We often hear of the dreaded passive income tax rules introduced in 2018 and their impact on the small business deduction (SBD) limit. Advisors welcomed this news as an opportunity to initiate a conversation with their clients about the use of life insurance as a strategy to mitigate the SBD grind. For the most part, there’s truth to this approach! But experience shows that it’s not a one-size fits all. It’s important to take a step back and truly understand the client’s unique situation before prescribing life insurance as the ultimate solution. If we don’t, we risk our credibility being called into question when their accountant is asked to review our recommendation. In this article, I will outline some of the steps to consider before rushing into an insurance recommendation. Before I do this, let’s first recap the passive income tax rules.
Recap of the passive income tax rules:
In 2018, the Federal budget phased out access to the small business tax rate for a Canadian-controlled private corporation (CCPC) and its associated corporations that earn more than $50,000 in passive income annually (i.e., interest, dividend, and capital gains inclusion, see full list below under (AAII)). This took effect in the 2019 tax year. The small business deduction (SBD) allows a CCPC to earn up to $500,000 of active business income (ABI) at rates as low as 9% depending on the province/territory. The small business limit is reduced by $5 for every $1 of adjusted aggregated investment income (AAII), over $50,000. At $150,000 of AAII the SBD limit is effectively reduced to 0. At this point, ABI will be taxed at the general tax rate (reflective of the tax rate for ABI>$500K) which can be as high as 31% depending on the province/territory. Effectively, reducing the tax deferral opportunities available to incorporated business owners.
What is Adjusted Aggregated Investment Income (AAII)?
Interest, rent, royalties
Policy gains, taxable portion of annuity payments, segregated fund allocations
Dividends from foreign corporations and Canadian corporations that aren’t connected to the recipient.
Taxable capital gains (exceptions apply if the property is principally used in the active business in Canada)
What is the 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 Nova Scotia. The highest personal tax rate in this province is 54%. Since active business income less than $500,000 is taxed at 11.5%, there’s a tax deferral opportunity of $217,500 by leaving the money in the corporation, (54%-11.5% = 42.5% X $500,000 = $212,500).
So how do the passive income tax rules affect business owners?
If we continue with the example above and the corporation is affected by the passive income tax rules, their active business income is instead taxed at the higher general tax rate of 29% (due to the impact of the SBD tax grind). This will reduce their tax deferral opportunity from $212,500 to $125,000 (54%-29% = 25% x $500,000 = $125,000). In effect, this means that the business owners’ corporation will have $87,500 less to invest ($212,500-$125,000 = $87,500). Having $125,000 extra to invest is still a generous tax deferral opportunity, but it’s not as good as $212,500. So, what can we do to avoid this reduction? More on this later.
Although the passive income tax rules did not increase taxes on passive income earned annually, it is important to note that losing access to the small business deduction reduces a corporation’s ability to defer income tax as more corporate income tax is paid upfront. This effectively reduces the tax deferral benefits of holding passive investments within a private corporation. From this perspective, the cost of the reduction of tax deferral is the forgone growth on the assets that are attributable to the deferred tax. Even if access to the SBD is lost (as the above Nova Scotia example illustrated), there’s still a tax deferral advantage when active business income is taxed at the higher general tax rate since it’s still a lot lower than the highest personal tax rate.
There are few notable exceptions to the passive income tax rules. Although, most provinces generally provided the same reduction to the small business deduction limit, Ontario and New Brunswick have decided not to follow the federal measures. For this reason, the combined federal and provincial rate in Ontario on the first $500,000 is 18.5% (assuming SBD limit is reduced to 0). Based on the Ontario numbers, this 6.3% difference (18.5% - 12.2% = 6.3%) results in additional corporate taxes of $31,500 (or tax deferral loss) instead of $71,500 (26.5% - 12.2% = 14.3% X $500,000) if Ontario decided to follow the federal measures. A reduction in tax deferral for sure, but not as bad as other provinces.
Does the Corporation have a problem?
Understanding a corporation’s projected adjusted aggregate investment income as well as its projected active business income will be key in determining whether it will be impacted by these rules. Simply being a CCPC which carries on an active business and holds a corporate investment portfolio, will not necessarily result in a negative impact.
When not to worry?
#1 If passive income earned is less than $50,000 annually.
#2 In scenarios where each shareholder has a small share of the small business deduction (SBD) limit, there may be little to no SBD limit left to grind down. The SBD limit must be shared amongst associated corporations (generally under common control). A good example of this is Professional Lawyer Corporations that are corporate partners of a law firm (LLP). The small business deduction is shared amongst all corporate partners. Secondly, if the corporation (and its associated corporations) have taxable capital more than $10 million, the SBD limit is reduced by $1 for every $80 of taxable capital over the $10 million threshold, being fully eliminated when taxable capital reaches $50 million. Generally, taxable capital is the sum of shareholder’s equity, surpluses, loan and advances to the corporation, less certain types of investments in other corporations.
#3 When corporations don’t qualify for the small business deduction (SBD): We generally find this with corporations that are only generating passive income and not running an active business (i.e., Investcos, Realcos, etc.).
