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Your Company – A User’s Guide Part 2 How Investment Income is Taxed

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Introduction 

If you own your own Canadian Controlled Private Company (CCPC) (i.e. your own small incorporated business or holding company), you’re probably still trying to digest all the new tax changes enacted this January or penciled to come your way in January of 2019. The last change (for now, at least) occurred in the most recent Federal Budget this March and focuses on how passive income will be taxed in your CCPC going forward. While I will address the key changes from this March partially in this and mostly in other articles, the real problem is that many of us have no idea how this income was taxed in the first place. According, this makes it difficult to plan and strategize so you can make money work for you as efficiently as possible or to understand how the new rules might (or might not) affect you.

Due to all of this confusion, I want to go back to the basics and attempt to demystify the confusing blend of acronyms, rules and calculations that are small business taxation. In my last article, I tried to explain how active business income is taxed in your company and how the dividends it pays you are taxed personally. I even threw in some comments about something called “integration theory” (no, it still has nothing to do with the civil rights movement) and the government’s general goal of trying to put someone earning money from a corporation, whether they pay themselves with salary or with dividends, in the same position as a businessperson who decided not to incorporate but who earned the same amount.

In the hopes that my earlier effort has pushed ajar the doorway to enlightenment, today’s effort will try to turn this toehold into something far more substantial so that when your accountant throws a few acronyms your way, you can send a few back in his or her general direction and then say something witty about integration theory. There is no way I can say all that needs to be said in one article, so stay tuned for articles that will hopefully fill in the cracks one piece at a time until you hopefully know so much that you feel like an amateur accountant without the pocket protector.

Like last time, all tax rates and thresholds in this article will be based on British Columbia law. The numbers will differ from province to province, but the general principles remain the same whether you live in St John’s, Newfoundland or Fort St. John, British Columbia.

The Taxation of Passive vs. Active Income – Why Different Rules for Different Types of Income?

Unfortunately, there are a lot of different rules and rates for passive income compared to active business income. This makes sense because the government has a different game plan in mind for how they tax investment dollars earned inside a company. While the government is keen to give a break to entrepreneurs looking to reinvest money back into their business by keeping tax rates on business earnings low so there is more cash left to buy that new widget maker, they don’t want to reward you for instead investing leftover corporate profits into things like stocks and bonds. Although there will still be a lot more to reinvest in the stock market inside a CCPC that was only taxed at 12% than for a sole proprietor who may be taxed at as much as 49.7% (and even higher in provinces like Ontario where we’re looking at potentially 53.53% – gulp!), they want to try to level the playing field by making shareholders in a CCPC either pay tax on their investment earnings at a really high rate corporately (50.67% on interest in B.C., for example) or essentially forcing them to pay the money out of the CCPC as mostly as dividends, so the owners are taxed on them personally at their marginal tax rates. Either way, it’s about the government getting more tax dollars sooner.

The most recent budget takes this philosophy of limiting your ability to stockpile unused business profits in corporate investments rather than paying it as you earn it one step further by penalizing CCPS who earn too much investment income starting in 2019. If your various CCPCs earn more than a combined $50,000 in passive income (i.e. income from things like the total of net rental income from most investment properties, investment interest, investment dividends and the taxable 50% of capital gains from non-business assets) in a single tax year, less of your active business income qualifies for the 12% small business rate. Every dollar over this threshold will reduce the amount of income that can be taxed at 12% by five dollars.

Thus, instead of getting the first $500,000 of active business income taxed at 12%, someone with more than $150,000 in passive income will have all of their active business income for that year taxed at 27%. As you can see from the chart in my last article, the business owner will get most of the extra tax paid up front back by paying less on the eligible dividends s/he receives when this money is paid out of the company that are more tax-friendly than the small business or ineligible dividends they would receive on money that was first taxed at the 12% rate. On the other hand, if the business owner wants to reinvest the money corporately, they won’t have as much to put into stocks and bonds after paying corporate tax at 27% instead of 12%. As a result, the CCPC owner will lose some of the tax deferral advantage s/he has over those of us who haven’t incorporated but have extra profits left to invest in the stock market. They may still be in a better position than their incorporated friends who might have less than 50% of their excess income to salt away for the future, but the gap won’t be as wide going forward.

Dividends Paid from your Company Derived from Investment Income and Business Income

When trying to wrap your head around the difference between how corporate business and investment dollars are taxed, the good new is that three types of dividends generated by your CCPC are the same regardless of how the money was earned in the first place. Thus, it doesn’t matter to the taxpayer if s/he receives their small business, eligible or capital dividends from money originally generated from business activities or from investment dollars, as their dividend dollars will be taxed identically in their hands. The CCPC simply declares what type of dividend it is paying out and the recipient will be taxed accordingly, regardless of whether that dividend originated from business profits or from investment prowess.

The bad news is that there are a lot more moving parts regarding how investments taxed corporately before your CCPC can gets to the point where it can pay you dividends. Even though it won’t make a difference to the shareholder (other than determining the size of the dividend cheque) whether the dividends came from business or investment income, it will make a big difference to the CCPC not only as to whether it was investment vs business income, but also whether the money was originally dividends from Canadian investments, interest or similar types of income, return of capital or capital gains. These different types of income are taxed in different ways and at different rates.

