- Accumulating Wealth
With respect to accumulating Wealth, please bear in mind this other topical yet profound question:
“How Big Is Your Stack?”
Its derivation is from the game of Poker and was put in context because it is more important than the other people/personalities at the Poker table, the cards in their hand(s), or the cards in your own hand. “How Much Do I Have?” dictates what you need to do to achieve your Wealth Accumulation goals in conjunction with your age/timeframe, your level of risk, etc …
Once you express to yourself/others that your Net Worth is in the millions, thus $250,000 is not “two hundred and fifty thousand” but rather “a quarter of a million dollars”, then you probably should avail yourself of a Trusted Wealth Professional.
Please see where you are on this Ladder to categorize your Net Worth (outside of primary residence or personal home):
- aHNW – aspiring High Net Worth; $10,000 to $100,000
- eHNW – emerging High Net Worth; $250,000 to $750,0000
- HNW – High Net Worth; $1,000,000 plus
- UHNW – Ultra High Net Worth; over $10,000,000 (starting point varies)
The question is now “Where Are You on the HNW Ladder?”
Please Note: Net Worth calculations typically include the value of the residential home but Home Ownership (renting versus owning) and location of the home typically greatly impact this calculation (price fluctuations).
There are generally two aspects to accumulating Wealth:
- minimization of taxes when compensating the business owner; through either explicit Tax Savings, or Tax Deferral
- Investment; growth and protection of existing monies and assets
Since the Small Business Deduction (SBD), of approximately 15%, only covers the first $500,000 of active business income, there are opportunities to decrease income to this level via bonuses (a form of salary), known as ‘Bonusing Down’; additional income, beyond MPS, can be achieved via Dividends.
Salary or Dividends
For the most part, the pertinent question is “How can I pay for my lifestyle while maintaining my business?” And the answer generally includes a discussion about Salary and Dividends in the context of Accumulating Wealth.
To help position the Salary and/or Dividend levels, let’s keep in mind a few approximate figures:
- $40,000 – a ‘poverty’ level for household income
- $80,000 — the average Canadian household income
- $100,000 – a minimum income for a Government Sunshine list
- $145,000 – In 2016, the approximate Maximum Pensionable Salary (MPS)
- $200,000 – Approximate amount need to pay MPS, contribute to a Registered Retirement Savings Plan and address all deductions and professional fees
Although a lot of theoretical work is undertaken to consider the ‘better’ Tax remuneration strategy, and it varies by Province, the interesting observation is that ‘low’ income business owners probably should not be incorporated unless they have subsidization from spouse, family, partners, inheritance, previous business sale, etc … The fees and administration negate the benefits of incorporation, unless limiting your personal liability is mandatory.
Active and Passive Business Income
It should be also noted that ‘active’ business income and ‘passive’ business income also have different tax consequences. Business income from the principle activities of the business, example a veterinarian caring for dogs and cats, is defined as ‘active’ business income. But if the veterinarian leases space to a dog groomer, the rental income is considered ‘passive’ income to the veterinarian and they will be taxed at the higher rate. Investment income is sometimes termed ‘passive’ income and it may be advantageous to pay come dividends in years where the investment/passive income is earned.
Salary or Dividends continued
For those Business Owners that are at the upper end of the example scale provided above, the best counsel is generally to pay yourself an annual salary up to the MPS limit, roughly $145,000 or monthly payments of approximately $12,000. If you need more income, use dividends. There might be slight differences per Province, but the advantage of drawing a salary is that you have contribution room for RRSPs (paid personally) or Individual Pension Plans (IPPs) and Retirement Compensation Agreements (RCAs), both paid from the business.
Paying a Salary involves paying Canada Pension Plan (CPP) and possibly Employment Insurance (EI), plus Health Taxes (limits and criteria supplied by your Tax Accountant), but the upside is that you now have access to a new Asset class. The CPP is a guaranteed and indexed to inflation payment that has survivor benefits. Currently in 2016 the maximum CPP amount is just over $1000 per month and this can be factored into your retirement planning (along with OAS – Old Age Security).
Please note: EI is generally not paid on Salary to the business owner and family members.
