The Best of The Blunt Bean Counter - Capital Dividends - A Tax-Free Withdrawal from your Company

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game (which is not going well by the way, as my handicap has gone up 3 strokes since the beginning of the year). Notwithstanding my handicap increase, I just came back from an awesome trip to Cabot Links. The picture below of the 16th hole at Cabot Cliffs is a bit deceiving since the tee is actually to the left and further up, but it is a blind shot to a two tier green so no day in the park. Plus, when the wind blows it is crazy. The first day with no wind I actually hit to within 15 feet of the pin, the next day with huge winds I aimed ten yards out to the ocean and the ball still blew left of the green, pretty crazy.

Anyways, back to the topic at hand. Next week I start a three-part series on cottages, but today, I am re-posting a March 2015 post that discussed how small corporate business owners can take advantage of the Capital Dividend Account ("CDA"). Given I had over 80 comments, it was of definite interest.

As per my post last week, Tax Planning Using Private Corporations - The New Liberal Proposals there may be future tax changes that impact the CDA. However, at this time, I cannot state with any certainty how those changes may impact the CDA account. 

Capital Dividends - A Tax-Free Withdrawal from your Company

If you are a private corporate business owner, you may be sitting on a treasure trove of tax-free money. Yes, I said tax-free money. The source of these “free” funds is the CDA, which I discuss in greater detail below. Although a CDA account is most often found in holding/investment companies, the largest accounts are often generated in active companies who have sold all or part of their business.

Private business owners often discuss with their professional advisors whether they should take salary and/or dividends, which are both taxable to the owner when paid. However, surprisingly, the possibility of paying a tax-free dividend is often overlooked, which is possible if the dividend is paid from the Capital Dividend Account (“CDA”) of a private corporation to a Canadian resident individual.

The Capital Dividend Account

The CDA tracks certain amounts that are not taxable to the Company and may be distributed to shareholders with no personal tax. For example:

(i) if the company earns a capital gain which is 50% taxable, the half that is not taxable is added to the CDA.

(ii) if the company was paid a capital dividend from another company it invested in, that amount is not taxable and is added to the CDA.

(iii) if the company sells a particular eligible capital property (“ECP”) in the year, the portion of the gain that is not taxable is added to the CDA. Please note that the addition to the CDA occurs at the end of the year in which the sale of the ECP took place. As a result, the CDA cannot be paid out tax-free until the first moment of the following taxation year (there have been significant changes to the ECP rules since I wrote this post, please speak to your accountant. For reference, I wrote this blog post on the changes).

(iv) if the company receives proceeds from a life insurance policy which are considered to be non-taxable, this is added to the CDA.

(v) if the company incurs a capital loss, 50% of such amount that will not be deductible in the current or future years against capital gains and will reduce the CDA.

Filing and Declaring a Capital Dividend

The following are the filing procedures and considerations as to the timing of declaring a capital dividend:

i) For the dividend to be tax-free, the company needs to make an election on Form T2054 - Election for a Capital Dividend Under Subsection 83(2), which is due to be filed with the Canada Revenue Agency on or before the earlier of the day that the dividend is paid or becomes payable.

A certified copy of the Director(s) resolution authorizing the capital dividend and a detailed calculation of the CDA at the earlier of the date the capital dividend is paid or becomes payable must accompany the Form T2054.

If the Form T2054 and attachments are filed late, a penalty will arise.

ii) If the Canada Revenue Agency reviews the election and determines that the capital dividend paid (or declared) was too high, then a penalty, equal to 3/5 of the excess of dividend over the CDA balance available, will arise.

It is possible to avoid such penalty if an election is made to treat the excess portion as a taxable dividend at the time it is paid, and such election is filed within 90 days after the date of the notice of assessment in respect of the tax on the excess, noted above.

To avoid these negative consequences, it is important to properly calculate the CDA.

iii) The CDA is a cumulative account from the date of incorporation (assuming it has always been a private corporation). If the company has not previously filed a Form T2054, it will be necessary to review the historical capital gains and losses and corporate activities from the date of incorporation to the date of the dividend in order to determine the correct CDA balance.

iiii) The CDA is paid at a moment in time. If you have a CDA balance but incur a loss the next day, your CDA balance is reduced. Thus, in general, it is prudent to pay a CDA dividend when the account reaches a material amount (this amount is different to each person) so that you do not take the risk of a capital loss reducing the balance in the account. If you pay a capital dividend and then incur a capital loss, the account can go negative.