As a result, how the CCPC earns its investment dollars will still have a huge impact on its shareholders, as the more tax paid on the money corporately, the less cash that will be left over to pay its shareholders dividends. Furthermore, the type of investment income earned inside the CCPC will determine what mix of dividend income it can pay out and, ultimately, how much of these dividend dollars the shareholder will be able to keep after taxes, since not all dividends are taxed the same and different types of investments produce different types of dividends.

Building on this last point, as you found out the hard way in my last article, CCPCs can pay out three different types of dividends, each of which produces different tax consequences. I’ll touch on these again in this article for those of you who need a refresher. I’ll provide a basic recap here, focusing on just how these types of dividends can be produced from investments but do remember that business earnings can also generate these types of dividends as well.

With no further ado, the three types of dividends you might receive from your CCPC from its investment portfolio are:

  • “Capital Dividends”, which are tax-free to the recipients. They are generated from the 50% of any capital gains realized inside the company minus realized capital losses. As well, some to all of the death benefits of any life insurance policies earned inside the CCPC generate these tax-free dividends. Your company might own life insurance for business or investment purposes, but this won’t affect how much of the death benefit can be paid out tax-free to shareholders.

 

  • “Eligible Dividends”, which are taxable in your hands, but provide an enhanced dividend tax credit which ultimately means that recipients in the lowest brackets might actually get money back from the government. For example, someone earning $30,000 in British Columbia who receives another $100 in eligible dividends would actually have $106.84 in their back pocket, or an extra $6.84 in bonus loot above the actual amount of the dividend. Those in higher tax brackets, however, might only get to keep as little as $71.32 of their $100 dividend cheque when the dust settles. Eligible dividends paid from a CCPC are taxed in the same way as eligible dividends paid directly to investors who own things like Canadian bank stocks in their non-registered accounts. This makes a lot of sense because eligible dividends paid out by a CCPC from investments come from the eligible dividends it receives from its own investments. In other words, for every dollar in eligible dividends your company receives from its own investments, your CCPC can pay out that same dollar in eligible dividends to its own shareholders, where it will be taxed in the same way as if they’d earned it directly from personally held investments.

 

  • “Ineligible” or “small business dividends.” In a nutshell, any type of investment income generated inside a CCPC that can’t be paid out as a Capital or eligible dividend has to get paid out as an Ineligible or small business dividend (excluding rare circumstances when it gets paid out as a salary or bonus or is used to pay down shareholder loans owing to that shareholder). For example, interest, U.S. dividends, return of capital payments, royalty and rental income, net of expenses would all need to be paid out as ineligible dividends. People getting ineligible dividends do get a tax credit that reduces the amount of tax they would otherwise have to pay on the money personally, but it’s not nearly as generous as an eligible dividend. For example, the same Vancouverite receiving $100 in ineligible dividends who otherwise made $30,000 this year would only get to keep $90.23, while his tennis partner who is in the highest tax bracket would keep only $56.30 after taxes.

Conclusion

Although there is a lot more information to come, this is as good a place to stop for today. If you can now identify each of the three types of dividends you might receive from your CCPC and understand how they are or, in the case of capital dividends, are not taxed in your hands, I will consider myself a happy man. If you’re clear that any of the three types of dividends might be generated by either investment or business income, or a mix of the two, then even better. If you can also talk about why our corporate tax system is designed as it and how earning too many passive investment dollars might impact how your active business income will be taxed as of next year, I will be over the moon.

Next time, I will focus on how different type of investment earnings are taxed corporately so you can better understand how much you will have left to reinvest or pay out. Even more importantly, I’ll talk about how many of those dollars you will get to keep when you receive dividend payments from your company and compare where you’d be after taxes if you invest corporately or personally. My goal is to give you enough information so you can ultimately make an informed choice regarding how to allocate investments among your personal, registered and corporate accounts in order to make your money go as far as possible. As I love to remind clients, it’s not what you make, but what you keep after the tax man has come and gone that really matters.

 

Leave to Grow or Withdraw Some Dough – Factors to Consider When Pondering Early RRSP Withdrawals – Part 3

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In this article, I’ll pick up where I left off at the end of my last article, fleshing out some of the things to keep in mind when deciding what to do with your RRSPs and RRIFs. For those of you coming late to the party who have not read the first two parts of this series, I suggest doing just that. Part 1 does some basic mathematical calculations showing how early RRSP withdrawals can mean big savings later in the right circumstances, while Part 2 starts explaining why. For those of you who have been with me since the beginning, the end is now in sight. Let’s cut to the chase.

  • GIS and Other Benefit Planning.People expecting to have very little taxable income during retirement may end up paying a lot more tax on the RRSP withdrawal by way of lost government benefits and government subsidies. If you expect to earn GIS benefits in future, each $2 in RRSP withdrawals can cost you about $1 in GIS benefits. Likewise, some provinces offer subsidies on drug costs during retirement based on income levels. Perhaps most importantly to some Canadians, the cost of public retirement facilities is based on income levels. Accordingly, reducing your tax hit prior to moving into an assisted living facility may reduce your care costs later. These are just some potential examples.
  • Poor Health or Life Expectancy. One of the biggest factors against withdrawing money early from your RRSP can be the lost profits you would have received on the money that you have to pay now in taxes that would have remained invested inside your RRSP if you do nothing. Although those lost profits will also be eventually taxed, some of them would still find their way into your back pocket. The less time between when you trigger taxes early compared to when you would have had to otherwise pay them anyway, the less time the tax paid early and profits on them would have had to grow inside your RRSP.

