Case study: Small business owner debates expansion

The situation

Alina Islam,* 39, is a dentist in Halifax. She employs another dentist on salary, plus three hygienists and a receptionist. Her practice is set up as a Canadian-controlled private corporation (CCPC), which means she’s taxed at the combined provincial-federal small business rate of 13.5% for business income up to $350,000. Above that, her business would fall into the next bracket of up to $500,000, where the rate is 26.5%.

Her business has $500,000 in retained cash. Her home, valued at $390,000, has $150,000 remaining in mortgage debt.

Her practice has never netted more than $350,000 per year, so she’s always been taxed at the lower rate. But the dentist a few streets over is retiring soon and has started referring clients. Young families have moved to the area, and she thinks business could pick up. She’d consider hiring another dentist and more hygienists if necessary.

Her accountant, a family friend, has joked that she shouldn’t bring in more than $350,000 so she can access the lower tax rate. Alina hates giving a penny more than necessary to the tax man, but figures there must be a tipping point and wants a second opinion.

Alina is single by choice, with no financial commitments (or investments) except for her practice and the mortgage on her fashionable Quinpool Road house. She doesn’t need the money, and would welcome the chance to maintain her flexible hours (the practice is open Monday to Thursday, and she closes it for a month each winter to head to a sunny locale). She keeps 60% to 70% of what she makes in the business, only taking dividends for living expenses.

At the same time, her competitive nature and love of dentistry are reasons to take on more clients, and she figures it’s time to start investing for retirement. What is the tax tipping point for Alina?

* This is a fictional scenario. Any resemblance to real persons is purely coincidental.

The $350,000 marker

A tax-efficient strategy for expanding her business

Jennifer Poon

Jeffrey Waugh

Jennifer Poon, Director, Tax and Estate Planning – Wealth, and Jeffrey Waugh, Director – Tax, Wealth & Insurance Planning Group, Sun Life Financial, look at tax and insurance considerations for Alina and her business. Read More

The experts

• 

  Wade Lawrence

  CFP, CLU, president, Lawrence Financial Services, Winnipeg

• 

  Paul Schnier

  tax lawyer, Blaney McMurtry LLP, Toronto

• 

  Bill Black

  CFP, CIM, wealth advisor, IPC Securities, Owen Sound, Ont.

Lawrence: I don’t see the $350,000 threshold as being a tipping point. If her earnings increase over that, she’s still going to have positive earnings after tax. Granted, she won’t be retaining as much of the dollar as she was when it was under $350,000, but she should be doing what she wants with her career.

Black: I would agree. Above the threshold, the amount of tax paid on the income simply goes up. It doesn’t affect the sale of shares for Canadian eligible corporations. There are lots of people who would suggest she should take safe income * and maybe bonus it—or dividend it up into a holding corporation. That is something to consider if it meets her objectives. For an eligible small business corporation, in some places, you get the tax-free sale of shares up to half a million dollars. A corporation can sell above $800,000 worth of shares, tax free, as long as you meet the eligibility (see “Qualifying for the tax-free sale of shares,” below.)

Schnier: It’s $835,716 this year; it’s indexed, so it goes up [with inflation]. If she wanted to sell her practice down the line, it could take the form of a sale of shares, which at this point [would leave] up to roughly $835,000 exempt from tax.

The bottom line is, if she wants to grow her practice, she’s still going to be making more money, net of tax. The tax rates on a small business in Nova Scotia are unusual because there are actually three brackets. Most provinces have two—you’re under the $500,000 or over it. Nova Scotia has this third bracket, so the small business rate is 13.5% under $350,000, then you go to 26.5% between $350,000 and $500,000, and then to 31% over $500,000.

You’d pay 31% corporate tax, and, if you take the money out in the form of dividends, you’re paying personal tax on those dividends. So you’re going to end up with combined rates of more than 50%, and maybe as high as 54%. But, end of the day, there’s still something left to take home, to invest, or for whatever she wants to do with it.

Taking a salary

Lawrence: She could look at taking salary out of the business. Let’s say her corporate income was $450,000, net of expenses. If you take $100,000 in salary, that becomes a deduction, so she’s able to keep the full $350,000 in the business at the lowest tax rate. Given that the salary and dividend are integrated, she’s not worse off from a tax perspective [to take a salary].

She would have to pay CPP premiums if she takes a salary, but given that she hasn’t had any retirement planning, she should probably consider that. A salary would also give her RRSP room, another mechanism for saving for retirement. It would also help her justify a health spending account in her corporation for deductions for any medical expenses.

Schnier: This integration at the 26.5% corporate tax rate would probably work fine. My concern is, once you get to the 31% rate, the integration might break down because of the additional corporate tax and the personal tax. If she were over the $500,000 threshold for earnings in the corporation, that’ll be taxed at 31%. If she paid herself a salary, that’s a deduction, and she can then get herself back down below the $500,000, or even the $350,000, depending on how much salary she took.

