April 21, 2008

The Problem of "Trapped" Retained Earnings

The government encourages small business (technically Canadian-Controlled Private Corporations or CCPCs) through favourable taxation. Let's see the effects in Alberta, the province with the lowest combined federal and provincial tax rates. Active business income up to the Small Business Limit (generally $400,000) is taxed at 14% and the balance at 29.5%. These rates are attractive compared to the 39% marginal tax rate on personal income.

All isn't rosy. Governments discourage small business from generating passive investment income with a hefty tax rate of 44.7%. And that's in low-taxed Alberta.

What Do Business Owners Do?
Typically, small business owners and incorporated professionals like doctors pay tax on income up to the Small Business Limit and retain these after-tax earnings in the corporation (e.g., $400,000 less 14% leaves $344,000 retained). Prior to eligible dividends, income above the Small Business Limit was generally paid out as a bonus (tax deductible to the business and taxable to the recipient). Now accountants often recommend that tax be paid and the after-tax earnings be retained unless the owner wants to spend the money.

A successful small business can easily have hundreds of thousands of dollars in retained earnings "trapped" inside the corporation to avoid additional taxation. This is not what the owners want.

Uses of Retained Earnings
Retained earnings can be used in three ways
  1. reinvested to grow the business (which results in more taxable income)
  2. spent (goes to owner via dividends from after-tax income, effectively taxed at the top marginal tax rate)
  3. saved in the corporation (and investment income taxed at rates higher than the top personal marginal tax rate)
Saved Retained Earnings
What tax-effective strategies deal with saved retained earnings? They can be invested in dividend paying shares of some Canadian companies since the dividends are received tax-free (and can be used to buy more of the same). This builds more retained earnings in the corporation, though.

Another solution is to transfer the retained earnings into universal life insurance for
Tax-Free Access
If the owner wants income in the future, the corporation can use the cash value as collateral for tax-free bank loans and distribute the proceeds to the owner as shareholder dividends. Since the collateral is so secure (an insurance contract backed by a multi-billion dollar insurance company), there are generally no requirements to pay the loan interest on an ongoing basis. Instead, the loan and the accumulated interest can be paid with the tax-free death benefit.



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