Further analysis may be required for any non-resident shareholders, since a payment from the CDA to a non-resident of Canada is subject to non-resident withholding tax and the dividend may be taxable in their country of residence.

Journal Entries

Some companies reflect capital dividends by adjusting journal entry (“AJE”), rather than paying the actual dividend. Where the dividend is paid by AJE, the shareholder loan is credited. This creates a tax-free loan owing from the company to the shareholder. The CRA has stated that an AJE on its own does not constitute payment of the funds and that a demand promissory note accepted by the recipient as absolute payment together with an indication of such an intention in the resolutions is at a minimum required to have the dividend considered paid and received.

Balance Determination

Where a company has had more than one accountant and/or has amalgamated with other corporations in the past, the determination of the CDA can be problematic. The CRA now allows you to file Schedule 89 to help your verify the account. Note, they may only verify part of the years, so for older companies, this may still be problematic.

Speak with your accountant to see if your private company has a CDA balance. If so, paying out a capital dividend should be considered as part of your Company’s overall remuneration strategy.

 

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 Federal Budget - Where is the Incentive For Success and Entrepreneurship?

Last Wednesday’s federal budget was pretty benign. Personal tax rates did not rise to 60% and the capital gains inclusion rate remained unchanged. However, many professionals, in particular accountants and lawyers, suffered a direct hit. The budget proposes that certain professionals must now pay tax on income they have not billed, by including work in progress in their taxable income. Small business owners escaped unscathed from this budget, but there are storm clouds on the horizon, as there could be some very punitive tax measures coming in the near term. 

If you wish to read a detailed summary of the budget, here is a link to BDO Canada's budget summary. However, for the purposes of today's post, I am just going to discuss the budgets impact on professionals and the warning shot sent across the bow of small business owners.

Let me state upfront, that I am of the view that government policy should not be to punish success and those willing to take risk (i.e. the so called top 1%, but probably the top 5-15%) but to encourage success and entrepreneurship. My view, which I will readily admit may be distorted because of my job and the high-net-worth individuals I deal with, is that small business owners and entrepreneurs (which in many cases includes professionals) are the largest creators of jobs for the “middle class”. Most prosperous people have risked much to achieve their success, in both financial capital and family time. They feel they deserve to be rewarded for that success, not penalized; which if I read the Liberal tea leaves correctly, is what is going to happen in the very near future. 

Professionals – A Change in Income Recognition – Billed Basis to WIP Basis

Currently certain professionals (accountants, dentists, lawyers, medical doctors, veterinarians and chiropractors) may elect to exclude the value of work in progress (WIP) pursuant to Section 34 of the Income Tax Act. This allows professionals to essentially recognize income for tax purposes only when it is actually billed (billed basis). The budget proposes that going forward, professionals will no longer be eligible for a Section 34 WIP deduction and will have to recognize income when services have been provided, even if not billed. The legislation provides a two-year transition period.

So in English. Let’s say I am doing some estate planning for Mary Smith. Mary engaged me to start the planning in November, 2016 and I spent $5,000 of time in November and December gathering information, corresponding with her estate lawyer and researching her issues. 

For accounting purposes, I must include the $5,000 of time I have spent on the file in my 2016 income under generally accepted accounting principles (accrual accounting). However, currently, I can elect under the aforementioned Section 34 to deduct the $5,000 of WIP from my 2016 taxable income since I have not yet billed Ms. Smith. Thus, for tax purposes my income in relation to Ms. Smith is nil. It should be noted that some professional firms have not even bothered recording their WIP, since it would net out with the offsetting Section 34 deduction. These firms will now be forced to change their reporting systems, so they can capture WIP. 

Back to my example. Let’s say I need to spend $2,000 more in time to finish the project in January, 2017 and finally get around to billing the client $7,000 in February, 2017. But Ms. Smith is one tough cookie. First she waits until March and calls me to argue about my bill and wears me down, so I reduce her fee to $6,000. She then takes three months to pay me so I finally receive $6,000 in June, 2017. 

