My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, June 29, 2015

Should You Fund Your TFSA With Corporate Funds?

Many business owners and professionals operate through corporations. One of the main benefits of using a corporation is the deferral of income tax (over 34% in some provinces) and as a result, many business owners attempt to leave as much money in their corporation as possible (in essence to build their own mini corporate retirement fund).

When Tax-Free Savings Plans (“TFSAs”) were introduced in 2009, most small business owners typically had a choice of two pots of money to fund their annual $5,000 contribution limit. They could fund their TFSA with non-registered money (savings accounts or brokerage accounts) or withdraw funds from their corporations.

Initially, most chose to fund their TFSAs with non-registered money, since this money had already been taxed. However, as time marched on, many people exhausted their non-registered money in funding their TFSAs or used these funds for their personal use, such as to renovate their homes, vacations etc.

Funding an owner/manager’s TFSA has become even more problematic with the proposed TFSA increase from $5,500 to $10,000 announced in the March, 2015 budget. Some of my clients who do not have any available non-registered money to fund their TFSAs have automatically assumed they should fund their future contributions with corporate funds, as opposed to leaving the funds in their corporations and not funding their TFSAs.

Their thinking is premised on the belief that their TFSAs will provide for tax-free withdrawals in the future, while the money remaining in their corporation will ultimately be taxable when the funds are withdrawn as dividends.

As I have also been contemplating the question of whether you are better off funding a TFSA with corporate funds (via a dividend), or not funding a TFSA at all and growing a corporate "retirement account", I decided to run some numbers to see what they reflected.

Based on some simple calculations (provided below), the answer is not necessarily clear cut, although in general, it appears you will in most cases want to fund your TFSA with corporate funds. I provide some general guidelines below.

For the mathematicians out there, please do not have any heart palpitations. I concede a vigorous analysis would include various permutations, combinations and Monte Carlo simulations, but I have neither the tools, nor the time to undertake such an analysis.

The BBC’s Analysis


In undertaking my calculations I made some large assumptions.

1. The individual taxpayer is at the highest marginal rate (in Ontario).

2. The initial active income earned in the corporation was taxed at the lowest corporate rate of 15.5% (in Ontario).

3. I assumed a 30 year investment horizon and I used a flat 5% rate of return on the money, whether the income earned was interest, capital gains or dividends (of course in real life, typically the return on capital gains would be far in excess of that of interest and dividends), but you need to have a standard comparison point.

4. For purposes of this exercise, I assumed all dividends received are eligible dividends from Canadian public companies. 

What Did I Determine


My calculations reflected the following:

1. If you are earning interest in your corporation, you are clearly better off removing those funds via a dividend and investing the after-tax proceeds in your TFSA.

2. If all you are earning is capital gains, you are probably better off leaving those funds in your corporation, rather than removing the money via a dividend and funding your TFSA.

3. If you are earning eligible dividends in your corporation, you are better off removing the funds from your company. However, the timing and your marginal tax rate at the time could change that decision.

Since most portfolios earn a blend of interest, capital gains and dividends, depending upon the actual mix (this is why you would need to run your own numbers), you will likely want to use corporate funds to invest in your TFSA.

I should note that I did play around a little with income tax brackets. I compared the $44,701- $72,064 and $89,401-$138,586 income tax brackets to the highest marginal rate bracket. I determined that at the lower brackets, there is a slightly larger bias to funding your TFSA with after-tax corporate funds for all types of income, but the differences were not compelling.

As noted above, a rugged analysis would require multiple simulations which I don't have the tools to undertake. This analysis would take into account the different corporate tax rates, rates of return, income levels, future and current tax rates, income smoothing, portfolio allocation and investing style (some people only invest in higher risk equities that will produce capital gains in their TFSA - i.e. the greatest upside with no tax).

I would like to think this post was not an exercise in mathematical futility. Instead, I hope it gives you reason for pause in automatically assuming you should fund your TFSA with corporate funds, as opposed to leaving those funds in your corporation to grow over time. In order to ensure you make the correct decision, you need to review this issue with your accountant taking into account your specific income tax and investing circumstances.

The Calculations



Year 1
Corporate Income
19,763
Corporate Dividend
16,700
Income Tax 15.5%
3,063
Personal Tax 40.13%
6,700
Net Proceeds
16,700
Net personal
10,000



TFSA
Funds
Five %
Total
Return
Year 2
10000
500
10500
Year 3
10500
525
11025
Year 4
11025
551
11576
Year 5
11576
579
12155
Year 10
14775
739
15513
Year 15
18856
943
19799
Year 20
24066
1203
25270
Year 25
30715
1536
32251
Year 30
39201
1960
41161



