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.

The Revised Tax On Split Income Rules

On December 13, 2017 the Liberals released a new and improved version of their income sprinkling/tax on split income (“TOSI”) proposals. The government’s backgrounder stated, “the revised draft legislative proposals include changes to better target and simplify their application”. I can agree with the targeted assertion; as some overly expansive drafting was corrected, but simplification, not in my world.

The new rules while more objective than the previous version, are still very subjective. In my opinion these revisions will just create more angst among the small business owners caught by these proposals and will result in court cases for years. Add in that these rules were released the week before the Christmas holidays and not issued in conjunction with the passive income rules that are supposedly to come in the next budget (planning for dividends may be dependent or intertwined with the final passive rules) and I don’t think the Finance Minister will be winning any politician of the year awards from any private business associations.

In my opinion, all these TOSI rules would not be necessary if the government would have simply disallowed income sprinkling for anyone under age 25 that that does not work full-time in a business and for all Canadians (whether business owners or not) started taxing spouses as a single-family unit. But then, nobody asked me.

Today, I will summarize whom I see as the winners and losers of these new proposals and those caught in the grey area. Finally, I will provide some details on the revisions to the TOSI rules.

As this legislation is new and will likely still require some clarification, I want to make it clear that this post is solely for general information purposes. You should consult with your professional advisor, so they can review these proposals based on your specific fact situation.

Scorecard

Winners

1. Business owners over 65

2. Individuals who inherited shares of a small business

3. Businesses where shares, votes and value are allocated evenly among family members and are not service businesses

4. Canadians who work at least 20 hours a week on a regular and continuous basis in the family business

5. Retired owners that were caught under the initial rules because they were considered related even though an arm’s length person now ran the corporation

Losers

1. Beneficiaries of shares held by Family Trusts

2. Professionals

3. Small businesses that provide services and do not sell products

4. Estate freezes recently undertaken and/or where there is large redemption value remaining in the preference shares issued upon the freeze

Unclear

1. Families were shares have already been distributed from a trust or were purchased upon incorporation and the parents have voting control

2. Estate freezes where most shares have been redeemed

The New Rules

The new rules are very detailed and I do not intend to regurgitate all of them here. I will summarize the rules only at a high level. For details and FAQ’s, please see this CRA link  (scroll half-way down the page to related products and you will see guidance and other more technical material).

The new rules have four key exclusions: 1. An excluded share test 2. Excluded business test 3. Reasonable rate of return test and 4. Retirement and inheritance exclusion.

I will summarize them below and discuss how they may affect you.

Excluded Shares- The share ownership test

The TOSI rules will not apply where you have attained the age of 25 and all of the following conditions are met:

• You own at least 10% of the outstanding shares of a corporation in terms of votes and value and the corporation meets all the following conditions:

(a) It earns less than 90% of its income from the provision of services

(b) It is not a professional corporation

(c) All or substantially all its income is not derived from a related business

At first blush, this test seems like a god-send for private corporations where family members are shareholders and have attained the age of 25. However, in many cases the parents have the majority of the voting rights and may have significant value in preference shares as result of a prior reorganization or estate freeze. Where the issue is only votes, you may be able to reorganize your corporate share structure to meet this condition as the government has stated that even though the rules are applicable January 1, 2018, you have until December 31, 2018 to get your corporate house “in order”.

This rule will essentially preclude the use of family trusts for income splitting purposes other than the capital gains exemption. It is important to note, that the TOSI rules will not apply to capital gains on the sale of qualified farm or fishing property and to the sale of qualified small business corporations (“QSBC”). Most private corporation owners reading this blog post have shares that either qualify as QSBC shares, or can be made to qualify for the capital gains exemption through a purifying transaction (see this post I wrote on this topic). The exclusion for the sale of these shares is not age dependent (however, where an individual is under 18 and the sale is to a related party, the exemption will be problematic). Not that I want to look a gift horse in the mouth, but we have all these complex rules to prevent income sprinkling and you are still allowed to allocate the 2018 exemption amount of $848,252 to a minor?

