There’s been a constant theme throughout the previous federal budgets to focus on high-net-worth individuals and certain corporations to beef up their tax revenue base. Although there have been rumours of potential increases to the capital gains inclusion rate from its current level of 50%, and changes to certain tax planning strategies, up until the latest budget, the status quo remains in place for most. One such strategy is the Capital Gains Surplus Strip (CGSS). This strategy has been and continues to be promoted by accountants to their ideal business owner clientele to extract funds out of a successful business tax-efficiently. Sound familiar! We as advisors often tout the benefits of corporately owned permanent life insurance as a method of extracting funds virtually tax-free via the use of the capital dividend account. On the surface, it seems like we may have competing opinions as to what’s the best course of action for the client. So, which one is better? Like almost everything else I write about, the answer is it DEPENDS! In this article, I hope to give you the tools required to help navigate this perceived threat. When all is said and done…you’ll notice it’s not as threatening as you first made it out to be.
What is the Capital Gains Surplus Strip (CGSS) strategy:
In addition to the CGSS, there have been two other methods of extracting corporate funds from the shareholder. They consist of either paying a salary or paying a dividend (see chart #1 below for a sample Ontario client). Since capital gains are taxed preferentially, it’s no surprise that the CGSS produces the best result from an after-tax income perspective. Tax savings range from $158,050 and $201,475 in personal tax, when compared to a non-eligible dividend or a salary method on a $750,000 payout. The CGSS strategy is a very complex transaction that requires sophisticated tax planning and must be done by an experienced tax professional. Although it’s a viable tax planning strategy, the availability may be limited further by the recent revisions made to the Alternative Minimum Tax rules introduced in June 2023.
The mechanics behind this strategy involves setting up a transaction that operates as a sale of shares of a corporation, therefore converting the money received for the sale of those shares into a capital gain. You start by creating a new corporation (which we’ll call “Newco”). Your existing corporation (“Opco”) then goes through a share reorganization where you receive different shares of Opco (i.e., preferred shares with values equal to what you want to strip out with low ACB, and other shares to stay behind). You then sell these preferred shares of Opco to Newco at their fair market value in exchange for a promissory note payable. This transaction triggers a capital gain that you must report on your personal income tax return. Over time, you can use assets from your Opco to repay the note payable to YOU (via Opco paying tax-free inter-corporate dividends to Newco or by combining the two companies).
What’s the BIG DEAL?
The CGSS strategy truly only makes sense if the client NEEDS to extract money from the corporation to support their personal lifestyle goals: such as a personal mortgage, food, kids’ extracurricular activities, and other spending. In addition, the benefits reflected in the tax savings realized, need to outweigh the cost to implement the strategy (legal/accounting fees). These fees can range from as low as $15K to as high as $100K for more complex arrangements. If funds are NOT NEEDED, why trigger any taxes at all, even if it does produce tax savings in comparison to the other alternatives (paying a dividend and/or salary)? You may recall from another article I wrote in June 2023 (titled: “The Corporation as an effective tax planning tool”), where I stressed that the goal of every business owner should be to only extract enough funds from their corporation to reflect the amount of what’s needed to support their personal lifestyle goals…NOTHING MORE AND NOTHING LESS! Once the funds are extracted, you’ve lost the benefits that tax deferral can provide over time.
Case study:
Here's an example assuming the business owner doesn’t need the money to support their short to mid-term lifestyle goals. Female age 63 non-smoker has currently $750,000 trapped surplus in the corporation. Her accountant suggested the idea of surplus stripping as means to lower her tax bill. She came to us to discuss this and other available options. Upon further analysis, we confirmed that the funds were not needed to support her lifestyle goals. She had a dual objective: 1) to leave money to her kids/grandkids and 2) to keep the money liquid as a potential secondary source of income to supplement her retirement, while lowering her overall tax bill. We suggested permanent whole life insurance with cash values. Let’s look!
As you can see, the capital gains surplus strip (CGSS) strategy triggers an immediate tax bill of roughly $200,000. This already puts her behind, as she only has $550,000 to invest personally (less once we factor in the cost to implement the strategy). Leaving the $750,000 in the corporation and redirecting the funds from a taxable investment to a non-taxable permanent life insurance, over 10 years, we’ve been able to demonstrate the added value it produces net to the estate. We’ve also been able to transform the tax deferral advantage of leaving the money in the corporation from a temporary status (if money is invested in traditional investments), to a permanent one (using life insurance) via the use of the capital dividend account.
Next time your client (or their accountant) tells you they have a strategy in place to extract funds tax efficiently from the corporation, you’ll be better equipped to respond.
Tony Gallippi, B.A.S (Hons.) CFP CLU
Director, Advanced Planning, Insurance
QFS
This communication reflects the views of Qualified Financial Services Inc. as of the date published. The information in this publication is for general information purposes only and is not to be construed as providing individual legal, tax, financial or other professional advice. Qualified Financial Services Inc. assumes no responsibility for any errors or omissions in the information contained herein nor for any reliance placed on such information. Please seek independent professional advice before making any decisions.
