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Tax planning for private company owner-managers

Tax planning for private company owner-managers

Synopsis
3 Minute Read

With recent federal tax changes, owner-managers of Canadian private corporations should consider these planning options to navigate the legislative changes effectively.

Canadians who earn more than $235,000 per year potentially face personal income tax rates exceeding 50 percent. With the introduction of the 2023 federal budget, new legislation further challenges these Canadians by either eliminating or significantly reducing the tax planning options available.

Private corporations will often accumulate valuable tax attribute balances. The strategic use of these tax attributes, along with other planning solutions, needs to be considered when owner-managers are compensated by their corporations. Some of these options are detailed below.

Capital dividend account (CDA)

Amounts paid from a corporation’s CDA to Canadian resident shareholders are tax-free. Many corporations will generate CDA through the realization of capital gains, where the corporation disposes of capital property with accrued value beyond its cost.

Fifty percent of a capital gain is taxable. The other half is added to the corporation’s CDA. Conversely, half of any capital losses will reduce the corporation’s CDA.

Refundable dividend tax on hand (RDTOH)

Two types of RDTOH can be generated within a private corporation: eligible RDTOH (ERDTOH) and non-eligible RDTOH (NERDTOH). Both pools are generated when a private corporation earns passive income.

ERDTOH is often generated when dividend income is received from marketable securities (e.g., bank stock). NERDTOH can commonly be generated by the earning of interest income or the realization of capital gains.

Corporations can pay eligible dividends to recover ERDTOH or non-eligible dividends to recover both ERDTOH and NERDTOH, thereby reducing the overall cost of withdrawing money from the corporation.

Shareholder loan and share capital repayments

There may be times when a shareholder injects funds into or pays expenses on behalf of their corporation. This will result in the corporation owing money back to the shareholder. Alternatively, shareholders may inject funds into their corporation by purchasing share capital from treasury.

Both shareholder loans and amounts paid for treasury shares can be repaid tax-free.

Intergenerational transfers

The introduction of Bill C-208 has finally allowed some Canadian entrepreneurs to transition (sell) their corporation to the next generation and achieve a tax result equivalent to selling their corporation to a third party. However, there are conditions, as the legislation is only intended to allow for the transfer of qualifying small business corporations, qualifying farming corporations, or qualifying fishing corporations.

Provided specific criteria are met, the rules introduced through Bill C-208 allow each of the transferring parents to utilize their lifetime capital gains exemption when transferring shares of their corporation to a corporation owned by a related individual. This exemption allows an individual to receive up to $1 million from the gain on sale tax-free, resulting in approximately $250,000 in tax savings for each parent.

Undertaking this planning allows the children to finance the purchase with funds from the corporation being acquired rather than their personal after-tax funds.

Where the noted criteria are not currently met, planning may make it possible in the future. However, taxpayers should be aware of proposed changes to the tax rules on intergenerational business transfers that are expected to come into effect on January 1, 2024.

Tax-exempt life insurance

Tax-exempt life insurance offers another way to provide tax-free wealth to family members in an environment where income splitting is no longer viable. Unlike term life insurance, tax-exempt life insurance facilitates investing for growth within the life insurance policy, similar to a retirement savings plan or pension. The value of the policy will grow over time beyond regular contributions.

Life insurance is often purchased within a corporation, with the corporation as the beneficiary. Although the corporation cannot deduct the related insurance premiums for tax purposes, the corporation can use money that would otherwise be subject to personal tax to fund the insurance premiums, as would be the case if the policy was owned personally.

When the policyholder passes away, the life insurance payout contributes an amount, dependent on the policy, to the corporation’s CDA (see above). This amount can be distributed tax-free to shareholders.

Alternative minimum tax (AMT)

When considering tax planning alternatives, it is important to note that Canada’s AMT regime is proposed to change on January 1, 2024. The proposed changes may significantly impact higher-income individuals — particularly those with substantial capital gains and those claiming significant tax credits such as donations.

Contact us

To learn more about these and other options to manage your tax liability, contact your local MNP Tax Advisor.

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