Professional corporations are excluded, as they have been one of the main targets of the Liberals throughout this whole debacle. However, pay careful attention to the word “services”. At first glance you think services is just another arrow aimed at professionals, but services as written (it is not defined anywhere) would seem to include the services of a barber, gardener, massage therapist, computer consultant etc. Many small businesses may not meet this exclusion if they don’t earn at least 11% of their revenue from the sale of products. In my opinion, this provision may “blow-back at the government once it is better understood; assuming the literal interpretation is the proper reading. It should be noted that if you and your spouse/children 18 years old and over meet the labour criteria for the excluded business test based discussed below, then having a service business will not in itself preclude you from income sprinkling.

The related business in (c) above is just a provision to ensure a service business does not impose another business between it and the family member to get around the rules, although, some tax observers are concerned this provision could accidentally cause issues where shares are held through a holding company. This is one area that the Liberals will need to clarify.

Excluded Business –The labour test

The TOSI rules will not apply where you are 18 or over and have been employed by an excluded business, which is “a business in which the individual is actively engaged on a regular, continuous and substantial basis in the taxation year of the individual in which an amount is received or in any five previous taxation years". The CRA states that “To access the exclusion in respect of five previous years of labour contributions, it is not necessary that the five previous years be consecutive or after 2017. Any combination of five previous years would satisfy the test”. The test will also account for businesses’ that are seasonal, such that the test will apply to the seasonal period

Finally, the CRA says “To provide greater certainty (but without limiting the generality of the test), an individual who works an average of 20 hours per week during the part of the year that a business operates will be deemed to be actively engaged on a regular, continuous and substantial basis for the year. If an individual does not meet the 20-hour threshold, then it will be a question of fact as to whether the individual was actively engaged in the business on a regular, continuous and substantial basis. However, even if an individual aged 25 or older does not meet the regular, continuous and substantial threshold, the TOSI will apply to amounts derived from a related business only to the extent that they are unreasonable (i.e., only the unreasonable excess will be subject to the TOSI)”.

This labour test is a fairly clear bright-line test; you must work over 20 hours per week for at least five previous years or you get into a subjective reasonability test that will likely result in most amounts being in excess of reasonability.

The CRA provided some guidance in the materials stating that records such as timesheets, schedules and logbooks will be sufficient to confirm the hours a person worked.

Reasonable Return on Capital Test

There are two tests within this exclusion:

1. Safe Harbour Test

2. Reasonable return test

Safe Harbour Test

Where an individual 18-24 years of age has contributed capital, and does not qualify for the excluded share or excluded business exclusions, they may still qualify for a “safe harbor exemption” (No that does not mean you take your money and hide it in a safe harbor in the Turks and Caicos).

It means that you will be provided an exclusion from TOSI income to the extent of your capital contribution x a prescribed rate (currently only 1%). i.e. If you contribute $100,000, you multiply the $100,000 x 1%=$1,000 and you can exclude $1,000. To be a blunt bean counter, this exclusion is pretty much useless, since a) The reality is that in probably 95% of the cases, most shareholders only contribute $100 or less to purchase their shares and b) as noted above, the low prescribed rate means even if you did contribute a fair bit of capital, such as $100k, your exclusion is still a meager $1,000.

Reasonable Return Test

For those 25 years of age and older, this very subjective test says that a reasonableness test is to be applied to such factors as:

• Work performed 
• Risks assumed by the individual in the business 
• Any other factors that may be relevant

Your guess is as good as mine as to how this would be applied. Consider Mr. A who is a shareholder and works full time in his business. His daughter also a shareholder, is a computer science student who comes up with a software application that leads to over one million dollars in new revenue for the business. What is her "reasonable" entitlement to dividends?

Retirement and Inheritance

The initial drafting of the proposals appeared to have inadvertently caused the TOSI rules to apply to retired private corporation owners and Canadians who had inherited private corporation shares. The new proposals have addressed these concerns.

The new TOSI rules provide the following exemptions:

1. Where an active owner-manager (someone who met the labour contribution rules) reaches age 65, the TOSI rules will not apply to their spouse (no matter their age). Note: these rules do not mean you can split your dividends like you do your pension income. They only allow you to pay dividends to your spouse who is not excluded by any of the provisions and avoid the TOSI rules where you are 65 or over.