For example, if you pull out $50,000 from your RRSP a year earlier than necessary at a 30% average tax rate rather than waiting and paying 50% on the same dollars the next year, although you’d only have $35,000 to work with initially, you’re probably still far ahead of where you’d be if you let it ride for an extra year. Even assuming your investments grew at 20% and were taxed completely as interest at 50% in both cases, I’d much rather settle for getting $3,500 after taxes on the $35,000 I withdrew early (or $37,500 after taxes) than paying 50% tax on $60,000 in my RRSP a year later and keeping only $30,000after the CRA gets its cut. Of course, the benefits of early withdrawal are far more pronounced if the non-registered money is invested more tax efficiently. For example, if the $35,000 went into a TFSA and still made 20%, the early withdrawer would earn $7,000 after tax that year while procrastinator would only make $5,000 after tax despite having $15,000 more before tax to sink into the market.

Ultimately, if you knew when you were going to pass on or that you wanted to use more than just the minimum amount you’d need to take out from your RRIFs in a few years, can get it out at a low tax rate, and can invest it tax-efficiently, it might make sense to bite the bullet.

  • Tax Deductible Investment Fees. If you pay investment fees inside your RRSP or RRIF, you can’t deduct them each year. Although you still pay them from inside your accounts and will get the same thing as a deduction eventually since you won’t have as much money to be taxed on, you need to wait until withdrawal to get this benefit. If, instead, you have a non-registered portfolio and pay a percentage annual or monthly fee to your broker, you can deduct this fee each year. This works particularly well if you are earning dividends, capital gains or return of capital, which are taxed at lower rates than the deduction you receive from paying your fees. Thus, you get to deduct your fees now if in an open account rather than later and get to deduct them against investment income that likely won’t be taxed as heavily as it would if invested inside your RRSP.
  • Potential Estate Unfairness When Using Beneficiary Designations. If naming multiple beneficiaries on an RRSP or RRIF, the survivor gets the whole thing if the other(s) don’t outlive you. This can be a problem if you name your children jointly but would want grandkids to inherit in their parents’ place. To make things even worse, the surviving children would get the money tax-free most of the time and your estate would be the one paying the piper. That would mean that if your grandkids inherited their deceased parents’ share of the rest of the estate that they would get a smaller piece of that pie as well, as their share of the estate would be net of the tax bill on the RRSPs that went to their aunts and uncles. Obviously, you can update your beneficiary designations if necessary if you are still healthy, but if you are not, this cannotusually be done through a Power of Attorney. Thus, if you are sick for many years, you are banking on the fact that nothing happens to any of your children during that time.

An easy solution is leaving the RRSPs etc. to your estate and accepting that this means probate fees and exposure to Will and estate issues. For larger registered plans, consider leaving them to a trust that can stipulate what happens to a deceased child’s share while still avoiding probate fees and estate challenge issues. Unfortunately, many people just rely on the simple beneficiary designations for their registered plans. Accordingly, I wanted to make sure my readers are aware of this problem.

Factors Discouraging Early Withdrawals

Most of the considerations mentioned in this and my first two articles in favour of pulling your RRSP money out early suggest keeping your RRSP intact should the necessary conditions not apply. For example, you might be better off taking some money out now if you are in a lower tax bracket, love dividends, have poor health and don’t expect to draw down your RRSP before death. Conversely, if you are in great health, may use all your RRSPs during your lifetime and love interest-based investments, you might be better off leaving things alone for now.

Here are a few other things to keep in mind that might suggest you keep your RRSPs intact for as long as possible:

  • RRSPs and RRIFs have creditor protection, which might be really useful for those unlucky few facing bankruptcy or a nasty law suit;

 

  • The first $2,000 of RRIF money for those over 65 qualifies for the pension income credit. Accordingly, some of us with smaller RRSPs might be better off (depending on whether they are getting GIC or other income-based benefits) to take their RRIF money out $2,000 at a time. Assuming that it all comes out this way over time, it essentially means you can get your RRIF money out with little tax owing. As well, your money gets to compound for longer as you wait, which can mean more money to you over the long term.

