Planning for the Creeping Tax Liability in your Corporation

In January, I wrote a post titled RRSPs and Corporations – Your Silent Creeping Tax Liability. The blog noted that whether you are currently working, near retirement or in retirement, you and/or your corporation have silent creeping tax liabilities accumulating in your Registered Retirement Savings Plan ("RRSP") and/or corporation.

I followed up in April, with a post on some potential planning to address the creeping RRSP liability. Today, I discuss some planning and considerations to reduce the creeping corporate tax liability you may be accruing.

Corporate Tax Attributes

Many corporations have built up corporate tax attributes that can be accessed prior to retirement or in retirement that can reduce the tax liability related to you and/or your corporation. I discuss these below.

Shareholder Loans

Repayment of shareholder loans owing to you and other shareholders is the most tax efficient way to remove funds from your corporation on a tax-free basis.

Capital Dividend Account

If your corporation has a capital dividend account ("CDA") balance, paying out capital dividends is a great way to remove funds on a tax-free basis and reduce your ultimate corporate tax liability (Non-resident shareholders are subject to withholding tax on capital dividends). See this blog post I wrote for all the details of a capital dividend account. 

For some unknown reason, many corporations do not pay out tax-free capital dividends from their CDA on timely basis. Since this account is a "moment in time" account, this can prove very costly if you incur capital losses. For example, if your corporation had previous capital gains and the CDA balance is say $100,000 today, but the corporation incurs capital losses of say $60,000 tomorrow, the CDA account will be reduced by $30,000 to $70,000. Thus, your corporation will have forgone $30,000 in tax-free dividends if the capital dividend had been paid before the capital losses were incurred. 

Due to the poor stock markets this year, you may be triggering capital losses as part of the corporation's investment and/or tax planning. Discuss paying out a capital dividend with your investment advisor and accountant before triggering any capital losses this year. 

Refundable Dividend Taxes On Hand

Your corporation may have balances in the following two notional accounts: Eligible Refundable Dividend Tax on Hand (ERDTOH) and Non-Eligible Refundable Dividend Tax on Hand (NERDTOH). These accounts are the successor accounts of what was formerly known as Refundable Dividend Tax On Hand (RDTOH). These accounts are essentially prior years corporate taxes paid that are refundable when the corporations pays dividends to the shareholders. The accounts act as a mechanism to ensure that you and your corporation are not double taxed. 

While your corporation needs to pay a taxable dividend to trigger refunds from these accounts (the rules are confusing, speak to your accountant), the government essentially pays your corporation a refund somewhat equivalent to the personal tax you owe on the dividend, so you net out much better than if you paid a taxable dividend with no refundable tax.

Return of Capital

If your corporation has “hard” paid-up-capital (“PUC”) for money you previously paid to purchase corporate shares from treasury, you should be able to return most of the PUC tax-free.

Income Splitting

Payment of Wages

If you have family members who work in the business and are not paid a salary or are paid a very low salary, consider paying them a “reasonable salary”. I say reasonable, as the CRA requires a salary to family members to be reasonable to be deductible.

Tax on Split Income Rules

The Tax on Split Income Rules (“TOSI”) rules are very complicated and far beyond today’s brief discussion. However, in general, TOSI will not apply on amounts paid to a business owner’s spouse or common-law partner, who are inactive in the business, so long as the business owner has reached age 65 during the year. This will be the case where the amount would have been excluded from TOSI had it been received by the business owner directly, by virtue of the fact that they would have otherwise met another exclusion. So, an inactive spouse whose shares were subject to TOSI before the business owner turned 65, will in most cases, now be able to receive dividends on their shares without the TOSI rules applying. It may also be possible to reorganize the company when the business owner turns 65 to provide shares to the inactive spouse.

Tax Reorganizations/Tax Planning

If you have a successful corporation (especially an active corporation), your accountant or tax lawyer may have one or two reorganization/tax plan ideas to consider that could possibly lower your creeping tax liability. The Federal budget in April this year contains proposals to limit a couple of these planning ideas, so you should speak to your accountant to review whether there are any planning opportunities still available that may work for you and your corporation(s).

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. Please note the blog post is time sensitive and subject to changes in legislation or law.

RRSPs and Corporations - Your Silent Creeping Tax Liability

Happy New Year and I hope 2022 brings you and your family good health and a quick return to something resembling normality. This is my first blog post since December 31st when I officially retired from my public accounting firm. The term “retired” is used loosely. I look at it as a bit of a sabbatical after almost 40 years in public accounting. I will be looking for a new opportunity outside the public accounting realm in accordance with the terms of my retirement agreement, possibly in the family office, multi-family office or investment manager space; I am too young (at least in my own mind) to full stop retire.

Back to the topic at hand. In late December I was updating a retirement spreadsheet I have for changes in my current circumstances and future income tax minimization. 

