How Business Owners Can Preserve the Small Business Corporate Income Tax Rate
If you’re the owner of a Canadian controlled private corporation (CCPC) that earns a significant amount of investment or “passive” income held inside your corporation, you may be losing out on the full benefit of the small business corporate income tax rate.
Currently, for CCPCs resident in British Columbia, the small business tax rate on the corporation’s first $500,000 of annual active business income is 11%. The tax rate applied to active business income in excess of $500,000 is taxed at the general business tax rate of 27%.
Tax rules were introduced in 2019 to penalize business owners that hold passive investments in their corporation in addition to the corporation carrying on an active business. Generally, the government didn’t like corporations building up passive investments with funds that had been generated, in part, from the corporate income tax savings provided by the lower small business corporate income tax rate. The 2019 tax changes also included provisions to restrict income sprinkling (a way corporations distribute income,usually by dividends,to lower income earning family members). This caused many business owners to keep their profits inside their corporations instead of paying out dividends. Retaining corporate profits means higher passive income.
Thus, with the tax changes, if a corporation is earning more than $50,000 in passive income in a year, the amount of active business income eligible for the small business corporate income tax rate is reduced by $5 for every $1 of passive income above the $50,000 threshold.
For the purposes of calculating passive income, each $1 of investment dividends and interest received counts as $1 towards the $50,000 threshold while each $1 of realized capital gains counts as $.50 for now, although there are concerns that this may increase in the future. Ultimately, if a corporation earns more than $150,00 in passive income in one year, none of its active business income will be eligible for the 11% small business rate the next year.
A tax-exempt permanent insurance plan does not produce passive investment income
The key for business owners is trying to keep their corporate income tax rate at the lower 11% instead of the higher general rate of 27%. How can this be accomplished? One way is to transfer the passive income being earned annually by the corporation to a tax-exempt corporate-owned permanent insurance plan. This type of insurance plan does not produce passive income and may preserve access to the small business corporate income tax rate. Since the corporation is the owner and beneficiary of the plan, everything stays inside the corporation. It’s a simple strategy of re-allocating taxable corporate investments dollars to a tax-exempt insurance plan.
The benefit here is that all of the insurance policy cash-values (the investment component of the insurance plan) grow tax sheltered; there is no income tax to pay as long as the money is left to grow inside the plan. None of the growth or income generated inside the policy counts towards the $50,000 threshold discussed above.
On death, the full amount of the death benefit, less the life insurance policy’s adjusted cost basis, creates a credit to his MPC’s capital dividend account (CDA), which can be used to create tax-free capital dividends. If Dr. Jones lives to a ripe old age, it’s possible that the entire insurance payment at death can be paid out of the company tax-free to his estate or other shareholders.
(The CDA credit is unique to corporate-owned life insurance. This is a notional account and appears on a company’s financial statement, which will have a significant benefit for owners of Canadian controlled private corporations. The balance in the CDA can be paid out to shareholders as a capital dividend and thus be exempt from tax. The death benefit of a corporate-owned life insurance policy is one item that can be credited to the CDA tax-free).
It’s important for businesses to keep track of passive investment income inside their corporation. Earning over $50,000 of passive income in a year will see a gradual reduction in the amount of active business eligible for the small business tax rate.Understanding what the new rules entail then creating a strategy to minimize corporate tax payable will help increase available corporate profits to reinvest in the business. For business owners with multiple corporations, particularly if they may sell one at some point, working with experienced insurance and tax advisors is essential for determining the right place to own any life insurance policy in order to optimize future tax savings.