Although business owners have a few good reasons to incorporate: creditor protection (via limited liability to protect personal assets from corporate creditors), access to the capital gains exemption, and access to low tax rates, there’s none more misunderstood or often overlooked than the tax deferral opportunity on profits. I’m reminded of this because of a recent case I was involved in that required us to, once again, showcase the power of this tax deferral opportunity. I touched upon this briefly in my last article, (Passive Income Rules” posted in April 2023), but I feel more of a deep dive is needed to hit home the message. This recent case will not only highlight the benefits of tax deferral but take a step further and show you how to make the tax deferral “PERMANENT” through life insurance.
The Corporation and You: Sample Script
Before we get into the case study, here’s a sample script you can use with your clients/prospects to display the benefits of using their corporation as an effective tax planning tool. This can be illustrated on a napkin or generated on a PowerPoint slide (with boxes, arrows, and yes, animations).
“As an incorporated business owner, there are two separate entities you need to focus on when it comes to paying taxes. One is your corporation and the taxes it pays on the active business income it generates. Two, you personally, and the taxes you pay on the income you earn either via salary or dividends. What stands between the corporation and you is a “thin wall” (metaphorically speaking). Any time money passes through this wall, from the corporation to you it triggers a tax. For the purposes of this discussion, let’s assume the highest marginal tax rate on personal income in Ontario at 53.53%. The goal of every business owner should be to limit the amount that passes this “wall” to an amount that simply reflects what’s needed to support your (and your family’s) current lifestyle goals, nothing more and nothing less. Unfortunately, I’m often confronted with business owners that are taking out more than they need. Either to purchase an investment, life insurance, critical illness insurance, and other financial products. Not only is it less expensive to pay for these things corporately (with cheaper after-tax corporate dollars as can be seen in Table #1 below), but if structured properly and the rules as set out by CRA are followed such things as disability insurance and private health savings plan can be tax-deductible to the corporation. Assuming you see the benefit and decide to structure your affairs so that these obligations are funded with corporate dollars instead, this will require you to leave more money in the corporation by default. Unfortunately, this too will trigger taxes. Although, the difference is you are taxed at a MUCH LOWER rate. The first $500,000 of active business income in Ontario is taxed a 12.2% (can be as low as 9% in some provinces). If there’s one thing you take from this discussion is the opportunity to defer taxes. There’s roughly a 41% tax deferral opportunity available. Said differently, for every $100 your corporation earns you can defer up $41 in taxes. The more you’re able to defer, the longer you’re able to defer, the more money you’ll be able to keep for you and your family.”
More on tax deferral opportunity
If the business owner doesn’t need the money to support their personal lifestyle goals it’s best to leave surplus cash generated by the business in the business, to avoid paying more taxes upfront. This will result in the corporation having more money to invest (or buy life insurance). Here’s a quick example of how tax deferral works. Let’s look at this from the perspective of a business owner in Ontario. The highest personal tax rate in this province is 53.53%. By deciding to leave the money in the corporation and since active business income (ABI) less than $500,000 is taxed at 12.2%, there’s a tax deferral opportunity of $41,330 for every $100,000 of ABI in the corporation (up to $500,000 of ABI). Here’s the calculation (53.53%-12.2% = 41.3% X $100,000 ABI = $41,330). If active business income is greater than $500,000 (as was the case in this case study that I’m about to showcase), then the tax deferral is less, but still a significant tax deferral, nonetheless. Active business income above $500,000 is taxed at the general tax rate, which is 26.5% in Ontario. At this level, the tax deferral opportunity is $27,030 for every $100,000 of active business income earned (53.53%-26.5% = 27.03% X $100,000 ABI = $27,030). Grant it, eventually you’ll have to pay the tax when you decide to remove the money from the corporation. But the longer you’re able to hold on to your money, the more you’re able to benefit from its growth. From this perspective, the tax deferral opportunity is really the growth on the assets that are attributable to the deferred tax (See table #3 for numbers)
Case study: “Jack and Jill”
Meet Jack and his wife Jill (46 and 45) young family with 2 kids, 10 and 8 yrs. old. Jack is a lawyer and a partner at a successful law practice (LLP: Limited liability partner) with 6 other partners. Jill is also a lawyer but is employed at one of Canada’s top 10 companies. Some partners at Jack’s firm decided to incorporate (i.e., corporate partners), others like Jack have not for assorted reasons (i.e., individual partners). The combined income net after-tax cash flow between Jack and Jill is roughly $80K/mth or $960K/yr. (Jack’s responsible for 90% of this). As many families in this stage of their lives and income levels, they also support a high standard of living: Big expensive home, big mortgage, saving for a cottage in the Muskoka’s, kids in expensive private school, extracurricular activities for the kids, expensive vacations, etc., etc., etc. Up until now, Jack did not see the benefit of incorporating, since there wasn’t a lot of money left over. Now that the mortgage is under control and a large fund has been set aside for their future cottage, it might be time to revisit this. Jack and Jill believe that their monthly lifestyle budget has stabilized to $47K/mth or $565K/yr. That means, that they really don’t need the balance of $33K/mth (or $396/yr.). Their objective for these funds is long-term in nature (i.e., retirement, estate).