#4 When active business income (ABI) is less than $500K with passive income above $50K (may not have any impact…see chart below): Not all small businesses earning active business income (ABI) at the small business deduction rate (SBD) are affected by the new reduction. What this chart tells us is that the less active business income (ABI) a corporation earns, the less they’re impacted by these rules (SBD tax grind). For example, CCPC’s earning an active business income of $250,000 can earn up to $100,000 of passive income with no impact. Likewise, CCPC’s earning active business income (ABI) of $100,000 can earn up to $131,000 of passive income with no impact. This is very important since sometimes as advisors, we just assume it’s a problem without considering the facts.
When to worry?
Corporations earning passive income above $50K and above the SBD threshold limits illustrated in the above chart, with 7-15 yrs. left to grow (example: CCPC’s earning $100,000 of passive income with active business income above $250,000). If this is the case, business owners affected may want to consider some of the ideas discussed below.
Potential ideas for advantageously reducing corporate investment income (in no particular order):
purchase exempt cash value permanent life insurance (more on this later)
· redesign investment portfolios to maximize tax deferral. Since they don’t trigger an annual income, they will not be included in the annual adjusted aggregated investment income (AAII) calculation.
Apply corporate investment funds to:
o repayment of corporate debt.
o acquire active business assets: such as inventory, machinery, equipment, and buildings.
o repay shareholder loans.
o pay available capital dividends to individual shareholders.
o pay dividends to the extent of the GRIP balance assuming there’s a balance to the eligible RDTOH account.
o pay non-eligible dividends: to the extent of the non-eligible RDTOH account.
o donate to charitable organizations: these donations will reduce the net worth of the corporation, therefore lowering the pool of money (passive assets) that generate corporate investment income (AAII). Although, donations are tax deductible by the corporation to the extent there is taxable income they do not reduce adjusted aggregate investment income.
o establish a Group Benefits plan: this is essential to attract and retain good employees and build morale (medical, dental, long-term disability, etc.)
o purchase Critical Illness Insurance with the return of premium on cancellation (ROPC). The funds applied to pay the premiums would no longer generate investment income.
o establish an Individual Pension Plan (IPP). The allowable contributions will be tax deductible by the corporation and will be removed from the corporation, and therefore no longer generate investment income for the corporation (client suitability analysis is needed before pursuing this option)
Purchase exempt cash value permanent life insurance:
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.
A cash value life insurance policy should never be undertaken as a good short-term investment, since for many years the sum of the premiums paid will exceed the cash surrender value, and during this period a negative internal rate of return results, unless death occurs.
Before any recommendation of life insurance is suggested, it’s imperative that we establish the need (or want) first. Whether it’s intended to address a looming estate tax liability, provide estate equalization, or a tax minimizing strategy using the capital dividend account (achieved by reallocating corporate investments that are taxable to an exempt permanent life insurance plan). The promise of reversing the effects of small business deduction (SBD) tax grind should be a by-product of the purchase and not the driver. The tail should not wag the dog.
Darren Smith (age 50) runs a successful scrap metal business in Nova Scotia. His corporation earns $500,000 of active business income each year of which he saves $100,000 annually for investments (and will continue to do so for another 15 years). Corporation currently has $2,000,000 in passive assets, half of which are fixed income, with a 4% growth rate and the other are equities with a 6% growth rate from realized gains. Since the corporation currently has passive income greater than $50,000, a portion of its ABI is taxed at 29% (2023 general tax rate in Nova Scotia) instead of 11.5% (2023 SBD rate in Nova Scotia). We’ve established that he has a need for life insurance to address his estate tax liabilities. We also wanted to show him 3 scenarios, where we would reposition some of his investment portfolio into a life insurance policy (using three different premium amounts: $50K/yr., $100K/yr. or $150K/yr. for 15 yrs.). The purpose of this exercise was to demonstrate how it may affect the taxation of his corporation’s ABI.
The cumulative tax cost (or lost tax deferral opportunity) on the corporation’s ABI of “DOING NOTHING” is $745,581 (over 15 yrs.). At the top end of the insurance scenarios, which requires us to commit $150K/yr. for 15yrs and results in the client repositioning $2.25 Mil of corporate investments into permanent life insurance, the cumulative tax cost on the corporation’s ABI reduces to $250,661. This results in a tax savings of $523,920. This tax savings can be applied to any purpose the business owner deems important (i.e., business expansion, or passive investments that are more geared toward mitigating this SBD grind). In summary, the life insurance scenarios not only provided a more cost-effective solution to address his looming tax liability at death, but it also reduced the effect of the SBD grind that his corporation otherwise would have experienced.
Although corporate owned life insurance can help business owners reduce their tax costs on passive corporate and mitigate the increased tax costs passive income can create for the corporation’s active business income, it’s important to not jump to this conclusion without all the facts. The key is to first establish a need/want for a permanent life insurance policy and then move forward to highlight the additional tax benefits it can provide.
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.