INTEREST
Funds
Five %
Corp Tax
RDTOH
Net Return
Return
46.17%
26.67%
(A)
(B)
(C )
(D)
A+B-C
Year 2
16,700
835
386
223
17,149
Year 3
17,149
857
396
229
17,611
Year 4
17,611
881
407
235
18,085
Year 5
18,085
904
417
241
18,572
Year 10
20,653
1033
477
275
21,209
Year 15
23,587
1179
544
315
24,221
Year 20
26,936
1347
622
359
27,661
Year 25
30,762
1538
710
410
31,590
Year 30
35,130
1757
811
468
36,076
RDTOH
9,600
9,600
Dividend paid
45,676
Tax on dividend
Tax 40.13%
18,330
Net Proceeds
27,346

  
CAPITAL GAIN
Funds
Five %
Corp Tax
RDTOH
Net Return
Return
23.09%
13.33%
(A)
(B)
(C )
(D)
A+B-C
Year 2
16,700
835
193
111
17,342
Year 3
17,342
867
200
115
18,009
Year 4
18,009
900
208
120
18,702
Year 5
18,702
935
216
124
19,421
Year 10
22,585
1129
261
150
23,453
Year 15
27,274
1364
315
181
28,323
Year 20
32,938
1647
380
219
34,204
Year 25
39,777
1989
459
265
41,307
Year 30
48,037
2402
555
319
49,884
43,146
9,962
5,738
Capital dividend        50%*$43,146
-21,573
Funds available for dividend
28,311
RDTOH paid out
5,738
5,738
Dividend paid
34,049
Tax on dividend paid
Tax 40.13%
13,664
20,385
Capital dividend paid out tax free
21,573
Net proceeds
41,958





ELIGIBLE DIVIDEND RECEIVED

Funds
Five %
Part 4 Tax
RDTOH
Net Return


Return
33.33%
33.33%


(A)
(B)
(C )
(D)
A+B-C
Year 2
16,700
835
278
278
17,257
Year 3
17,257
863
288
288
17,832
Year 4
17,832
892
297
297
18,426
Year 5
18,426
921
307
307
19,041
Year 10
21,709
1085
362
362
22,433
Year 15
25,577
1279
426
426
26,430
Year 20
30,134
1507
502
502
31,139
Year 25
35,503
1775
592
592
36,686
Year 30
41,828
2091
697
697
43,222
RDTOH
39,782

13,259
13,259
Dividend paid

56,481
Tax on eligible dividend ($39,782*.3382)

-13,454
Tax on ineligible dividend ($16,699*.4013)

-6,701
Net proceeds

36,326




Note: I apologize for the formatting on the dividend chart. I made a change and now cannot get it back to its original format.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

20 comments:

  1. Hi Mark,

    Very interesting analysis. I always assumed without actually running the numbers that it would be more beneficial to defer the funds in the corporation since after the dividend you would have less left to invest. In light of your calculations, I may have to reconsider :)

    One small note on the "dividend" scenario, I believe $16,700 of the $56,481 dividend paid to the shareholder would be taxed at the non-eligible rate since that income was taxed at the low rate. This would make the TFSA alternative look slightly better.

    ReplyDelete
    Replies
    1. Hi Simon

      Thx, you are correct, I missed that, hard to get anyone to pay attention to reviewing your numbers the last week of June when all the December year ends are due. Thx.

      Delete
  2. I think one should also consider the diversification benefits of a TFSA. Your analysis assumes no change in 30 years, which is debatable. As an example, it wouldn't surprise me if the tax advantages of a CCPC decline with time, at least for some of those with a CCPC. By diversifying between a corporate account, RRSP , TFSA and maybe even an open account, you decrease risk.

    ReplyDelete
    Replies
    1. Thx Anon

      Yes I think that is a consideration, although you could argue that if the rates change for CCPCs you could remove the money that benefited at that time.

      Delete
  3. Hi Mark,

    This is a very good analysis, however, I believe that there should be some mention that if the funds are left in the corporation, there is an opportunity to take the dividends out over time especially in years where the person's personal tax rate is lower.

    I'm not sure how that would be factored into this analysis as it is extremely difficult if not impossible to predict when the funds will be withdrawn.

    Dan

    ReplyDelete
    Replies
    1. Thx Dan:

      I noted that when I said the factors to be considered include income smoothing, which would encompass paying dividends over time. But as you note, it would require multiple simulations to even attempt to determine the benefits.

      Delete
  4. Cool! I'd like to think my suggestion helped spark this idea. :) Glad to see my rough estimates turned out about right too.

    ReplyDelete
    Replies
    1. Hey Nathan

      It was your suggestion that sparked the idea!

      Delete
  5. Just starting out with incorporation. I take out a salary to maximize RRSP contribution space and the rest stays invested in CCPC. Was planning on taking dividends and putting them in RRSP for the fixed income portion of my portfolio.

    I know the whole TFSA vs RRSP question has been looked at previously, but I'm not sure in this context? Did you not discuss RRSP because you're assuming the CCPCs owners would be drawing only dividends for living expenses and not have contribution room or is there another reason I'm overlooking?