 

  • RRSPs and RRIFs have beneficiary designations, which is an easy way of avoiding probate and potentially estate creditors. You can get this protection within TFSAs, segregated funds or other planning techniques if owned outside of your RRSP or RRIF, but it might also require a bit more effort and work on your part to put this in place;

 

  • If you have a financially dependent, disabled child or grandchild, you may be able to rollover up to $200,000 of your RRSP or RRIF to that person at your death, minus any other contributions made to their plans during their lifetime; and

 

  • It is easier for you to budget when inside your RRSP / RRIF. Some of us, such as those who are spenders or have a hard time saying no when children ask us for money, may benefit from keeping the cash in the RRSP / RRIF as long as possible if it helps with budgeting or makes it a bit harder to write that cheque for a child that is not truly in need;

Conclusion

Don’t get me wrong – I love RRSPs, particularly for clients in high tax brackets now than expect to be in lower tax brackets later. It’s just that I think about them in the same way that I think about investing – it’s all about having an exit strategy. If I can cash in registered money on the cheap, deploy it more tax efficiently afterwards and also increase my financial flexibility, then, why wouldn’t I? Although it probably means looking at a smaller pool of investable assets in the short and also perhaps the medium term, it all comes down to how much is left after taxes and what I can do with the money rather than the size of my account before the tax man has received his due. Finally, life and circumstances are always changing and are rather complex. I like to be financially nimble and to be able to raise cash without worrying about triggering a huge RRSP withdrawal tax bill, unless the costs of withdrawing more of my RRSP money now simply don’t make sense.

Accordingly, rather than relying on principles like it’s always good to defer RRSP withdrawals or to always take the money and run, it really depends on individual circumstances and usually requires revisiting your planning from time to time to see if yesterday’s advice still holds true today. Thus, I must unfortunately return to where I began two long articles ago. If asked whether or not it makes sense to withdraw RRSPs early, my answer still remains: it depends. Now, at least, I hope you know why.

Knowing More about the Company You Keep: Learning How Small Businesses Are Taxed So You Can Plan and Invest Intelligently

Part One – Taxation of Active Business Income, Dividends and Integration Theory

A lot of financial planning is learning how to move your pieces effectively around the chessboard of life in order to get the best possible outcome. This is particularly so when doing tax planning – by merely rearranging who owns what and how they use it can have a profound affect on a family’s overall tax bill. As I like to repeat so often that it’s become a mantra: it’s not what you make, but what you keep after appeasing the tax man is what matters.  And, when clients get sick of hearing this, I then tell them that no one cares more about your money that you do – no matter who’s helping you, the more you know yourself the better off you’ll be. Today’s article speaks to both of those maxims.

In particular, I want to talk about how small private companies, aka “Canadian-Controlled Private Companies” or “CCPCs” are taxed. The tax rules for CCPCs are not simple and seem to be written in a tongue not known to common man. Accordingly, when I start working with new clients, many of them are either paying more tax than is necessary right now or will overpay in taxes in the future because they don’t know the rules, have not got the necessary advice from their other advisors and have not planned 10 or 20 years down the road. Moreover, even if they have received good advice at some point, life and the law both change. Thus, yesterday’s pearls of wisdom may no longer apply to today’s realities. This is particularly true in light of the changes imposed on small business owners by the current federal government since last July that are either now in effect or coming soon.

With all of this in mind, this article, and those to follow, are designed to outline some of the basic principles of corporate taxation in (more or less) simple English so anyone taking the time to muddle through will be able to make better tax decisions going forward, ask better questions of their professional advisors and hopefully, sleep better at night by having more control over their own situation. Accordingly, pour a good cup of coffee, or perhaps something even stronger, and let’s begin.

Integration Theory and How It Works When Earning Active Business Income

Why small businesses are taxed as they are comes down to something that tax types call “integration theory.” Although it sounds like something from the civil rights movement of the American 60’s, it’s a really far less exciting and involves far more math. The basic premise is that a businessperson running a sole proprietorship (I’ll call him “Jack”) and someone running the same business inside a company (why not call her “Jill”) should pay about the same amount of tax on the profits they use to support their families and spend on exotic vacations abroad. Tax rates and policy are designed to achieve this result. For this article, I’ll use exclusively B.C. personal and corporate tax rates.

One of the main differences between Jack and Jill is that Jack is taxed completely in his own name on all business income. He will have a lot more deductions since he is a business owner than someone who is an employee, but all his income will be taxed in most cases in the year that it is earned based on his level of income and marginal tax rates. In other words, if he earns a lot in one year, he will pay a lot more tax on the last dollar of income since it will be taxed at a higher marginal rate than if he hadn’t earned as much that year. He really can’t delay his day of reckoning and pay tax on some of the extra money he earned this year until a year when his business is not faring so well. Thus, even if he wanted to reinvest a bunch of the money back into his business, he might only have $.50 on the dollar or less, depending on where he lived, on at least part of his earnings in high income years.

Jill, on the other hand, has far more tax control. In her case, she can decide how much money to pay out of her company to herself in salary, which means she can avoid paying tax personally at high marginal rates by not paying out money she might want to reinvest to either grow her business or to set aside for a rainy day which, as you may know, are not uncommon in Vancouver. In B.C., the first $500,000 of profit, after Jill pays herself a salary and deducts all other expenses, is taxed at about 12% at this point. Accordingly, instead of having only the $.50 after taxes that Joe might have to buy a new business laptop or a new widget-maker, Jill would have perhaps $.88 left to do so. The same principle would apply if they both wanted to buy office space or use the extra money to invest in some crazy investment their neighbour talked about that they’re positive will double within a year.

If Jill’s net profits exceeded $500,000 or she gets caught by a provision in the new tax rules for investment income inside CCPCs just announced in March’s budget that can reduce how much of her active business income can be taxed at 12%, the excess will be taxed at around 27% out Vancouver way. Thus, even though she won’t have as much money left to reinvest on the excess portion than the money that was taxed at 12% (i.e. $.73 vs. $.88 per dollar), she’ll still have a lot more cash for widget-buying than Joe who might have only $.50 or even less if living in places like Toronto on money that was taxed at really high personal rates.