Canadian Tax Integration changed in 2014 and the intent is that Salary and Dividends are taxed equally when the full business and personal taxes are totaled. This isn’t perfectly exact ‘tax integration’ but it changed many Tax Accountants views towards paying Dividends only and leaving the remaining cash balance in the corporation. The (passive) investment income, from the surplus cash within the corporation, was and still, is taxed at a higher rate. Income splitting opportunities are still available and can be exercised through Salary and/or Dividends.
Income Splitting is generally a ‘High-Low’ strategy. Income, in various forms, is paid from the ‘High’ tax bracket earner to those in the ‘Low’ tax bracket. So salary, dividends or capital gains can be paid through to shareholders or beneficiaries of the OpCo/HoldCo or trust. The tests from the CRA ensure that these payments are ‘reasonable’ or else the attribution rules will kick in and the income will find its way back to the higher tax bracket earner. In the case of salary, that must be a bona fide employer-employee relationship. Kiddie Tax rules were enacted because Business Owners were transferring wealth to family member in exchange for no actual work being performed.
The recommendation of using Salary up to the MPS limit of $145,000 opens the door for accumulating Wealth through Registered options now. If you don’t fully spend the take-home portion of your Salary, you can personally fund an RRSP and/or TFSA. If you have surplus cash within your corporation, the business can fund an IPP or an RCA for the business owners (certain criteria apply).
Con’s of Salary and Dividends
Although the overall tax on either Salary or Dividends should be quite close, it is important to note that while the positive (or Pro) position is stated when explaining either Salary or Dividends, as a compensation strategy, the opposite (or ‘Con’) position should be explained as well. The quick summary below serves as a level-setting list that you are welcome to verify with your Tax Accountant – overall ‘tax’ should be close to equal.
- The Canadian Tax rules have changed recently, this has impacted (more so) Dividend remuneration
- No Canada Pension Plan (CPP) but you may have already maxed this out (if you were an employee early in your career/business with salaried earnings)
- No pensionable earnings for RRSPs/IPPs/RCAs – and accumulation of contribution ‘room’ i.e. carried forward RRSP room
- Because no salary you may not receive other personal tax credits based on salaried earnings
- Pay both sides of CPP; as the employee and the employer. There are upper bounds.
- Pay EI and Health Tax (if appropriate)
- May need to setup Payroll (with possibly regulation deductions – business income could be variable in the beginnings of your business)
- Losses (business, capital and business investment) cannot be dealt with more effectively (given the carry forward and carry back regulations) if you paid yourself a salary
Everyone agrees though – bonus down to the $500k Small Business Limit. This provides RRSP and IPP/RCA contribution room as well.
A CEO of a medium-sized Canadian Tax firm once said
“Why wouldn’t you take advantage of all the Tax Deferral mechanisms available to you?”
That’s where your Tax Accountant can help you. In particular, when and how to use the 3 classifications of Dividends (eligible, regular/ineligible or a capital), with their Gross-Up and Tax Credit rates. This is an invaluable service in conjunction with OpCo/HoldCo/Family-Trust structure and income-splitting strategies.
- Eligible – a dividend paid to a Canadian resident by a CCPC
- Ineligible/Regular/Ordinary – as above but already received Small Business tax treatment
- Capital; usually termed Return of Capital and typically are non-taxable. There are multiple rules and regulations surrounding Capital Dividends and their use of the Capital Dividend Account (CDA) and Refundable Dividend Tax on Hand (RDTOH) system.
Note 1: You pay higher tax on foreign dividends as there are no gross-up and credit treatments.
Note 2: The Canadian Federal Government has announced their intentions to change dividend tax rates in conjunction with the Small Business tax rates. This is still a work in progress.
Note 3: The Capital Dividend Account ‘accepts’ tax-free dividends in certain situations (ie. from life insurance or sale of shares/ assets).
Note4: RDTOH will not be covered in this Overview other than to note that a ‘refund’ is not always the preferred tax and cash flow strategy.