Savings

Black: She hasn’t saved any money other than the half a million in the corporation. She certainly could establish a holding company and start to pay dividend funds up to the holding company to be invested. How they are invested in the holdco is very important because of the tax rate for inactive business income. We’d look at the way it’s invested to make sure it’s tax efficient inside the holdco. The ideal depends on the situation, based on a dialogue with the client about her goals and obectives. Suffice to say, you want to stay away from interest income inside a corporation.

Schnier: There is a point about retaining passive investments inside an operating company or a holdco. If she wanted to sell her practice to take advantage of the small business corporation capital gains exemption, she would have to sell the shares personally. The holdco couldn’t sell the shares of the company that carries on the practice.

The shares would have to qualify. One of the qualifications is that more than 50% of the assets have to be used in the active business for two years prior to the sale. So, if she were to build up a lot of earnings and investments in this holdco, that may tip her offside. That’s because to the extent the half million dollars of retained earnings… exceeds the value of the practice, it goes offside the small business capital gains exemption.

I’m not a big fan of investing through a holding company unless you have family members and want to take advantage of income sprinkling and channeling income to them at lower tax rates. If it’s a single person—because our system pays a refundable tax—the holdco will pay tax on investment income of about 54%. That’s pretty much the same as what a person would pay personally [on] investment income.

Business tax options on $450,000, Nova Scotia, 2017
	Dividend1	Regular income
Original intended payment	$100,000	$100,000
Less: corporate tax paid @ 26.5%	$26,500	N/A
Proceeds	$73,500	$100,000
Less: Tax owed	$26,750.581	$29,820 (29.82% of income)
Plus: Dividend tax credit	$18,024.661	N/A
Personal taxes paid	$8,725.92	$29,820
Final proceeds to Alina	$64,774.08	$70,180
Corporate net income	$450,000 (no salary deduction)	$350,000 ($100,000 salary deduction)
Total corporate tax paid	$73,750 (13.5% on $350,000; 26.5% on next $100,000)	$47,250 (13.5% on $350,000)
Total tax cost	$82.475.92 ($8,725.92 + $73,750)	$77,070 ($29,820 + $47,250)
Caveats and assumptions › Alina’s marginal personal tax rate is 43.5%; her average tax rate is 29.82%. › This chart excludes salary deductions such as CPP and EI. › In the dividend scenario, we assume Alina has no other income. In the salary scenario, we assume the employment income is her only income. 1 The $100,000 dividend is taxed as a blended eligible (N.S.; 17% gross-up) and ineligible (federal; 38% gross-up) dividend. Dividend tax credits are also blended. Sources: Advisor’s Edge Report and Doug Carroll, practice lead, Tax, Estate & Financial Planning at Meridian

Federal review of tax strategies

Schnier: In the federal budget, the minister announced a review of the use of private companies and how they’re used by what they call the wealthy—because it’s always the wealthy who are the villains in this piece.

Sprinkling investment income among family members in lower tax rates is one thing they’re looking at. The other issue is accumulating income in a company without subjecting it to the shareholder tax.

Black: That is a very damaging proposition. Certainly, there’s a certain amount of cash flow required, inside a corporation, to run operations. The capital on hand in the corporation may be there for investment purposes, but certainly it could be invested there until it’s required for use. For the government to take that tack, it’s very damaging for corporations, and we’re hoping they won’t.

Lawrence: You have to break down planning into what we know with certainty would not be affected by government tax changes, and perhaps implement on those items. Leave the other items as a discussion, saying, “Based on the rules of the land today, this is what we’d recommend, but perhaps hold off on implementation until there’s clarification on what the rules are going to be.”

$835,716

Small business corporations that qualify can sell up to this value of shares, tax-free, in 2017

RRSPs

Lawrence: She should probably start to take out some salary and begin RRSP and CPP contributions. There will be a one-year delay on the RRSP contributions because it’s based on prior-year earned income. I assume she has no contribution room because she’s always been taking out dividends. But, if she were to pay herself a $100,000 salary, it would create $18,000 worth of RRSP contribution room for 2018.

Schnier: For 2017, the maximum RRSP contribution is approximately $24,000. On that basis she could go up to $150,000 in salary once she goes over the $350,000 business income threshold. If it gets over $500,000, there’s certainly going to be a preference for salary. She could probably take enough salary to take the business down to the $350,000 limit.

I’m also fussed about the $150,000 in mortgage debt. She has all this money sitting around and the ability to take money out of the company, so why is she paying non-deductible interest on her mortgage? Your home is a principal residence. It’s your best investment, tax-free.

Insurance

Lawrence: I look at someone who’s single, who’s looking at taking on more business risk. She’s reliant solely on herself, so I’m concerned about disability coverage. She should potentially have a critical illness policy as well. Personal disability coverage is going to provide her tax-free income in the event of a disability. As a business owner, the insurer is going to assess that based on her combined personal tax return and her corporate tax return.

