Corporate Tax

Tax Planning for Small Businesses

Paul Sharpe, CPA, CA
/
October 21, 2022

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This article will discuss five levels of tax planning for Canadian small business owners. We’ll discuss them in order of risk and complexity.

Tax Planning in Canada

When people think about tax planning, they might conjure up images of offshore accounts in the Cayman Islands or corporations in Delaware. However, there are some much simpler ways that small business owners can use tax planning to their advantage.

This article will discuss five levels of tax planning for Canadian small business owners. We’ll discuss them in order of risk and complexity. 

These strategies escalate in cost and risk as we go, so buckle up!

If you'd rather have Joe explain it to you, check out the video below 👇

RRSPs and TFSAs (Level 1)

The first level of tax planning is fairly common, but still excellent and quite underused.

Business owners can use RRSPs and / or TFSAs to help save money for the future. They are low cost and low risk and any business owner should look at these first if they want to reduce the amount of tax they’re paying.

RRSPs and TFSAs are ingrained into our tax system so are unlikely to be going anywhere in the near future.

RRSPs vs TFSAs

What’s the difference between RRSPs and TFSAs?

RRSPs are registered retirement savings plans and TFSAs are tax free savings accounts.

They are both excellent savings vehicles but have different tax implications.

How RRSPs Work

With an RRSP, you get a tax deduction when you make a contribution. This means you pay less tax in the current year.

The money inside an RRSP grows tax free until you withdraw it in retirement. 

When you do withdraw the money, you pay tax on the amount of the withdrawal at your marginal tax rate in that year.

How TFSAs Work

With a TFSA, you do not get a tax deduction when you make a contribution. This means you don’t actually save any tax in the current year.

Instead, the money inside a TFSA grows tax free until you withdraw it.  

When you withdraw funds from your TFSA, you don’t have to pay tax on the withdrawal like you do with an RRSP.

Both TFSAs and RRSPs are excellent savings vehicles but which one is better depends on your particular situation.

When to Use RRSP vs TFSA

This is an overly simplified way of looking at things, but in general it’s a good way to look at it.

  • RRSP - If you think you will be in a lower tax bracket in retirement than you are now, an RRSP is probably the better choice.
  • TFSA - If you think you will be in a higher tax bracket in retirement than you are now, a TFSA is probably the better choice.
  • Both - If you’re not sure, you can always use both!

There are other factors that go into this decision like how much contribution room you have and how long you plan on saving the money before you need it.  

It’s worth having a chat with an accountant or financial planner if you’re not sure what to do. 

Incorporate Your Business (Tax Planning Level 2)

Incorporating your business gives you access to low small business corporate tax rates, which allows you to reinvest funds back into your business and build your wealth.

The chances that the government will remove the benefits of incorporating is pretty small; however the government has curtailed some benefits of income splitting in the last few years.

However, incorporation is a safe and effective tax planning strategy as it aligns well with government objectives, which are to grow the economy through business and employment growth.

The main drawback to incorporating is the additional administrative cost and burden.

Costs of Incorporation

  • Incorporation fees,
  • Annual corporate tax filing and legal filings
  • More compliance (corporate documents, minute book, etc.)

You are bringing a new entity into the world after all. Plus, if you ever want to shut it down, you will have costs there as well.

For many business owners, though, the benefits can outweigh those additional costs.

The benefits of incorporating in Canada

  • Limited Liability - It allows for business growth without personal liability.
  • Lower Tax Rates - The business can claim the small business deduction, which gives it a lower tax rate on the first $500,000 of business income.
  • Income Splitting - The business can split income with family members who own shares in the company, as long as they are involved in the business. This can result in significant tax savings. However, the government has put restrictions on this in recent years.
  • Accumulate Wealth - The business can accumulate more wealth within it than an unincorporated business before facing higher tax rates, although the government has also put restrictions on this.

When to Incorporate Your Business

If you’re not sure about incorporating, you can start by checking out our article on when it makes sense to incorporate your business.

The next step then would be to reach out to your accountant for a chat to see if incorporating makes sense.

How to Incorporate Your Business

If you’re ready to incorporate, you can also check out our review of Ownr, an online platform for incorporating and managing corporate documents.  

The article has information on various ways to incorporate your business and some tips on when each method may make sense for you.

Corporate Structuring (Tax Planning Level 3)

The next level of tax planning that we’ll discuss is corporate structuring or the use of holding companies.

Creating a holding company can be a great tax planning strategy to protect and build wealth under certain circumstances. 

As with incorporation overall, it’s a pretty low risk strategy. However, as it is more complex, you will face more administrative cost and burden.

There are a few important benefits to using a holding company.

Asset Protection

Operating companies are exposed to risk through their everyday business activities. Transferring some of the assets of an operating company to a holding company can provide a layer of protection in the event that creditors come after those assets.