 

In reviewing the income tax section of the spreadsheet, the quantum of my future or "deferred" tax liability struck me once again. Whether you are currently working, near retirement or in retirement, you have silent creeping tax liabilities accumulating in your Registered Retirement Savings Plan ("RRSP") and/or corporation [for me, in my professional corporation ("PC")]. In my experience, we tend to "forget" or minimize this tax liability, so I though I would discuss it today.

RRSPs are Great while you are Working, not as Great when you Retire

I think most readers will know this, but to quickly recap, contributions to a RRSP result in a tax deduction in the year made (or subsequent year if you don’t fully claim the contribution) and your RRSP grows tax-free until you convert the RRSP by the end of the year you turn 71. For most people, a RRSP works well as their contributions are made at a time their marginal tax rate is higher than they expect in retirement, so they have an ultimate tax savings. Despite the tax effectiveness of your RRSP, the value is somewhat of an illusion, as you are also accumulating a large, deferred tax liability, as the entire value of your RRSP will be taxable in your retirement.

There are a couple options for a RRSP when your turn 71, including a lump sum withdrawal, the purchase of an annuity or the option most people select, converting their RRSP into a Registered Retirement Income Fund (“RRIF”).

Once you convert your RRSP into a RRIF any future withdrawals are subject to income tax (you are now paying tax on your accumulated lifetime contributions and earnings that were tax-free in your RRSP) a sometimes nasty surprise in quantum for some people. You must start drawing your annual minimum RRIF payment by December 31 of the year following the year you establish your RRIF. Since you will typically still be 71 the year following the establishment of your RRIF, the minimum withdrawal will be 5.28% (you may be able to use your spouses age to lower the withdrawal rate) and will rise each year to around 10.2% by 88 and the withdrawal rates will continue to rise dramatically after age 88.

Each year this minimum withdrawal will be taxable on top of any old age security, CPP, pension income and any other investment or other type of income you earn. The marginal tax rate on these RRIF withdrawals can be substantial depending upon your financial circumstances. Luckily for many, you can elect to split your RRIF pension income with your spouse (Form T1032 -Joint Election to Split Pension Income) and thus, you can often lower your effective family tax rate through this election. However, even with the election, the deferred tax hit on your RRIF withdrawals can still be substantial.

Corporations – You have only Paid Part of the Tax

As noted above, I was struck by the quantum of my tax liability for not only my RRSP, but the investments retained in my PC. For purposes of this discussion, consider a PC to be the same as any corporation you may have. Most active companies will have paid corporate tax historically anywhere from say 12% to 26%, depending upon the corporate province of residence. You have thus deferred anywhere from say 20%-40% in tax by keeping the earnings in your corporation (again depending upon the province). Assuming you need to take money from your corporation in retirement, you will then have to deal with this deferred tax liability when you take the money (typically as a dividend).

Similar to a RRIF, you will owe income tax on this deferred tax (the deferred tax is less than your RRIF, since the corporation paid some tax, whereas you paid no tax on your RRSP). If you have been earning investment income in your corporation, you may have some tax attributes like refundable tax to reduce your tax liability, but the original money earned and deferred by the original active company is still subject to a tax hit even though it is now co-mingled with investment income earned on these deferred earnings. Without getting technical, you still have a large, deferred tax liability as you withdraw funds from your corporation.

Income Taxes and Your Retirement Withdrawal Rate

I have written a couple times on how much money you need to retire. In 2014, I wrote an extensive six-part series titled How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! (The links to this series are under Retirement on the far-right hand side of the blog). 

 

I updated this series between January and March 2021. Most of my various retirement articles and series revolve around the 4% Withdrawal Rule, which is one of the most commonly accepted retirement rules of thumb. Simply put, the rule says that if you have an equally balanced portfolio of stocks and bonds, you should be able to withdraw 4% of your retirement savings each year, adjusted for inflation, and those savings will last for 30-35 years.

In Part 1 of the original 2014 series, I had a section on some of the criticisms of the 4% rule. The first and the most impactful limitation being the model does not account for income taxes on non-registered accounts and registered accounts Note: many of the studies I discuss in both 2014 and again in 2021, still support that the 4% withdrawal works despite any income tax limitations, but I thought it important to reflect this limitation of the rule.

 

I plan to write a future blog post on possible tax planning that you can consider to minimize the tax hit from your RRSP/RRIF and corporation in retirement.

 

As discussed above, where you have a RRSP and/or corporation, income taxes are a creeping liability. Thus, it is important to ensure that when you are younger, you are cognizant of these taxes and as you get closer to retirement, you ensure you have a financial plan that accounts for these deferred/creeping taxes.

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. Please note the blog post is time sensitive and subject to changes in legislation or law.