Under current tax law, other than the fact she is a bit of a pain in the butt, I don’t really care about all this since I will pay tax on the $6,000 in 2017 and have the money in hand. 

Under the proposed rules, I will have to include in my 2016 income up to $5,000 of WIP even though I have not yet billed the client and I am not paid until June of the following year. I will thus potentially have a significant cash flow issue. I have to pay tax on money I have not yet billed and collected. Part of the government’s rationale for this proposed legislation is that professionals expense the costs of their WIP in the current year. While that is a fair concern to some extent, those costs are actually paid in the year, so expenses are being matched to payment, while the new legislation does not match billing to income inclusion.

I have been asked if contingent or success based fees could be considered WIP. I don't have an answer at this time; this will need to be clarified by the CRA.

Many professionals have used this WIP deduction to defer their current tax burden to their retirement years when their tax rates are lower. This will no longer be available.

Transitional Rules

In addition to the future cash flow issue discussed in my example above, professionals will face a short-term cash flow issue in that their current Section 34 WIP will be taxed over the next couple years, causing significant and unexpected increases to taxable income for which they had not expected to pay tax.

For the first taxation year that begins after March 22, 2017, in computing income, the budget proposes that 50% of the lesser of the cost of the WIP and its fair market value will be allowed as a deduction. For subsequent taxation years, 100% of the lesser of the cost of WIP and its fair market value will be required to be included in income. For professionals with December 31st year ends, these income inclusions will come in their December 2018 and 2019 year-ends. This additional tax comes on the heel of the increase in marginal rates to 54% further exacerbating the issue.

For those wondering what exactly is the cost of WIP, that is a good question, still to be determined. In the old days, a billable hour was set based on the formula of  1/3 salary, 1/3 overhead and 1/3 profit. So is the cost of WIP under this old school calculation the 1/3 salary, 2/3 salary and overhead or some other variation? That does not even consider the significant historical discount firms take on their WIP, anywhere from 10-30%.

Tax Planning Using Private Corporations

The budget discussion highlighted several tax planning strategies using private corporations, which the government feels can result in high income individuals gaining unfair tax advantages that are not available to other Canadians. The government is reviewing these areas and will be releasing a paper in the upcoming months setting out these issues in more detail and their policy responses. Every small business owner should be concerned significant changes are coming in respect of many of the standard current tax planning strategies they utilize.

The budget specifically noted the Liberals are reviewing the following strategies:

“Sprinkling income using private corporations, which can reduce income taxes by causing income that would otherwise be realized by an individual facing a high personal income tax rate to instead be realized (e.g., via dividends or capital gains) by family members who are subject to lower personal tax rates (or who may not be taxable at all)”. 

I interpret the above to mean the government will be reviewing family trusts and the use of discretionary dividends amongst other tax planning strategies.

“Holding a passive investment portfolio inside a private corporation, which may be financially advantageous for owners of private corporations compared to otherwise similar investors. This is mainly due to the fact that corporate income tax rates, which are generally much lower than personal rates, facilitate accumulation of earnings that can be invested in a passive portfolio”. 

This discussion point is very disconcerting. I interpret this to mean that the Liberals are not only going to review the use and availability of the small business deduction which has been rumored from day one, but they are even going to look at the after-tax earnings and the use of holding companies.

It should be noted there is no tax advantage to having an investment portfolio inside a corporation. The issue is that if a small business makes $10,000 from its active business activities, it would only pay $1,500 in corporate income tax and have $8,500 to invest, whereas a middle class Canadian would only have only say $6,000 to $7,500 to invest depending upon their income and marginal tax rate.

“Converting a private corporation’s regular income into capital gains, which can reduce income taxes by taking advantage of the lower tax rates on capital gains. Income is normally paid out of a private corporation in the form of salary or dividends to the principals, who are taxed at the recipient’s personal income tax rate (subject to a tax credit for dividends reflecting the corporate tax presumed to have been paid). In contrast, only one-half of capital gains are included in income, resulting in a significantly lower tax rate on income that is converted from dividends to capital gains”.