On the other hand, when Jill wants to take the same $.88 or $73 left over after her company paid tax on it out of the company, she will have to pay some tax personally on that money in order for her to be left in a similar position as Joe, who has probably already paid a lot more tax on the money. It could be Jill takes the money out in the same year that it was earned or perhaps a decade later. For now, let’s just assume that this happened during the same year as her company (“Jillco”) earned the profits in the first place. In this instance, perhaps Jill decided to pay herself through dividends instead of salary because she didn’t want to pay any more into the CPP and was willing to forgo earning any more RRSP room and some of the other perks that can come from taking salary instead of dividends.

In any event, whatever the reason behind Jill’s decision, this is where integration theory comes into play once again. It wants Jill and Joe to pay about the same amount of tax on their personal earnings that year. Since Jill will be earning dividends paid from money that was already taxed in Jillco, it’s only fair that she gets credit for either the 12% or 27% that the company already paid on these business earnings.

Salary vs. Dividend Comparison – Integration Theory in Action

This example shows the different tax results if Jill was already earning $100,000 and needed to decide what to do if her company made an extra $1,000 in profits. The size of any dividend cheque will depend on whether the income was first taxed corporately at the 12% or 27% rate, as this tax bill needs to be deducted from the $1,000 profit before paying out dividends. If taxed at the lower rate, the $880 dividend ($1,000 minus $120 in tax) paid out will be taxed as a small business dividend, while if taxed at the general rate, the $730 dividend ($1,000 minus $270 in tax) will be an eligible dividend.  When they talk about “eligible dividends”, they just mean a dividend that is eligible for more tax relief in the recipient’s hands. In this case, the higher tax credit generated on eligible dividends is intended to compensate Jill for having to pay tax at a higher rate on the money corporately than if she had been able to pay tax on it at the 12% rate.

To further make the numbers jibe, the actual amount of Jill’s dividend payments will be increased (“grossed-up”) by 16% (i.e. increased from $880 to $1020.80 in taxable income) if a small business dividend and by 38% (i.e. increased from $730 to $1007.40 in taxable income) for an eligible dividend for income tax purposes. The purpose behind this additional mathematical madness is to make sure that Jill is paying tax on the same $1,000 (give or take) and in the same tax bracket as would have been the case if she’d taken the money as salary. As you’ll see below, after the gross up, Jill will be declaring about $1,000 worth of income any way you slice it. On the other hand, she will get a dividend tax credit of 25.0198% of the grossed-up amount of $1,007.40 if she receives an eligible dividend  (which is 34.53% of $730 she actually received) received in order to compensate her for the 27% tax Jillco had already paid on that same $1,000.If she gets an ineligible / small business dividend instead, she’ll get a dividend tax credit of 12.1013 of the grossed-up amount of $1,007.40 (14.0348% of the $880 she actual receives).

Crunching the Numbers

If Jill takes the extra $1,000 as salary or if Joe had been the one earning the extra $1,000 as a sole proprietor after already making $100,000 that year:

  • $1,000 – 38.29% (the marginal tax rate for someone earning $100,000 in income).
  • After-tax amount in Jill or Joe’s jeans: $617.10

In other words, if Jill takes the extra $1,000 in salary rather than as dividends, she’d be left with exactly the same amount as Joe. It’s only when the money gets paid out as dividends that things start to change.

If Jill first paid 12% small business tax in Jillco and took the remaining amount as small business dividend:

  • Amount paid out as dividend ($1,000 net of 12% small business tax): $880. (“A”)
  • Grossed-up Dividend: $1,020.80 (A ($880) x 1.16 (i.e. a 16% gross-up) (“B”).
  • Tax on Grossed-up Amount: $390.86 (B ($1,020.80) x .3829 marginal tax rate) (“C”)
  • Small Business Dividend Tax Credit: $123.53 (B ($1020.80) x .121013) (“D”)
  • Total Personal Income Tax Owing (C-D or $390.86 – $123.53): $267.33 (“E”)
  • After-tax money in Jill’s jeans (A-E) or $880 – $267.33: $612.67

If Jill first paid 27% on the $1,000 in Jillco and received the remaining amount as an eligible dividend:

  • Amount paid out as dividend ($1,000 net of 27% small business rate tax): $730. (“A”)
  • Grossed-up Dividend: $1,007.40 (A or $730 x 1.38) (“B”).
  • Tax on Grossed-up Amount: $385.73 (B or $1,007.40  x .3829 marginal tax rate) (“C”)
  • Small Business Dividend Tax Credit: $252.05 (B or $1,007.40 x .250198) (“D”)
  • Total Personal Income Tax Owing (C-D) or $385.73 -$252.05: $133.68 (“E”)
  • After-tax amount in Jill’s jeans (A-E) $730 -$133.68: $596.32