Help You Claim the Lifetime Capital Gains Exemption

The lifetime capital gains exemption (LCGE) provides owners of Canadian Controlled Private Corporations (most small incorporated businesses in Canada) with tax-free capital gains of up to $913,630.

Some operating companies may not be eligible for the LCGE because they need to show that most of their assets are used in active business. If an operating company also holds a bunch of investments, this requirement might not be met.

A holding company can help with this by having the operating company transfer funds to the holding company through tax-free corporate dividends. The funds can then be invested in the holding company instead of the operating company.

This helps the operating company meet the requirement that most of their assets are used in business activities.

Tax Deferral from a Holding Company

A holding company can provide some flexibility around the timing of when income is earned (and therefore taxed). This creates some tax deferral opportunities for the owner of the business.

If you’re interested in learning more about holding companies, start with our guide to holding companies linked here.  

Once you understand how they work, it’s a good idea to reach out to a tax professional to help you structure things properly.

Using Insurance (Tax Planning Level 4)

Insurance can be a handy tool for tax planning. However, we’re getting up there in the complexity and risk levels.  

The government has made some light indication that they may target health benefits for taxability in the future, but nothing has been brought forward yet.

Life insurance policies already have limitations attached to them around deductibility of premiums.  Plus there is always the risk that the government could target them for taxation in the future.

We’ll look at the basics around using health insurance and life insurance as tax planning devices.

Health Insurance

At the moment, health insurance can be a handy tool for tax planning. Health insurance plans make it easier to deduct medical expenses for owners and employees.

It’s a good way to provide benefits to your employees of the company (owners included) and also ensure that the medical spend is tax deductible within the corporation.

Life Insurance

Life insurance can be another tool for tax planning and wealth creation. It is especially important when it comes to estate planning.

If a business owner wants to provide her children with a nest egg once she passes away, a life insurance policy can help with this.

An example is the best way to describe this.

Beth the business owner has an incorporated business and the company earns more money than Beth needs for her and her spouse. Beth would like to transfer cash from her company to her children when she passes away.

Beth could invest the funds to try and grow the money available to her children when she passes. However, life insurance might be a better way to achieve her goals.

Instead of holding investments directly within the company, Beth may choose to have her corporation purchase a life insurance policy with those same funds.

In this case, Beth would be the life assured (her life is what is insured.  The company would be the policyholder and beneficiary meaning that the company pays for the insurance and gets the proceeds when Beth dies.

With some forms of life insurance, the policy holder (Beth’s company) is able to contribute additional funds above and beyond the monthly insurance premiums.

Those funds are then invested in marketable securities that can grow tax free within the insurance policy. 

When the life insurance policy is paid out to Beth’s company upon her death, the payout may be increased by the growth of those investments.  

Beth’s children would then have a larger pool of money to inherit from the funds in the corporation.  If everything is set up properly, some of these funds can also be withdrawn tax-free from the company by Beth’s children.

Benefits of this corporate owned life-insurance strategy:

  • Premiums are paid with corporate dollars - The corporation pays the premiums instead of the individual. Life insurance premiums aren’t usually tax deductible within the company; however, the benefit is that the life insurance policy is not purchased with after tax dollars like it would be if Beth bought it personally.
  • Tax-free growth - The investments can then grow tax free within the insurance policy whereas the investment income would otherwise be subject to tax if investments were owned directly by the company.
  • Avoid reduction to SBD - Investing the funds within the life insurance policy allows the company to avoid a potential reduction of its small business deduction (as discussed above in the holding company example).
  • Increase capital dividend account - The proceeds from the life insurance policy can create a pool of tax-free money within the company. This is called the capital dividend account. If Beth’s children are also shareholders of the company, they can receive tax-free capital dividends from this pool of money.

These life insurance policies can be quite complex and the details may vary from one policy to the next.

Up here in level 4, it’s especially critical to speak with professionals. We would recommend consulting with a tax accountant and an insurance broker who specializes in corporate life insurance policies.

Tax Havens and Loopholes (Tax Planning Level 5)

We are now hitting expert+ level on tax planning and the lines can start to blur towards tax evasion, which is most definitely not legal.

If you have ever had the feeling that the uber rich play by a different set of rules, then you are probably on the right track.

As quickly as CRA closes loopholes, there are teams of professionals trying to discover and exploit new loopholes within the tax code. This in itself is not illegal and lawyers and other tax professionals are completely within their rights to do so.

That doesn’t mean that you, the small business owner, are able to access these loopholes. These would be tightly held secrets and offered only to those who stand to benefit (and pay) the most.

They are a constantly moving target, so unless you are able to keep a tax lawyer on speed dial, they probably aren’t for you. Besides, even if you do get away with it for a while, it can most definitely catch up to you.

Article by
Paul Sharpe, CPA, CA
.
Originally published
October 21, 2022
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