There is some planning that goes on along these lines, but I don’t see this as a major issue for the vast majority of small business owners.

Associated Companies

The government is proposing to change the rules regarding association such that if you have one corporation owned legally by one spouse and another legally by another spouse, they may become associated because they are factually controlled by one spouse. As result, instead of each corporation having a small business deduction, both the husband and wife’s corporation may have to share one small business deduction. 

Government’s Objective

In the budget paper, the government said it “will ensure that corporations that contribute to job creation and economic growth by actively investing in their business continue to benefit from a highly competitive tax regime”. How it intends to do this is the $64,000 question. My concern is that you risk shrinking the middle class that the government is so keen on helping, if you de-incentivize small business owners and entrepreneurs to take the personal and capital risks needed to start new companies and invest in new ones. I can tell you I already have significant negative feedback from my clients who have to pay 54% tax; if you also remove their ability to income split and small business tax preferences, my personal opinion is you will have a disenfranchised a segment of the population that like it or not, is a large part of the engine behind the economy.  

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.

What Small Business Owners Need to Know - Intercorporate Dividends are not Necessarily Tax-Free Anymore

For many years, it has been standard tax planning to pay any excess cash from your operating company (“Opco”) as a dividend to your holding company (“Holdco”) for asset protection, retirement planning or other investment or business reasons. Where your Holdco is connected to your Opco (in general terms, Holdco is connected where it owns more than 10% of the votes and value of Opco), those dividends will flow tax-free to your Holdco. Where Opco has refundable dividend tax on hand, a dividend paid to Holdco can trigger Part IV tax; so speak to your accountant first.

[Note: As discussed in my blog post the Capital Gains Exemption is Not a Gimme, you may not always want your Opco to be owned directly by your Holdco].

The government became concerned taxpayers were utilizing the tax-free nature of intercorporate dividends to defer or reduce capital gains tax, especially prior to the sale of a business. Thus, the 2015 Federal budget introduced anti-avoidance rules (draft legislation was released in July, 2015 with request for comments) effective for dividends received by a corporation on or after April 21, 2015. These anti-avoidance rules have caused uncertainty in respect to the payment of what were prior to the budget, tax-free intercorporate dividends.

Currently there are “capital gains stripping " anti-avoidance rules contained in Section 55 of the Income Tax Act. These rules have been in place for years and generally are only problematic where there is a contemplated or actual sale to an arm’s length person and the payment of a dividend and an ownership change are part of the same series of transactions. These rules are very complex, but in basic terms, dividends can be paid tax-free to the extent the corporation has what is known as “safe income”, which in simplistic terms is essentially income earned by the corporation after tax. To the extent the corporation does not have safe income, the dividend in whole or part will be converted to a capital gain.

The new rules are broad and now not only catch the arm’s length sales noted in the prior paragraph, but will now capture dividends for which the purpose of the dividend “is to significantly reduce the value of the share”. This is why the new rules are troublesome. When is the standard dividend planning noted in the first paragraph, a dividend to reduce the value of a corporation’s shares?

The rules leave taxpayers and their advisors in the positions of needing to prove that the significant reduction of value that obviously occurs when the operating company pays excess cash to its Holdco is not the intended purpose of the dividend. The issue is more vexing when you consider that often the reduction of the value of Opco was intended, but was not done for tax purposes, but for business or investing purposes.

We are left with uncertainty where large dividends are paid to a holding company, including where the dividend was paid for asset protection purposes and then loaned back to the Opco. The CRA has stated that “lumpy dividends” (large one-time payments) may be considered to have been paid to reduce the value of a share, which is disconcerting.

There are other concerns including stock dividends, but they are beyond the scope of this blog post.

You should discuss with your accountant whether intercorporate dividends should be deferred until there is further clarity in respect of the legislation or whether it is prudent to undertake a calculation of safe income (which are expensive and time consuming) prior to paying a dividend, even if not in contemplation of a sale.

To reflect how much uncertainty and confusion there is with these rules; I am going to have a double disclaimer today. In addition to my usual disclaimer at the bottom of my post, I will again inform you; do not act on any of the general information in this blog post without discussing the issue with your accountant.