2. If you are over 18 and inherit shares in a private corporation from someone who met the TOSI one of the TOSI exclusions, those shares will continue to be excluded.

Salary

The new rules do not apply to salary. However, there has always been a reasonableness test for salaries paid to family members vis a vie what would you pay an arm’s length persons and that rule will still apply.

Prescribed loans

The new rules do not appear to prevent the use of prescribed loans where you purchase public securities. See this blog and speak to your advisor about whether this strategy would be advisable for your situation.

At this time, I am not entirely comfortable answering questions on these proposals, until we have further clarity. So, if you ask a question or provide a comment on this post, I may not answer the question or will couch the answer. So please don’t expect definitive answers if you ask a question.

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.

Tax Planning Using Private Corporations - The New Liberal Proposals

I am going to set aside my summer "Best of The Blunt Bean Counter" series for one week, to provide my comments on the new tax proposals for private corporations set forth by the Liberal government last week.

Tax Planning Using Private Corporations - The New Liberal Proposals

On July 18th, Finance Minister Bill Morneau released a consultation paper and related draft legislation proposing changes to how private corporations will be taxed moving forward in the name of tax fairness. I would suggest most private business owners and professionals using PC's in particular (the government seems to take umbrage with professionals) are going to be very upset by these proposals.

Fairness is subject to personal interpretation. I could argue it is not fair government workers get gold plated pension plans while the rest of us have no company plans or restricted defined contribution plans and need to save for retirement through RRSPs and TFSAs. I could also argue that is not fair entrepreneurs who risk their life savings will now under these proposals end up tax neutral with their employees who take no risk. Rant over, let's get to the proposals

Income Splitting

Many private business owners pay salaries to family members and have structures where family members own shares. The government is proposing that effective for 2018 and later, any salaries or dividends paid to a spouse or child regardless of age (currently there are kiddie tax rules for children under 18) will be subject to a reasonableness provision (what an arms-length person would be paid) and any remuneration in excess of the reasonable amount will now be taxed at the top marginal personal rates of the parent. How the government will determine reasonableness is a good question. In any event, income splitting will be severely curtailed

Some specific reasonableness proposals include:

1. Determination of labour contributions by children. The rules will be different for those 18-24 than for those are 25.

2. Review of capital contributed to the business. Again based on age bracket tests.

These rules will significantly change how many families remunerate the family unit.

In addition to restricting salaries and dividends, the proposals will also restrict the use and multiplication of the capital gains exemption ($835,716 for 2017). Children under 18 will no longer qualify for the LCGE ("Lifetime Capital Gains Exemption") and for other family members that were subject to the reasonableness provisions; the LCGE will be restricted or eliminated.

Capital gains allocated out of a family trust will now generally not be eligible for the LCGE.

These rules will be effective for 2018, however, transitional rules are being proposed.

Passive Investments in Corporations

Currently if a corporation earns less than $500,000 the company pays tax at 15.5% in Ontario and a similar amount in each province. This results in a tax deferral, not a tax saving of up to 38%. This deferral provides corporations money to grow and invest and create jobs. The government is concerned that where this money is not used to grow the company but invested passively in GIC's stocks, others companies, real estate, etc. it is unfair when compared to a salaried person. The government is proposing to now tax this 38% deferral.

The proposals of how to do this are beyond complicated and I really don't understand the concern here (the government is asking for feedback to determine to how best implement this, thus, there is no timeline on these provisions as of yet). This is a tax deferral on risk capital and not an absolute tax saving. As per my various posts on whether to use a RRSP or leave the money in your corporation, many small biz owners are leaving money in their corporations and using this money to fund their retirement; so this will have a huge impact on many people.

Converting income into capital gains

The proposals include various provisions to prevent income from being converted into capital gains. I have no issue with this general provision as much of the planning is a pure tax play. However, as of now, some tax commentators suggest the proposals appear to have potentially created possible double tax on death where standard "pipeline planning" is undertaken. Essentially where the estate would have had a capital gain, that gain may become a dividend which is taxed 15-20% higher than the capital gain. Many private business owners have purchased insurance to cover their estate tax and the insurance may now be insufficient.These measures will be effective as of July 18, 2017.

