I’ve given up trying to find pictures for such dry topics like incorporation so I figured I’d go with my science nerd side instead 🙂
Another key advantage of a personal corporation is the ability to control when you take personal income. Deferring personal taxation via retained earnings in a CCPC typically works best when combined with investing these retained earnings to allow compound interest for many years and then draw those funds out in retirement at lower personal tax rates.
I will purposely be ignoring the advantage of tax deferred passive investment of retained earnings within a corporation as it relates to income smoothing. I felt given the proposed tax changes, separating the two topics would be best. Removing the investing component does significantly diminish the value of income smoothing, but I will shows some circumstances were it can still benefit the incorporated professional.
In the previous post, I showed why income splitting with a spouse can lead to absolute tax savings. I like to think of income smoothing via a CCPC like this – income splitting with your future self. Unlike income splitting, income smoothing can work with just one shareholder in a CCPC. Smoothing can also use multiple shareholders to create a larger advantage. Given the new potential tax changes, I will assume in this post that smoothing can only occur to one individual.
Income splitting with your future self can only work if you can spend less money than you earn after tax. It requires retained corporate earnings to distribute in future years. It works when your future tax bracket will be lower than if you took all the earned income personally right away. Hopefully the concept of increased savings rate is established and you plan to save some money in all future years. The magnitude of future benefit to income smoothing will largely depend on:
- The consistency of retained corporate earnings
Imagine a small business that goes through many cycles. It may be quite profitable for a few years and then run losses for a few years.
If that business paid out all the retained earnings from profitable years with big bonuses to shareholders and employees, it may go bankrupt during its loss-making years.
If it kept those profits in preparation for lean years, it may be able to continue paying employees and shareholders from previous years’ retained earnings to ride out the storm.
Many businesses rely on prudent cash flow management to keep operations continuing. This issue pertains less to personal services CCPC’s. For many professionals like doctors, lawyers and dentists, the earnings remain relatively consistent as long as they are working. Others, like mortgage brokers or realtors, do have business cyclicality to their profession.
Generally speaking, the more consistent the CCPC retained earnings are, the higher likelihood it can benefit from income smoothing tax planning.
2) The absolute amount of retained earnings/ year achievable
Income smoothing will be of little benefit if you retain only a few thousand dollars each year. The key advantage is to act as a significant supplemental income in future years. Either a high income or a significant savings rate is needed to manage this. The larger the amount of corporate retained earnings, the higher likelihood that income smoothing will benefit you.
Examples of Income Smoothing #1 – Maternity/Paternity or Sabbatical Leave
I will continue with the Ontario professional from the earlier posts earning $250K/year consistently after business expenses. In previous examples, the professional needed all the income drawn out to pay for personal living costs. The new assumption is that only $100K/year after tax is required for living costs and no income splitting is possible.
*Note that all future scenarios will ignore CPP/EI and focus solely on total tax for simplicity
Scenario A – Without Corporation
All $250K/year is taken personally with a tax bill of ~$97K leaving $153K after tax.
Only $100K is needed to live per year, so the other $53 K is placed into a savings account.
After 2 years of income, a personal leave for 1 year is needed but living costs remain the same.
$106K saved over 2 years – $100K living cost in personal leave = $6K leftover personally
Scenario #2 – With CCPC
$145K/year in salary is needed from the corporation to leave $100.5K personally after tax for the family to spend.
$105K remains within the corporation taxed at 15% leaving ~ $90K/year in retained corporate earnings.
$180K is available after 2 years when the one year leave is needed
$145K paid in salary from corporation for required $100K personal income in leave
$180K minus $145K = $35K additional corporate retained earnings leftover for future distribution.
Even if all $180K was withdrawn personally in the leave:
after tax income would be ~$119K – $100K living expense = $19K leftover personally
Income Smoothing Example #2 – Early Retirement/FIRE With No Investment Growth (see this post for intro to FIRE)
Assumption is our Ontario professional now makes $350K/year after business expenses and still only needs $100K after tax personal to live and still has no income splitting potential. I have increased the salary for this scenario to make the retirement date still look ok given that we are assuming zero investment growth.
SWR (Safe Withdrawal Rate) 4% assumed (or 25x living expenses) which means $2.5 million after tax money required. To remove the passive income growth variable as discussed in the intro, we will assume the worst stock market in investing history where investing returns earn 0% but no inflation occurs (not that far off Japan in the last 20 years but that is a whole other topic).
Scenario A – Without Corporation
All $350K taken as salary = ~$150K tax paid = $200K after tax
$100K for living expenses and $100K/year saved placed.
In 25 years, $2.5 million has been saved which is all after tax dollars. FIRE has been achieved.
Scenario B – With CCPC
$145K salary drawn from corporation leaves $100K after tax personal income.
$205K remaining taxed at 15% = ~$175K retained corporate earnings/year.
To reach FIRE, corporate retained earnings needs to equal 25x the $145K salary draw = $3.625 million.
It will take only 20.7 years to achieve FIRE in this scenario.
Even when an additional $10,000/year is removed for incorporation accountant/lawyer costs, this change to about 22 years vs 25 years to FIRE.
In my opinion, this scenario is the number one reason why incorporation will likely still benefit high income earners even if income splitting and tax deferred investing rules are changed by the government. See more on this below. As long as your retained earnings are high, it is hard to go wrong deferring taxation at a high rate.