In summary, although it’s not perfect integration, the size of the wad in the back of Jill’s jeans is pretty similar in all three scenarios after the dust settles. Eligible dividends are more valuable to recipients because they produce a bigger tax credit.  Fortunately, you won’t have to do all of my calculations going forward, as there are tax charts that cut to the chase and tell your net tax rate after applying the dividend tax credit when receiving any type of dividends at any income level. Unfortunately, you should still calculate the grossed-up amount of any dividends you wish to pay out in advance to ensure that you don’t mistakenly push yourself into a higher tax bracket than intended. In the end, tax planning involves trying to pay the right amount of dividends to the right person during the right tax year so that they don’t receive too much total income from their particular mix of company salary, eligible and small business dividends, as well as other income they earn personally from other sources like pensions, personally-held investments and so on. This requires both knowing how dividends are taxed and at what income levels the different tax rates kick in. Hopefully, this article and a link to current tax rates in your province of residence will steer you in the right direction: https://www.taxtips.ca/marginaltaxrates.htm

Capital Dividends

 Before wrapping up today’s missive, we need to talk about one final type of dividend that Jill might receive from Jillco from time to time. If Jillco realizes capital gains, such as from selling an office building or from the stock that crazy neighbour talked her into buying several paragraphs ago, integration theory needs to account for the 50% that Joe would have received tax-free in his own hands if he was the one selling the building or stock. Likewise, if Joe owned life insurance on his key employee, Dick (of Dick and Jane fame), he’s receive the entire death benefit in his own hands tax-free.

I’ll have a lot more to say about capital dividends going forward, when I talk about how passive or investment income is taxed inside Jillco. For now, the key is that our tax system is designed so that Jillco can pay out the non-taxable 50% of any capital gains it earns and a portion (although not necessarily all) of any life insurance death benefit it receives to Jill. Jillco receives both the 50% non-taxable portion of any capital gain and 100% of the death benefit of a qualifying life insurance policy tax-free, just as Joe does. The problem was that both eligible and small business dividends would require Jill to pay tax on any amount received, which would put her in a worse position than Jack, who gets that money for his own use tax-free.

To solve this problem, the government created “capital dividends”, which Jill can receive from Jillco tax-free. Jillco’s accountant is in charge of tracking the non-taxable portion of any capital gain, minus any capital losses Jillco earns that year, such as if Jillco sold the stock Jill had heard about from her crazy neighbour at a loss. Jillco would also get credit for the death benefit of any life insurance policies it received minus a tax adjustment. In simple terms, most or all of any term life insurance policy could be paid out to Jill for free through capital dividends, but for permanent policies with a cash or investment portion, some of that value would still go to Jillco tax-free but would have to be paid out to Jill as taxable small business dividends, which all depends on the type of policy, the size of the investment portion and the age of the deceased at the time of his passing (the older the deceased, the greater the percentage of death benefit that can be paid to Jill for free). Fortunately, insurance companies track these tax values, which will change from year to year. To this total, her accountant would also add any capital dividend room on hand that hadn’t been paid out to Jill in previous years.

In any event, that’s probably more than enough for today. For now, let’s just focus on the fact that sometimes Jill can receive tax-free capital dividends from Jillco when it sells assets that produce capital gains or someone covered by a company life insurance policy dies. We’ll have more to say how the taxable portion of any capital gains (i.e. the 50% that is taxed, as opposed to the 50% paid out as capital dividends) are taxed next time.

Conclusion

If you’ve made it this far, you will hopefully have a better idea of how active business income is taxed and how the different types of dividends fit into the system. You probably have also already heard far too much about integration theory as well. Although today’s article focused on active business income and Jill’s tax situation if she paid out all her corporate earnings as soon as possible, many businessowners benefit the most when they stockpile excess earnings within their company so they have more to invest for the future and in the expectation that they might be able to pay less tax on the money in the future when they withdraw it as dividends if they are then in a lower tax bracket. Accordingly, my next article will attempt to start deciphering the mystery of how investment income is taxed in CCPCs, since investing corporately rather than personally is one of the main benefits of incorporating your business. Today’s article is hopefully a useful first step along that convoluted road. Just don’t be surprised if integration theory once more makes a surprise appearance.

Investing Inside an Insurance Policy –Part 3: Universal Life Insurance as an Investment

Introduction

Think that life insurance is just a tool to make sure that junior gets the university vacation if you die in your 40s, your spouse doesn’t have to worry about mortgage payments if you die in your 60’s or your kids have enough money to pay the final tax bill on the family cottage if you die in your 80’s?  Not so fast, says the insurance industry. They are now seeking a place at the table when clients discuss ways of funding their own retirement, particularly for those clients in higher tax brackets and those that have their own corporations.

The first two parts of this series have detailed some of the significant tax advantages enjoyed by life insurance and steps you can take to mitigate risk when looking to invest through life insurance or if you’re already the proud owner of a policy to call your own. To date, I’ve said little about your actual investment options inside an insurance policy, although I’ll focus solely on “Universal Life” or UL Policies, the insurance that most closely resemble traditional investments. For those of who are fans of Participating Whole Life (“Par”) Policies, you’ll unfortunately have to wait until next time. Finally, regardless of whether you’re looking at either of these types of policies or even more basic permanent policies, my (hopefully) final article in this series will hopefully provide you with guidelines to use when measuring life insurance against traditional investments, as any comparison between options is only as accurate as the underlying assumptions.