I will also not address or answer any of the comments and questions on this post, because of the uncertainty of the rules.

Small Business Owners - Get on my Mailing List

If you are an owner-manager and/or a shareholder in a corporation and would like to be on my corporate mailing list, please email me at bluntbeancounter@gmail.com

I will be sending out specific mailings on matters of importance to small business owners and I am considering, depending upon the interest, holding a roundtable for small business owners who are in the Toronto area.

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.

Thanks for Reading

Last week I passed two million page views on my blog! Considering my topic area and the fact I write at most once a week, I am very proud of this accomplishment. I would like to thank you; my readers for helping me achieve this milestone.

Over the next couple months, I am going to try an experiment. Starting tomorrow, and then every second week, I am going to write blog posts under the heading "What Small Business Owners Need to Know". In these posts I will discuss topics such as inter-corporate dividends, corporate-owned life insurance, shareholder agreements and succession planning ("One Day You Will Sell the Business").

While these topics will be of greater interest to owners of small businesses, some of them, such as the post on life insurance will have a personal component; so you may want to at least scan through these, even if you are not a small business owner.

In the weeks I am not posting about small business issues, I have a couple blogs that deal with personal and estate issues for which I have high expectations. I will keep you in suspense on these, since there have been a few times when I or a guest poster have written a blog post I consider "excellent" and they turn out to be duds. While others times, I have written about what in my opinion are rather pedestrian topics and they turn out to be very popular blogs. So we will see if you share my opinion once these blogs are posted.

Until tomorrow... when I discuss how Intercorporate Dividends – Are Not Necessarily Tax-Free Anymore.

The Best of The Blunt Bean Counter - Estate Freeze - A Tax Solution for the Succession of a Small Business

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a June, 2014 blog post on Estate Freezes. If this topic interests you, there were two follow-up posts based on noted author Tom Deans, that suggest an Estate Freeze could be the wrong solution for family succession and a discussion of some vital issues when transferring a family business.

Estate Freeze – A Tax Solution for the Succession of a Small Business

Winston Churchill once said, “Let our advance worrying, become advance thinking and planning.” Small business owners often worry about their exit strategy and/or succession plan. They may also be concerned about what would happen to their business if they have a health scare or receive an ultimatum from a child working in their business. Often a small business owner’s worry becomes their anxiety, instead of their advanced planning.

As a small business owner, at the end of the day, there are essentially only two exit strategy/succession options you need to plan and/or consider:

(1) A sale of your business, typically to a competitor, sometimes to current management or very infrequently, an actual sale to a child or other family member; or

(2) A transfer of the business to your children without a sale (for purposes of this article I will refer to this option as an “estate freeze”).

My blog post today discusses estate freezes. How you can transfer your business tax-free to a successor (typically your children, sometimes to existing management) while continuing to control and receive remuneration from your business.

As noted in the links in the first paragraph, Tom Deans the author of Every Family's Business (the bestselling family business book of all-time) believes a business should in most cases be sold and never handed over to the next generation (such as done with an estate freeze) without the parent(s) adequately being compensated for the business, including their children.

What is an Estate Freeze?

The most tax efficient manner to transfer your business to your children is to undertake an estate freeze. An estate freeze allows your child(ren) to carry on your business, while at the same time you receive shares worth the current value of your business. In addition, once your share value is locked-in, your future income tax liability in respect of your company’s shares is fixed and can only decrease. Keep in mind that when you freeze the value of your company you are not receiving any monies for your shares at that time. There may be ways to monetize that value in the future, but on an estate freeze, you typically only receive shares of value, not cash.

The key risk in any estate freeze is that your children may partially or fully devalue these shares and your company. So while an estate freeze may be the most tax efficient way to transfer your business, it may not be the best decision from an economic or monetization perspective. 

In a typical estate freeze, you exchange your common shares of your corporation on a tax-free basis for preferred shares that have a permanent value (“frozen value”) equal to the common shares’ fair market value (“FMV”) at the time of the freeze. Subsequently, a successor or successors, say your children or family trust can subscribe for new common shares of the corporation for a nominal amount.

