning Month and Small Business Month. Given the importance of planning for Canadians and the fact that small businesses are the engine of the economy, we could argue that we should celebrate both every month. For this week, we thought it would be good to see where these two topics overlap and how Canadian business owners can better plan their financial affairs outside the day-to-day commercial pursuits.

 

Planning is always important, but arguably more so this year. Businesses have not only had to deal with the uncertainty over labour and supply disruptions, but back-and-forth opinions on the state of the economy, inflation and where interest rates are going. Oh yes, and there is probably the most important U.S. election in just a few weeks. Just to add to the burden, Ottawa decided to increase the capital gains inclusion rate for corporations to 66-2/3% from 50%. Worse still, Parliament has yet to pass the legislation and the CRA has said that it won’t have updated tax forms ready until January.

 

Take it or Leave it

 

Regardless of whether the tabled capital gains proposals make it through to fruition, business owners should be looking at the advantages and disadvantages of generating investment income inside their corporation or personally. Earlier this month, CIBC’s Managing Director for Tax and Estate Planning, Jamie Golombek, co-hosted a webinar and published a new report that examined this very question.

 

Even though the inclusion rate is slated to be higher on capital gains inside the corporation, it can still be the case that amount of after-tax income generated will be higher. The reason for this is that with the tax rates on business income lower than for individuals, there is a larger amount of capital available after tax to invest. This would be the case for Small Business Deduction (SPD) income, which is on the first $500,000 of active business income, or General Income, which is on active income in excess of $500,000.

 

 

In the example above, we show a company with $10,000 of SPD income. After tax, there is $8,780 available to either invest or pay out to the business owner in the form of a dividend. Now, let’s assume that the investment made will grow by 5% (capital gain). If invested in the company, two-thirds of the $439 gain will be taxed as investment income, which works out to $147 in both refundable and non-refundable tax. The net gain is $292. Adding back the $90 in refundable tax, the total net gain would be $382. If the business owner then wants to pay this out as a dividend, the net proceeds would be $269 (the one-third of the gain that is non-taxable, or $146, plus an after-tax dividend of $123).

 

If, instead, the business owner paid themselves a dividend of $8,780 and was in the highest tax bracket for Ontario, then they would pay personal tax of $4,190 on that dividend, resulting in $4,590 left to invest. Again, assume 5% growth on that capital and we have a capital gain of $230. Only 50% of this gain is included for tax, or $115, so there would be $62 tax paid on that amount. The net gain then would be $168. That is a hundred dollars less than the after-tax dividend produced from the gain made on the investment inside of the company.

 

 

The above chart shows how the cumulative proceeds from investing within the company versus doing so personally compare over a time span of 30 years. Based on the assumptions in the example, corporate deferred gains would amount to $15,000 versus $10,800 on personal deferred gains.

 

Now, there are other factors at play here. For example, the 50% inclusion rate for the personal investment only applies for gains less than $250,000 in a given year. And, not all business owners will be in the top marginal tax bracket. Furthermore, the analysis could change if you have other family members inside of the company, where some income-splitting opportunities might exist. And there could be other factors, such as the risk that after-tax income inside the company might be vulnerable in cases where creditors make a claim against the business.

 

Your Own Pension

 

Outside of investing retained capital in the corporation, business owners should also be planning out how they are preparing for retirement. Should they be utilizing RRSPs, which means paying out a salary each year to create contribution room, or is there a better option? As we have discussed before in the newsletter, one of the best retirement savings tools available to business owners is the Individual Pension Plan, or IPP. Similar to other high-quality defined benefit pensions in Canada, the IPP is designed to create a predictable retirement income flow in the future, while offering attractive wealth accumulation and tax benefits along the way. For the basic mechanics on how the IPP works, you can read my article from July 5, 2024.

 

Some recent changes in the rules have made these plans even better. For example, the amount of initial corporate capital needed to start an IPP is less now than in the past. What I mean by this is that when a business owner starts an IPP, they have to transfer in a required amount of RRSP assets and the company also contributes a specific. For those in the early stages of running a business, the amount of retained earnings in the company may not have been enough to cover that contribution. This is especially true of young physicians just beginning to practice. Under current rules, a company can amortize the required contribution over ten years. 

 

Another recent change impacts what happens at the end of the IPP when we wind it up. Traditionally, this process would result in three separate capital transfers taking place. One would be the return of any voluntary RRSP contributions made by the business owner (or other family members) during the time of the IPP, which are transferred back to an RRSP or RRIF. This is followed by amounts in the defined benefit section of the IPP. Like when you commute a pension from a company you work for, some of that gets transferred into a locked-in RRSP or LIF account, and then finally a cash amount that is taxable.  Today, both the voluntary RRSP contributions and defined benefit amounts can flow out to a RRIF. This provides increased flexibility of capital to the business owner in retirement.

 

Keep your Staff

 

A Registered Retirement Savings Plan (or RRSP), is an type of investment account, available to all Canadian’s over the age of 16 with employment income. This will serve as a form of retirement income and becomes increasingly important especially when the individual is either self-employed, or works for an employer who does not offer a registered pension plan. To make saving for retirement more accessible, companies may offer a Group RRSP. This is essentially an investment account that employees can join through the organization while maintaining registration with the Canadian government to qualify for tax benefits associated with contributions.

 

Along with all of the benefits of utilizing RRSPs to save for retirement on a tax deferred basis, there are some additional advantages of offering a group RRSP to your employees. As the saying goes “pay yourself first”, group RRSPs offer just that – either a percentage or fixed amount comes directly off of an employees gross pay and into savings. This also results in paying less tax per pay check. Employers also have the ability to match a portion or invest an amount based on salary into the Group RRSP as well, creating something of a guaranteed return on the employees contribution. Undoubtedly, this helps to align owners and employees, showing dedication to financial stability in retirement. Of course, all contributions must still be within the employees RRSP deduction limit.

 

From an investment perspective, the Group RRSP can be tailored to each employees unique investment objective and risk tolerance. For example, an individual who has just begun work in their 20s will have a longer time horizon and will have ability to withstand more risk in an investment portfolio vs an individual who has a much shorter run-way to retirement. Should an employee leave the company, they can transfer their group RRSP tax deferred into an individually held RRSP at a financial institution; and in some cases, they may be able to remain with the same provider and simply exit the group plan structure.

 

There are many factors to consider when planning your financial affairs as a business owner. By carefully weighing the pros and cons of different strategies and taking advantage of available tools like IPPs and Group RRSPs, you can set yourself up for a more secure financial future. Planning is not just about the short term; it’s about laying the groundwork for a successful and sustainable business journey. 

 

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend. 

Andrew Pyle