But, before I go any further, I wish to thank the insurance advisors I’ve canvassed for their insurance investment recommendations: Lee Brooks of View 360 Insurance Advisory (New Westminster, British Columbia), Tyler Eastman, Sun Life Advisor (Terrace, British Columbia), John Ong, Certified Financial Planner (Vancouver, British Columbia) and fellow Money Saver Contributing Editor, Rino Rancanelli, owner of CorporateTaxShelter.ca(Oakville, Ontario).

Setting the Stage

While Par Policies are something of a mysterious black box that spits out policy dividends each year and often offer guaranteed increases in cash value, UL policies are generally more transparent, flexible and multi-purpose creatures. There is a set minimum premium payable monthly or yearly for guaranteed death benefit or “face value” of the policy but extra contributions are allowed into what is called an “accumulating fund” that is essentially a tax-free investment account whose balance at death is paid out tax-free on top of the face value. Each insurer offers its own set of different investment options. Traditionally, this meant predominantly mutual funds, which has often meant more uncertain and volatile returns than Par Policies and some rather steep investment management fees.

Like Par Policies, the greatest risk to owning a UL is having the policy run out of money when the owner doesn’t have extra funds to contribute to the cause. Traditionally, there has been a far greater chance of this happening for UL policies than their Par compatriots for a few reasons:

  • Although a UL policy will offer you far more upside than a Par Policy, it also exposes you to double digit losses in a year if you pick riskier investment options and all does not go well.
  • Inability to lock in gains. If you get paid a policy dividend in your Par policy, it gets added to the cash value and the insurance company can’t take it away from you the next year if their investments don’t perform as expected.Accordingly, they invest more conservatively and factor lots of margin for safety when setting premium rates. UL policies give clients the chance for making a lot more profit but don’t generally provide them with this safety net, except for “limited pay” policies that at least ensure that you are no longer responsible for ongoing premium payments after a set period of time even though any additional contributions you’ve invested are still fully at risk. I have listed a few exceptions to the rule later in this article.
  • Overly optimistic investment return assumptions. In the 80’s and 90’s, when markets soaring and interest rates were high, UL policies were the policies of choice, while Par Policies were considered yesterday’s news. Although illustrations for both types of policies purchased during this period have not lived up to expectations, UL policies (particularly if invested in mostly equities) took far more of the pain. While Par policies ended up paying less than everyone hoped, at least they continued to pay out policy dividends year over year. In contrast, negative portfolio returns in UL policies meant that the anticipated growth that was supposed to pay future policy premiums was not merely growing slower than expected but was actually shrinking. That meant policies running out of money far sooner.
  • Yearly Increases in Premiums. It was common for clients to purchase UL policies that had yearly increases in their insurance costs (sometimes to set ages and sometimes indefinitely) to keep costs low in the early years so they could have more money working for them in their investment fund. The theory was that the opportunity to have more money in the market longer helped clients since the extra profits they would earn on their investments in the early years would pay for the increased insurance costs on the back end. When performance lagged and the clients didn’t continue to contribute fresh funds to keep their UL policies on course, the increases in fees, modest for younger clients but growing significantly for older clients, ultimately made many policies unsustainable. By contrast, Par Policies generally offer a level premium for life so that, even if they weren’t able to be self-funding as early as originally illustrated, the cost of keeping the policy going was not nearly as significant.

On the other hand, life is about learning from one’s mistakes. Just because UL policies have performed badly in the past, doesn’t mean that there is no place for them in your future. The potential tax savings and advantages offered by these policies are real and can still offer significant benefits to the right clients. For the same reason that it can be a mistake for investors to completely shun investing in the stock market just because they’ve been bitten in the past, it may also be a missed opportunity for investors to not investigate using ULs now merely because of past problems. The secret is often to learn from and fix the mistakes of the past rather than abandoning a strategy without a backward glance.

Along those lines, the insurance industry has made some significant changes to their investment offerings and the investment fees charged on these offerings that do a lot to mitigate risk and enhance performance. Moreover, no one is purchasing these policies on the expectation of continuous double-digit returns, which means that it is now a lot easier for ULs to live up to their promises. In defence of insurance advisors past, however, it wasn’t merely the insurance industry that was assuming that investors in that period would continue to enjoy double-digit returns in perpetuity; many investment portfolios burdened by similar unrealistic expectations also floundered and flopped.

Finally, more clients select policies with level premiums, specially designed policies that allow tax sheltering but reduce or even almost eliminate the insurance costs over time, or, if they do choose yearly increases in costs, doing so with a contractual right to switch over to a fixed yearly charge at a later date of their choosing at a predetermined rate. In other words, they can take advantage of the rather significant savings and potentially improved overall results by paying yearly increasing rates for a number of years but preselecting a time to bite the bullet and switch over to level rates based on their age at that time in order to control future costs. In the end, UL policies are a lot like an electric drill– if used in the right situation, in a careful, safe manner and regularly maintained, it just might be the best tool for the right job, although if used inappropriate, there is the chance of pain and shocks.

Changes in UL Investment Options

In my previous article in these series, I argued that it’s important to manage your UL policy in the same way as the rest of your investments. This means reviewing and potentially rebalancing the investments inside your portfolio at least once a year, changing your holdings if your time horizon and risk tolerance change and getting your insurance advisor to update your policy illustrations every few years so you can make small changes immediately rather than facing large changes later.