Investing: Asset Classes
Corporate real estate holdings, residential homes and other properties are an asset class unto themselves given the rapid rise in real estate and the historic low levels of interest rates. Many business owners, and for that matter, home owners, are ‘House Rich and Cash Poor’. So as we acknowledge that a ‘Peak’ Real Estate valuation timeframe exists, capital gains and rental income from your holdings will also be considered as part of your Wealth Accumulation strategies. And that perhaps will include converting non-deductible personal debt to a valid business expense.
Re-mentioning CPP as an Investible Asset Class, there are many Canadians that are proud to accept this payment, almost to the point of believing they are entitled to it (no matter what the contributions were). But you need Salary as a remuneration strategy to ‘invest’ in this asset class.
A Trusted Wealth Professional can offer you generally any Canadian financial instrument from any Canadian institution. And you can invest your TFSA, RRSP, RESP, IPP, RCA, IRP, etc … as well as your corporate account with them.
Wealth Accumulation Summary
A Business Owner can conclude from section 2. Accumulating Wealth is that they should be looking at moving up the Net Worth Ladder. If you only take just enough cash/remuneration from your business to fund your basic lifestyle expenses, how can you utilize your corporation to achieve investments in a variety of different asset classes to increase your Net Worth? Your Tax Accountant and CFO will help you apportion cash for short term needs and emergencies, and your Trusted Wealth Professional can help you with investments in other asset classes.
Essentially you are creating a Wealth Portfolio of different asset classes within different tax-efficient structures.
Additional Wealth Accumulation Strategies
Leaving cash in the CCPC, to be taxed at 15% is far better than withdrawing salary/dividends to be taxed at the highest levels (over 50%).
If you were applying to a Bank for a business loan, the general rule of thumb is to halve your revenues and double your expenses. That is an interesting way to view your Net Worth. If you thought that $1,000,000 was all you needed to retire upon and you would spend only $60,000 per year; perhaps you could plan, or strive, for $2,000,000 and possible annual expenses of $120,000. Maybe you fall short of these lofty new targets but you will need more to protect against taxes and inflation that increases basic lifestyle costs (food, transportation, etc…). Your Trusted Wealth Professional can help you construct a Financial Plan if you are unsure about your Net Worth, Lifestyle Expenses, or the Size of the Stack you’ll need to ‘retire with the lifestyle you desire’
Estate Freezes can be used in conjunction with Income Splitting, as you have the opportunity to create/increase Spousal and Family Net Worth’s as well. You would be capping your own wealth through the Estate Freeze but ensuring the transfer of future wealth growth to other family members in a more tax efficient manner.
As mentioned above, opportunities to convert Personal Debt to Business Debt may be appropriate. There are strategies around mortgages on real estate, student debt, etc ….
Corporate, Spousal and Other Loans, with their associated Payback (principal and interest) will not be covered in this Condensed Overview. However it should be noted that the CRA prescribed rate is currently only 1% and can be locked-in-for-life. Your Tax Accountant will know how to setup these Loans such that income attribution does not become transferred to your business. Please note that ‘Other’ loans could be loans to a Family Trust for investment purposes.
Other allowable remuneration forms from the Corporation to the Business Owner, such as Retirement Allowances, Automobile usage, and Management Fees, exist as a method of having the business pay for allowable expenses. The ‘reasonableness’ test will apply to many of these compensation forms and your Tax Accountant will know best how to guide you. But the general principal is that you should let the business pay for whatever it can before paying for it personally.
How Big is Your Stack?
Can you climb the High Net Worth Ladder by paying less Taxes and investing wisely? A good starting point is to consider if you are above or below $200,000 of free cash flow per year, for remuneration and retirement investing.
Decisions abound in relation to your Total Net Worth.
- Do you need to expand your business with $100,000 from retained earnings, or should you attract $1,000,000 in private equity to procure/finance the building where you operate your business?
- Should you invest through the corporation and pay higher tax, or do you have $50,000 in contribution room within your TFSA?
- How should you acquire international vacation property?
- How liquid are my investments if I require funds because of illness or disability?
Essentially you are Wealth Planning for 3 unique time situations:
- When you are operating your business and require income
- When you are retired; not working and require income
- And when you are not in one of the above two categories