By Richard Yasinski
Special to The Canadian Design and Construction Report
Incorporated business owners have a number of ways to invest either personally or in their corporations. A business owners’ investment strategy must be mindful of the tax structure and situation of the owners. When it comes to investing, business owners must understand more than most about how income is taxed.
My grandfather used to say: “It’s not how much you make, it’s how much you keep.” But he was referring to the days he’d take the cash from his pay envelope to the pub and what he left with after a few pints and games of cards. This saying is more appropriate than he knew for any business owner planning an investment strategy.
The first step in developing an investment strategy is understanding the types of income that can be earned and how each is taxed. Admittedly this is a little complex but for anyone building a portfolio this is the basic information we must understand or we’ll be doomed to earning less on our hard earned investment dollars. So here goes and stay with me:
There are four types of “income” we can earn and an incorporated business owner could earn all of them.
• First there is income that is 100 per cent taxable – typically from employment and interest earned from savings accounts or interest earning investments.
• Second there are dividends which are taxed at a lower rate than salary or interest and vary based on whether they are eligible (usually from public corporations); in eligible (private corporations); foreign dividends (from foreign sources); and return of capital (tax paid capital returned as income).
• Third there are capital gains, where 50 per cent of the gain on the investment is taxable as income.
• Lastly is “return of capital” which is simply the return of the tax paid money originally invested.
Incorporated business owners can choose to earn regular income (a salary) or dividends from their corporation or a combination. A salary is 100 per cent taxable and earns RSP room at the rate of 18 per cent of gross salary per year. This allows the business owner to contribute to their RSP – which of course grows tax free.
The disadvantage, depending on how you view this, is for a business owner earning more than $54,900, maximum annual CPP contributions must be made of $2,544 (2016) for the employee (the business owner) and another $2,544 by the employer (the business owner). So for business owners earning a salary, they are effectively contributing twice what an employee contributes and will only ever collect one pension.
There are benefits to having CPP, an opportunity for a disability and survivor pensions, and these need to be considered. Generally, if a business owner is drawing a salary, they should maximize their RSP contributions annually to take advantage of this deduction. Ideally business owners should draw the maximum salary to generate maximum RSP contributions – $140,944 of earnings attract the maximum RSP contribution allowed which is $25,370.
Incorporated business owners could also consider an Individual Pension Plan or IPP. This is effectively a super RSP with allowable contributions based on an actuarial analysis of the contribution amount needed to fund a pension for the owner. Depending on the years the business has been incorporated, the age and health of the owner, significantly more could be contributed to this registered plan.
Another option is a Retirement Compensation Arrangement which allows tax deductible corporate dollars to be deposited into a plan on behalf of the business owner. No tax is paid until the benefits are received.
If an incorporated business owner earns a salary, they have the option of using RSPs, an IPP or an RCA. Investments held in these types of structures can be individual stocks and bonds and mutual funds. Each structure has its pros and cons depending on the business owner’s salary, years left in business, number of owners and age. All of these strategies will result in 100 per cent taxable income which may or may not qualify for income splitting until age 65. Individuals drawing more than $72,809 currently will start to see their income clawed back at the rate of 15 per cent per $1000 – effectively another tax on income which results in about 55 per cent tax on every $1 greater than this amount.
Income paid to a business owner as dividends does not earn any RSP room. A business owner earning income in this way typically sets up a holding company (HOLDCO), where a corporate investment account is opened. This HOLDCO could own shares of the operating company or be the beneficiary of a family trust, which owns shares of the operating company.
The primary advantage of the family trust structure is the ability to distribute dividends to all beneficiaries (family members or others) at the discretion of the trustees. A HOLDCO owning shares of an operating company can also distribute dividends to shareholders at the discretion of the owners but shareholders can potentially claim a portion of the company equity – an issue when shareholders divorce.
Incorporated business owners could invest their after tax corporate profits into individual stocks, bonds, mutual funds, real estate or many other types of investments. However, these investments, when earning interest, dividend or capital gains and left in the HOLDCO investment account, are taxed at the highest rate. Typically, the strategy is for this income to flow out to the business owner as part of their dividend income.
When compared to investing in an RSP, where 100 per cent of the contribution is tax deductible and the investments grow tax free, investing in a HOLDCO account may seem questionable. The real advantage of this strategy is at the time of withdrawal. A HOLDCO investment account can distribute dividends to the shareholders and be income split very effectively. For example, an individual earning only approximately $33,000 of dividends pays no tax.
For both types of income, salary or dividends, any additional income earned and not needed for lifestyle expenses, could be withdrawn from the business at a low tax rate and should be invested in a TFSA. With savings rates so low, the advantage of using a non-taxable account for long term retirement assets is considerable. It’s significantly more beneficial to not pay tax on a six per cent return than on a one per cent return.
So, here are my recommendations for investing for business owners and their significant other:
• Understand the four types of income, how you might generate them and how they are taxed;
• Understand the impact of investing in a registered account (RSP, IPP, RCA) compared with a corporate HOLDCO and how each strategy helps defer or reduce tax for your situation;
• Only then create a comprehensive financial plan (this doesn’t mean long – one page!) of how you will earn income and invest and review annually. When life changes, so does the plan; and
• Work with a certified financial planner with the skills you need to help you set up and manage your investment plan. Training, experience and focus are worth every penny of their fees.
Richard Yasinski is an independent financial planner practising since 1996. Watch his video, www.financiallysound.ca.