What Now?

The proposals are very complex and I have simplified them for discussion purposes above. We need to see the final legislation after the consultation period and work through the implications before definitive answers and planning can be undertaken.

That being said, will you have to close down or wind-up your private corporation or professional corporations or wind up your family trust?

My preliminary thoughts are if your corporation has large retained earnings there would be a significant tax cost to wind up your corporation and thus you would likely still maintain the company (I say this because it appears the proposals will not impact prior earnings and/ or prior refundable taxes earned and thus, these retained earnings would not be subject to the potentially punitive rules). If your company's retained earnings are not significant, the answer will be less obvious and there will be other issues to consider such as asset protection and the adjusted cost base of partnership interests for professional corporations etc.

While new corporations will not have the same income splitting and tax deferral benefits, they will still likely make sense for asset protection purposes and if you may be able to access even one LCGE exemption and /or you will be using profits to invest back in the business and not for passive purposes.

The incorporation of new professional corporations likely will no longer make sense for tax deferral purposes if all the PC income is taxed at the highest marginal rate, but they may still make sense for other reasons, but I would expect their use to be curtailed.

Family Trusts will likely continue to make sense for ownership and estate planning purposes but may no longer be useful for tax only purposes

It is too early to definitively answer any of the above questions, but those are my initial thoughts.

In conclusion, the impact of these proposals is potentially massive. This is in essence a regime change and not a tinkering of the current rules. Unfortunately, I don't think most small business owners have any idea what is about to hit them in the next few months.

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.

The Ontario Retirement Pension Plan - Who is Self-employed?

The consultation paper on the Ontario Retirement Pension Plan (ORPP) has been released. You can read it here.

One of the most significant groups excluded from the ORPP are self-employed people. In the initial announcement it was unclear who was considered self-employed. Was it a sole proprietor? Was it a corporation with sole shareholder or was it a professional corporation, or was it all of the above?

These questions have been addressed in the consultation paper and essentially, you are considered self-employed if you operate an unincorporated business or are the shareholder of a corporation and

only receive dividends as remuneration.

Who Are the Self-Employed?

 

For purposes of the ORPP, the paper states that self-employed individuals not eligible to participate in the ORPP would refer only to individuals who either:

1. own and operate unincorporated businesses (i.e., sole proprietors, partnerships and some independent contractors); or

2. own and operate incorporated businesses but are not employees and do not receive a salary or wages as compensation (e.g., an individual who receives distributions from the corporation that are not considered salary or wages, such as dividends).

“By contrast, an individual who owns and operates an incorporated business and earns a salary or wages as an employee of the business would not be considered self-employed for the purposes of ORPP eligibility. As a result, these incorporated owner-operators would be required to participate in the ORPP, to the extent that they are considered eligible employees.”

The report states that according to Statistics Canada, “On average, incorporated owner-operators receive two-thirds of their annual income from wages and salaries. In the event that these individuals receive other types of income (e.g., dividends), they would not make contributions to the ORPP on this other income.”

Unique Status of the Self-Employed

 

The report notes that the self-employed occupy a unique position in the labour market, in that their income can fluctuate year to year, and that self-employed individuals may feel that it is more prudent to invest in their business, rather than contribute to a mandatory savings plan.

Notwithstanding the above, the report notes that “evidence suggests that self-employed individuals may also be undersaving for retirement. In fact, research indicates that self-employed individuals are less likely to be financially prepared for retirement when compared with paid employees.”

Submissions

 

The report states that “although the self-employed under current ITA rules would not be able to enrol in and make contributions to the ORPP, there may be interest among self-employed individuals in participating in the ORPP, as they do in the CPP. Ontario could engage in discussions with the Government of Canada to amend the relevant ITA rules to allow individuals who are not in an employment relationship and who do not report income from salary and wages to participate in the ORPP, as is the case with the CPP.”

As someone who operates through a professional corporation, I am not that keen to make an employee and employer contribution to the plan; however, other self-employed individuals may feel the ORPP would help supplement their retirement income and would welcome the opportunity to have the option to be part of the plan.

If you are self-employed and wish to make a submission or comment, you can do so at: ORPP@ontario.ca.

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.