Income Smoothing Example #3 – Saving for A House Down Payment using a Shareholder Loan
Assumption is back to the Ontario individual making $350K/year after corporate expenses again without income splitting and needing $100K after tax for living expenses.
Goal is to save 20% on a $1.5 million home purchase = $300K down payment.
Scenario #1 – Without Corp
$250K salary pays $97K tax leaving $153K after tax.
$100K/year spending and $53K saved.
In 6 years there is $300K down payment and $18K additional personal cash.
Scenario #2 – With CCPC and a Shareholder Loan
$145K salary leads to $100K after tax spending, BUT the professional chooses to pay extra tax now to create a shareholder loan. I know it seems crazy to pay extra tax unnecessarily, but I will show you how it can be worthwhile.
A shareholder loan is when an individual shareholder loans the corporation money to help with its operations. This can be for investment into the business or into passive investments. It is essentially a book keeping entry that your accountant would track and be carried as a liability to the company until it is paid. In theory this can go the opposite way with the company loaning a shareholder money, but that is not the intent of this example.
The following steps will create a shareholder loan:
1) pay the same $145K salary for living costs leaving $100K personal after-tax income
2) pay an extra ineligible dividend from the corporate tax retained earnings. The amount of dividend depends on how much you need available in the future. In this example, a $75K ineligible dividend works well. The calculation looks like this
$250K corporate income – 145K salary = $105K in corporate earnings with 15% tax = $89K after tax corporate earnings
$75K ineligible dividend is paid from retained earnings which leaves $46K after paying personal dividend tax in the professional’s hands
3) This $46K is loaned back to the company (not used personally) creating a shareholder loan credit.
4) At the end of year 1, there is $89K – $75K dividend = $14K retained corporate earnings AND $46K of shareholder loan credit which has been sent back into the CCPC = $60K retained behind in the corporation.
5) After 5 years, there would be $70K ($14K x 5 years) retained corporate earnings and a $230K ($46K x 5 years) shareholder loan credit held within the corporation for a total of $300K in the CCPC. Remember that the shareholder credit part can be paid out TAX FREE from the corporation, because the professional already paid the personal tax in previous years. The key has been that the tax was paid out at a lower effective tax rate then if it was all paid out in the year it was earned as salary.
6) In the final year, the professional needs $70K after tax from the ineligible dividend to be able to have the required $300K down payment.
The corporation will have $89K from the 6th year retained earnings + $70K accumulated retained earnings from year 1-5 = $159K total retained
$120K ineligible dividend paid out = $70K after dividend tax available + $230K shareholder loan paid out personally tax free = $300K down payment
$159K – $120K corporate dividend leaves $39K within the corporation
Final result = $300K personal down payment and $39K in corp, vs $18K leftover personally in Scenario #1
A shareholder loan helps smooth the removal of corporate income so that the yearly tax rate can avoid creeping too high. It also clearly beats taking out $300K for the down payment from a CCPC from excess assets in just one tax year. This is because the professional’s living costs + $300K assures paying the highest 50% tax bracket for most of the income.
This example is a bit more complicated so you may have to read it a few times for it to make sense. Feel free to ask any clarification points as our family has created this shareholder loan over the last few years and I am quite familiar with it. A good Capital Dividend account can also help build shareholder loan too, but I will talk about that in the tax deferred investing post.
Proposed Tax Changes
It remains unclear from the Finance department paper how income smoothing might be affected moving forward. There are references to increased tax on retained corporate earnings that are not used in the active business. It seems hard to see how CRA would tax retained earnings immediately beyond the 15% corporate tax. The problem right now is the high degree of uncertainty.
Many of the possible ways of increasing the effective small business tax rate discussed in the Finance department paper involves the CRA adjusting the tax treatment upon the sale of corporate investments. This is a process referred to as deferred taxation in the Finance paper. This will likely primarily affect the tax treatment of GAINS in the investment, not necessarily the initial retained earnings used to invest better known as the adjusted cost base (ACB). If an investment went from $1 million ACB to $1.5 million, it is the $500K profit that will take a significant hit in how it is treated when paid out to the individual, but the original $1 million is treated no differently than if it had sat in cash the entire time.
The assumption that only growth of investments will be taxed aggressively implies that retained earnings that sit stagnant or have little growth can still be paid out in future years where the marginal tax brackets are lower. Example #2 above shows the scenario with only the ACB left in the CCPC since there was no investment growth. The professional using a CCPC was able to retire 3 years earlier still than the non-incorporated one.
I will be watching the final rules closely. If the final tax changes lead to an immediate increased taxation above the small business tax rate for any retained earnings, then everything I said above in regards to ACB no longer applies since the tax deferral is gone. If the initial tax deferral still occurs and the growth is heavily taxed to make the process similar to if you had invested personally, then incorporation still will likely have its place for new high income earning professionals in the future for the ACB reason described above.
For the last several years, income smoothing has worked wonders for our family to create maximum flexibility in our life choices. We have benefitted from a significant amount of corporate savings which has compounded at a solid rate. A significant part of our FIRE status can be attributed to large amounts of retained corporate earnings to pay out at lower tax rates if we stopped working today.
Income smoothing works extremely well when combined with income splitting with spouses and kids, deferred taxable portfolio growth and ongoing low corporate tax rates. The tax changes will hurt many of the scenarios where income smoothing applies, but for the professional with significant amount of potential retained earnings each year, a corporation will still likely make sense.