We posed the question to Jack about incorporating so he can have more money to invest. Remember this extra $33K/mth is after-personal taxes (assuming a 53.53% tax rate). Pre-tax to him personally is $71K/mth. If instead, he incorporated, and the corporation received the funds, this $71K/mth pre-tax to the corporation would only be exposed to a tax rate of 26.5% (based on the general tax rate). The reason we landed on 26.5% tax rate instead of the lower 12.2% rate is because all 7 partners of the law firm must equally share the small business deduction limit on the first $500K of ABI. This results in a significantly small portion of partners’ overall annual income being taxed at 12.2%. Therefore, the amount available to invest in the corporation, after-tax is $52K/mth. This represents a tax deferral opportunity of $19K/mth (see chart#2). Imagine what an extra $19K/mth ($52K minus $33K) can do to their long-term plans.
After further discussions, we decided to leave a bit of a buffer for “surprise” lifestyle expenses and only work with roughly half of this disposable income. So, they settled on comparing $15.8K/mth. (or $190K/yr.) after-tax personally, to its after-tax corporate equivalent of $25K/mth. (or $300K/yr.). Let’s see how they stack up assuming 10 annual deposits, applying a 5% growth rate, and comparing the after-tax values to them personally or to the estate in yr. 40. (See table #3). You can see the power of the tax deferral in action. Even though the funds must exit the corporation eventually and therefore be exposed to tax integration, the growth of those tax-deferred funds created a huge boost to them personally (or estate). A boost of over $1.6 million by year 40.
Now, that we’ve established the opportunity for tax deferral by incorporating, we turned the focus on making this tax deferral permanent. Here we discussed redirecting those funds from a taxable investment portfolio within the corporation to a corporately owned permanent life insurance with cash value build-up for potential future income needs (see table#4). Here’s where we see the power of the capital dividend account (CDA) in action. Upon death, a credit to the capital dividend account is created by the life insurance policy which creates a channel for funds to move from the corporation to the estate TAX FREE. This is how we make the tax deferral, permanent. Assuming they don’t touch any of the money during their lifetime, we’ve gone from producing an estate value of $4.3 Mil. (via investing personally), to $5.6 Mil. (via investing corporately), to $17.9 Mil (via a corporately held life insurance). A boost of $13.6 Mil.
What about retirement?
Now let’s focus on using the cash values within the policy to address their potential need to supplement their retirement goals. The cash value of a whole life or universal life insurance policy will accumulate on a tax-deferred basis subject to the condition the policy remains tax-exempt, meaning the cash value remains below the maximum tax actuarial reserve (MTAR) and no partial cash withdrawals or change of ownership occur. So, from the onset: Deposits that go into the policy grow on a tax deferred basis, reducing the corporate tax bill. At a future date (i.e., 10-15yrs), cash values can be used as collateral to access funds without triggering taxes (assuming a personal borrowing strategy) or tax effectively (assuming a corporate borrowing strategy which will illustrate below). See my article titled “Corporate borrowing vs Personal borrowing” March 2022. In this example, we assumed corporate borrowing (see table#5). Funds are received tax free to the corporation and paid out as taxable dividend to the shareholder resulting in an after-tax payout of $171K/yr. starting in yr. 20. Based on the assumption that we equalize the after-tax payout between both options (investment vs insurance) during their retirement phase, we can conclude that the insurance solution produces a much better estate outcome. A $5.6 million boost to be exact! If we factor in and assume Jack’s corporation can take advantage of the excess CDA room created by this strategy, the potential tax savings available add an additional $4.3 million to the estate. Topping out to a $9.9 million estate boost. Not bad.
If a business owner is successful in generating wealth beyond lifestyle needs, the reason to incorporate becomes obvious. The tax deferral opportunity is the main ingredient that brings to life the claim of the corporation as an effective tax planning tool. The more you’re able to defer, the longer you’re able to defer, the more money you’ll be able to keep for you and your family. The power of the tax deferral can be significantly ENHANCED AND MADE PERMANENT by means of the CDA by introducing permanent life insurance to the corporate passive asset portfolio.
Tony Gallippi, B.A.S (Hons.) CFP CLU
Director, Advanced Planning, Insurance
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.