She’s probably insurable for approximately $15,000 a month of tax-free disability benefit. I’d recommend an office overhead policy, owned by her corporation, as it’s deductible. If she becomes disabled for a short period, typically 12 months to two years, it provides funds into the corporation.

Estate planning

Schnier: Just because she’s single doesn’t mean she has no need for a will. She has a practice that’s worth money, half a million dollars of accumulated money inside the corporation, a house that’s worth close to $400,000. She should have a will to deal with her assets.

Lawrence: I’d also say a power of attorney and a healthcare directive, which allows you to appoint someone to make medical decisions on your behalf if you become incapacitated.

Black: Dental practices are very saleable. Most of them trade on multiples—a combination of a multiple of net revenue, a multiple of gross revenue, depending on the business. She will have that lump sum of income that could be added to her cash flow for retirement purposes and her savings program.

Lawrence: She’s nicely on track, if she gets a good advisor and effectively puts her assets to work.

Qualifying for the tax-free sale of shares

Small business corporations that qualify can sell shares, tax-free, valued up to $835,716 in 2017.

CRA says qualified small business corporation shares must meet all of these conditions:

• at the time of sale, it was a share of the capital stock of a small business corporation,^† and it was owned by you, your spouse or common-law partner, or a partnership of which you were a member;
• throughout that part of the 24 months immediately before the share was disposed of, while the share was owned by you, a partnership of which you were a member, or a person related to you, it was a share of a Canadian-controlled private corporation^† and more than 50% of the fair market value of the assets of the corporation were:
• used mainly in an active business carried on primarily in Canada by the Canadian-controlled private corporation, or by a related corporation;
• certain shares or debts of connected corporations;
• or a combination of these two types of assets;
• and throughout the 24 months immediately before the share was disposed of, no one owned the share other than you, a partnership of which you were a member, or a person related to you.

† As defined by CRA

_______________________________________________________________________

A tax-efficient strategy for expanding her business

Jennifer Poon, Director, Tax and Estate Planning – Wealth, and Jeffrey Waugh, Director – Tax, Wealth & Insurance Planning Group, Sun Life Financial, look at tax and insurance considerations for Alina and her business.

As Alina grows her business, her practice may gross more than $350,000 annually. A common (and good) practice is to take a salary – which is a business deduction – to reduce taxable corporate income to the $350,000 threshold needed to take advantage of the lower corporate tax rate of 13.5% in Nova Scotia.²

For Alina, in addition to getting a lower corporate tax rate, paying herself a salary has three additional advantages:

• Employment income is considered earned income and will generate registered retirement savings plan (RRSP) contribution room for Alina (whereas receiving dividends won’t).
• She’ll be able to contribute to employment insurance (EI) and the Canada Pension Plan (CPP), which she can draw on later.
• An employee salary is a business expense; the employee can file a claim for back wages in the event of bankruptcy.

Compared with paying herself a dividend, Alina’s professional corporation would have to pay corporate tax first and then issue her a dividend that would be subject to her marginal tax rate for a non-eligible dividend.

Other considerations

With her business expanding, Alina will also want to consider the following:

• Given that her business is incorporated, Alina should consider key person life insurance on herself and possibly other dentists/hygienists who play a key role in the practice. This will help mitigate against the financial loss should one of them die (helping to reassure potential creditors, hire a replacement, etc.). Some key points to keep in mind:
  • The corporation can be the owner, premium payer and beneficiary of the life insurance policy.
  • Since her corporation’s income is taxed at significantly lower rates than she would personally be at these income levels, it needs to generate less before-tax income to pay the premium than if Alina was paying personally.
  • The death benefit, less the policy’s adjusted cost basis at time of death, will create a credit to the corporation’s capital dividend account (CDA). Capital dividends can be paid tax-free to shareholders. The CDA credit provides a tax-effective way of moving the money out of the company to the new shareholders or her estate.

• Alina may also want to think about corporate-owned critical illness insurance for herself. This will help protect the corporation against financial losses if she suffers a covered critical illness. She could also look at personally owned critical illness insurance, which would provide her with a tax-free lump sum benefit directly if she suffers a covered critical illness. Alina will need to work with her tax advisors to determine the most appropriate structure and solution.

• In addition, Alina will need to review and possibly top up her disability income insurance to make sure she’s fully protected.

• Since she’ll need to engage her legal advisors, this is also a great opportunity to review and update her will (or draft and execute a will, if she doesn’t already have one), health care directive and power of attorney documents.

Meeting with her team of advisors to discuss these next steps will help Alina confidently move forward with a plan for expanding her business.

²Thresholds and tax rates vary by province. The 2017-18 Nova Scotia provincial budget, released on April 27, 2017, proposes to increase the small business threshold from $350,000 to $500,000 as of January 1, 2017.

NEXT STEPS

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