    My income should be essentially stable throughout my career

    ReplyDelete
    Replies
    1. Hi Tim

      I have discussed the div vs salary issue before in a 3 part series on salary or dividend, see the right side of the page under favourite tax posts. Many people are still split on the issue. I have many clients take the max salary so they can contribute to their RRSPs and others who only take dividends and build up the funds in their CCPC.

      Delete
  6. Thanks for the reply. So assuming one does have RRSP room and has gone that route. My question is: Should you fund your RRSP, or TFSA, with corporate funds for the fixed income portion of a portfolio.

    ReplyDelete
    Replies
    1. Hi Tim

      I cannot provide investment advice as an accountant. However, from a tax perspective, since the TFSA is tax-free, you may want to consider your TFSA for growth stocks.

      Delete
  7. Hi Mark,

    I was directed to this post by Tim (I'm guessing it's the same Tim as above) when he referenced it in a comment on my blog post covering the same topic. I have done some analysis with various asset allocations and tax rates over time. You might find it interesting, and I'd love to hear your thoughts.

    http://thecanadianfinancialadvisor.com/blog/2015/8/7/the-tfsa-should-not-be-overlooked-by-incorporated-individuals-with-long-time-horizons

    Ben

    ReplyDelete
    Replies
    1. Thx Ben, well aware of your firm and a couple members of it. Will take a look when I have a few minutes.

      Delete
  8. Yes same Tim. Been a bit quiet at work last few days and on a bit of an investing self-education binge so I don't feel so ignorant when I meet my accountant.

    Two more questions/comments, I was reading Jamie Golombek's article, "In Good Company: Retaining investment income in your corporation" and he suggests taking out the non-taxable portion of capital gains on a regular basis in case of future capital losses. That is hard to model/predict of course but would this be a significant consideration in deciding asset location for an equity fund in terms of registered vs non registered account--I guess it would depend on how volatile the market was?

    He also points out that in most provinces (not ON as in your example) there is a tax advantage to dividend out eligible dividends rather then keep in CCPC. I'm not sure how that would affect above?

    In the end my conclusion has been to save registered account space for fixed income and foreign equities -- which is basically what my accountant said :)

    ReplyDelete
    Replies
    1. Hi Tim,

      As noted, I dont provide investment advice or tax advice, especially where you have an accountant already.

      The capital dividend (read my blog on the topic) would not typically be a consideration in asset allocation as it is a by product of capital gains, not visa versa.

      Delete
  9. Mark - TFSA questions / comments.
    1. I'm old enough to remember when there was no tax applied to interest income. When our government changed this rule it only reinforced my feelings - they are crooks.
    2. I've checked on the CRA website for individuals - specifically my situation - and found the CRAs records have significant errors (in my favor). I wonder what would happen if I were to "fill up" the "$30,000 room" the CRA says I have since by my records I have made the maximum contribution each year.
    3. A pet peeve of mine: most financial institutions "fine" you with a fee if you move funds to another competitor. I learned that lesson now I will wait, withdraw in Dec and put the funds into the other account in Jan.
    4. Finally another pet peeve and this goes for RSPs as well (which I don't have anymore) the fact you cannot invest in some products which are not approved by CRA. Example: a company which provides mortgages and funds to companies or individuals and pays their clients who provide the capital 8%.

    Long winded I know. Sorry. Take care, Paul

    ReplyDelete
    Replies
    1. Hi Paul,

      I hope u feel better now :)

      The CRA is often a year behind on TFSAs but not many years. Pretty strange, not sure worth the penalty risk to try it.

      Delete
    2. Mark,
      Ah but to apply the penalty the CRA would have to prove I knew what I was doing. I'm an old man whose memory is fading.
      I'm sure in your years of experience working with clients vs the CRA you have come across errors CRA has made.
      Clarification ... I hope.
      Note: When you see rates think GICs
      2009 I open TFSA with ING A and deposit $5K
      2010 + 11 Max $ into TFSA at ING
      2012 ScotiaBank buys out ING and drops rates so I move all TFSA$ to First Ontario (no transfer fee by ING) and deposit max for the year.
      2013 & 14 max out TFSA
      2015 First Ontario rates are not competitive with credit union B so open another TFSA and move some $ from First Ontario which triggers a fee (that really pisses me off because I lose 1yr of interest and the fee has come out of my TFSA!!!).
      2016 I note on the CRA website $30K of deposits are not recorded so I now have MORE ROOM! But as you say if I use the room there is a penalty. But I say to CRA where is your proof? I'm just going by CRA records.
      2016 I plan to withdraw all from TFSA held at First Ontario in Dec then in Jan 2017 deposit it all with credit union B. Do I need to do advise First Ontario? Why?
      When and IF credit union B notifies CRA of my large deposit in 2017 I have records to show it was a withdrawal in 2016 then redeposited in 2017. Perfectly legal.

      I know I know. I'm an accountants worst nightmare.
      Paul

      Delete