Noting all of this, in the end, it still often comes down to investments inside the policy. My personal bias is to use UL policies for the slow and steady portion of your portfolio rather than the “shoot for the moon” component. The less volatile your investments, the less likely things can go wrong. Furthermore, for the same reasons I love investments that pay interest and dividends along the way in order to reduce the need to eat into capital during down markets, I love similar investments inside UL policies in order to generate cash to pay the annual premium costs.

Fortunately, there are an ever-increasing number of investment options. One insurer actually offers more than 200 investment choices for UL investors, although I am not completely convinced that more is always better. Many of these are mutual funds, often the same ones you could select within an RRSP or an open account, but they aren’t the only game in town. Here are a few of the more innovative choices:

  • A Mortgage Investment Corporation. BMO offers you the chance to invest in a portfolio of mortgages held by a Mortgage Investment Corporation (“MIC”) that would pay around 6% and is a non-stock market investment. Since this is a private investment, this means not having to worry about stock market fluctuations and, despite a low interest rate environment, earning a yield that is probably higher than the one used to illustrate the performance of your UL Policy. It also means that yield should increase relatively quickly when mortgage rates go up, as the mortgages are all two years or less and there are always mortgages coming due and fresh money is being lent at the new market rate.
  • A Stock Market Investment that Guarantees No Losses. BMO offers the “Guaranteed Market Index Account”, which it describes as offering the security of a GIC with exposure to the TSX 60. It’s a simple proposition – you get 50% of the market upside each year but none of the downside. Although this doesn’t eliminate volatility and still means having to eat into capital during a bad year to pay premiums, it does offer some exposure to the market during good times and better protects your capital during the bad ones.
  • Absolute Return Funds. Sun Life offers a fund designed to make a yearly profit of 5% more than the overnight lending rate over every 3-year period, regardless of market conditions by using a bunch of strategies, depending on market conditions at that time. Thus, instead of claiming a successful record merely because it has lost less than its competitors, it is only successful if it’s making you the promised profit, regardless of what the market does. Furthermore, they strive to be less than half as volatile as the global stock market.
  • Diversified Accounts. Sun Life Offers the Sun Life Diversified Account that reminds me a lot of the investment portfolio you’d receive inside a Par Policy: private mortgages, some private investments, real estate, public bonds and some public equities. It also smooths returns in order to provide less volatility and predictability. At the time of this article, it pays daily interest equal to about 4% per year and guarantees that your yearly return will never drop below 0%.
  • Hybrid UL / Par Policies. Industrial Alliance offers a product called the “Equibuild” that is designed to give you the best of both worlds. The basic premiums go into a fund that generates guaranteed cash value like you’d enjoy with a Par Policy and pays policy dividends. Any extra money you contribute can be allocated to Equibuild Fund, which is the Par policy equivalent, or towards more traditional UL investments. There is also even the option to use extra money to buy an additional paid up death benefit each year. As another feature, there is a cash for life feature where the owner is guaranteed payment for life if he wants to use the policy for retirement purposes.

Obviously, there are likely other intriguing insurance investment options out there, as these are only some of the options I’ve discovered on my own and through my cadre of insurance advisor friends.  I suggest doing what I do when working with financial planning clients who are potentially interested in life insurance – collaborating with a licensed insurance advisor (which I am not, as my focus is on big picture planning despite owning my Certified Life Underwriter Designation and having spent 15 years advising insurance advisors) who can make specific policy recommendations.

Unless your insurance advisor is experienced in overall financial planning and knows your situation, I strongly suggest getting a financial planner familiar with your overarching financial plan review the size, type and ownership of the policy suggested to ensure that it’s the best possible fit. Think about buying life insurance like shoe shopping – even though you need new runners for an upcoming marathon, if you buy the wrong pair or overpay, you may either not make it across the finish line or, if you do, the resulting discomfort and stress of cramped toes or living outside your budget may ultimately make the experience a lot less enjoyable.

Also, when deciding whether to own the policy personally, corporately, in a trust or as a combination of these choices, it’s important to get it right the first time, as there are often tax costs that can arise if you have to change ownership of a policy later. Unfortunately, I often get involved after the policy is already in place, when options are more limited and changes can be expensive.

Conclusion

Although many clients feel more comfortable with Par Policies (which I will talk about more next time), I still see UL Policies as a strong choice for the right client in the right situation. They offer more flexibility and transparency. For example, some UL policies both allow the entire cash value of the investment account to be withdrawn tax-free during life in the event of a disability and allow you to change your policy investments at your own discretion, which may allow clients to perform better over the long term if they play their cards right.

In the end, each policy has its own advantages – for example, clients planning on borrowing against their policies during retirement are often able to borrow more against the cash value of Par Policies than their UL cousins while someone planning on withdrawing directly from their policy during retirement might be better served with a cheaper UL policy with reducing insurance costs. Ultimately, I believe that insurance can become a valuable tool in many retirement plans and that the type of policy best suited to the purpose depends on the client and situation. In these days of steadily increasing income tax rates, life insurance and all the tax benefits that come with it might be worth a second look when looking to fund your retirement.