This concept is best explained with an example. Assume Mr. A has an incorporated business worth $3,000,000 and wants to undertake an estate freeze. In the course of the freeze, Mr. A is issued new preferred shares worth $3,000,000 and his children or a family trust subscribes for new common shares for nominal consideration. Mr. A’s tax liability in relation to these shares on death, is now fixed at approximately $750,000 in Ontario at the high rate. Often, a key aspect of an estate freeze is a plan to reduce the tax liability by redeeming the preferred shares on a year by year basis as discussed below.

If you have access to your lifetime capital gains exemption (currently at $813,600 but indexed for inflation), your income tax liability may be reduced when the shares are eventually sold or upon your death if you still own them at that time. Finally, you may choose to crystallize your exemption when you freeze the shares.

The preferred shares received on the freeze can be created such that they allow you to maintain voting control of your corporation until you are satisfied your child(ren), is(are) running the company in the manner you desire. This maybe a double-edged sword, as you may tend to hold onto control long after your successors have proven themselves. This may become a contentious issue.

Preferred shares can also serve as a source of retirement income. Typically what is done is that your preferred shares are redeemed gradually. So, for example, if you need $100,000 before tax a year to live, you can redeem $100,000 of your preferred shares each year. Let’s say you live 20 years and redeem a $100,000 a year. By the time of your death, you will have redeemed $2,000,000 ($100,000 x 20 years) of your preferred shares and they will now only be worth $1,000,000 ($3,000,000 original value less $2,000,000) at your death. Your income tax liability on these shares at the time of your death will now only be approximately $250,000.

The Benefits of an Estate Freeze

1. On death (something we should all be planning for), an individual is subject to a deemed disposition (i.e. a sale) on all of his/her assets at FMV, which would include his/her shares of the business. An estate freeze sets your maximum income tax liability upon this deemed sale and as discussed above, this liability can be lowered over the years by redeeming the shares.

2. Family members will be able to become shareholders of the business at a minimal cost and be motivated to build the business (although Tom Deans would dispute this assertion).

3. Instead of having children directly subscribe for new common shares, you can create a discretionary family trust to hold the common shares. Every year, the corporation can pay dividends to the family trust which can then allocate the dividends to family members with lower marginal tax rates. This mechanism allows for great income splitting opportunities.

4. On the eventual sale of the business, the children or family trust may realize a significant capital gain. Assuming that the business qualifies for the capital gains exemption, the family trust can allocate this capital gain to each beneficiary who may be able to use his/her own lifetime capital gains exemption limit to shield $813,600 or more of capital gains from income tax.

One of the more critical aspects of an estate freeze is the determination of the fair market value ("FMV") of your business. In order to ensure that an estate freeze proceeds as smoothly as possible, the FMV of the company must be calculated. In the event that the FMV determined is challenged by the Canada Revenue Agency (the “CRA”) the attributes of the preferred shares will have a purchase price adjustment clause that will let the freezer reset the FMV. The CRA has stated in the past that they will generally accept the use of a purchase price adjustment clause if a “reasonable attempt” has been made in valuing the company. Engaging a third party independent Chartered Business Valuator to prepare a valuation report is generally accepted as a “reasonable attempt” in estimating the FMV.

Issues to Consider Before Implementing an Estate Freeze

An estate freeze does not make sense for all business owners. While the above benefits do sound very enticing, it depends on each owner’s personal circumstances. Issues to be considered include:

1. Are you relying on the value of the company to fund your retirement? If so, it may be best to sell and ensure you have a secure retirement.

2. Do you have an identified successor, i.e. child, able and willing to work in your business?

3. Can you bring one child into the business without creating a dispute amongst your children?

4. Are your children married and how may a divorce or separation impact the business?

Long-time readers of my blog will know that I am a proponent of family discussions and getting over the money taboo. I cannot overstate the importance of having a detailed discussion with your family if you plan to hand your business over to one or more of your children. If you pass that hurdle, you must speak with your accountant and lawyer to ensure you understand the implications of the freeze and how to properly implement the corporate restructuring. Finally, your tax advisor will want to structure the freeze such that it can be “thawed” if the business suffers a setback due to the economy, or your child(ren) prove incapable of running the company.

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.

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