Global meltdown. Bear market. Recession. It’s hard to stay positive in the face of today’s economic uncertainty. But here’s a bit of good news: as an entrepreneur, you have access to a host of tax-saving strategies that aren’t available to the average individual. From retirement structures to health-care accounts to easily accessible investment options, you can save big on your annual personal tax bill. Ask your financial advisor about these entrepreneur-friendly tax-planning vehicles:
Balance your paycheque: How you withdraw company money affects your personal taxes, so weigh carefully the impact of taking dividends versus salary, and consider retirement-savings strategies such as individual pension plans or retirement compensation agreements. (See “Better ways to retire rich.”)
Depending on your circumstances, dividends may be taxed more favourably than salary, says Karen Yull, principal, national tax with Grant Thornton LLP in Toronto. However, dividends do not qualify as earned income for building up an RRSP contribution limit — for that, you need a salary.
John Nicola, CEO of Vancouver-based Nicola Wealth Management Ltd., offers some rules of thumb. If your company’s taxable income is above the $400,000 threshold for the reduced small-business tax rate, he says, “Draw enough salary to maximize your RRSPs or, better still, an IPP if you’re over roughly age 45. Any other compensation that you require beyond that is ideally paid in the form of dividends, either directly to you or through a family trust to other family members.”
On the other hand, if your company pays the small-business rate, he says, “By far the most attractive form of compensation is a dividend.” That’s because the combined corporate and personal taxes on the dividend will amount to less than personal taxes, Canada Pension Plan and Employment Insurance premiums on the equivalent salary. While you won’t be able to contribute to an RRSP, there are other tax-effective options for saving for your retirement.
Establish a health spending account: An account that funds health-care costs for you (as an employee) and your dependents, this strategy converts medical expenses into tax-deductible business expenses.
Unincorporated entrepreneurs can set up a “private health services plan” that allows a maximum deposit of $1,500 per person per year for you, your spouse and each eligible dependent over age 18 ($750 per minor dependent), with a time limit of 24 months to use the contribution. However, a corporation can establish a “health and welfare trust,” with no monetary or time limits. Both accounts cover “pretty much anything prescribed by a registered health professional,” says Tina Tehranchian, a certified financial planner and branch manager at Assante Capital Management Ltd. in Toronto: think braces, Botox or physiotherapy.
The tax payoff: 100% of your contribution to the account is eligible as a tax-deductible business expense for the year in which you contribute. You’ll pay an admin fee of about 10%, but that’s tax-deductible too.
Split your income: Income splitting is a way to move some of your personal income (taxed at a high rate) onto the tax returns of any spouse or adult children who are taxed at a lower rate in order to reduce the overall taxes your family pays.
Income splitting also generates higher RRSP limits for family members, adds David Phipps, senior financial advisor at Assante Capital Management Ltd. in Ottawa: “It also creates more room for your family to save in a tax-sheltered environment.”
You can split income in several ways, including lending money to your spouse or children for investing or business purposes, or you can pay family members a salary. Of course, they’ll need to provide a service to your company. And their salary must pass a “reasonability test,” meaning it must be roughly what you would pay an arm’s-length person to do the work, or you risk raising a red flag come tax time.
Establish an Employee Profit-Sharing Plan (EPSP): An EPSP is a special-purpose trust that allows the designated beneficiaries to share in company profits. If you list employed family members as beneficiaries, you can flow profits to them without facing the reasonability test applied to salary, says Peter Merrick, a certified financial planner and president of Toronto-based MerrickWealth.com. Plus, the money is taxable in their hands (presumably, at a lower rate than in yours), and they won’t have to pay CPP premiums on EPSP money.
Use a family trust/personal holding company combo: Nicola suggests this strategy may work for entrepreneurs who hold their assets in a personal holding company.
Set up a family trust to own the shares of your operating company. List your family members and also your personal holding company as the trust beneficiaries. In addition to adding a layer of creditor protection, this strategy allows for income splitting, says Nicola, “because profits from your operating company can be paid as dividends to the trust, where they are taxable in the hands of the beneficiaries (at lower rates than for you), or they are paid through the trust to your holding company, where they are not taxed at all and can then be invested.”
Make tax-smart investments: Consider these three tax-effective investment vehicles:
>Corporate-class structured mutual funds: Unlike traditional mutual funds, corporate-class mutual funds are essentially a family of funds held under one single taxable corporation. Relatively new but avaiable from most mutual fund companies, corporate-class funds allow investors to buy and sell funds within the family without any tax consequences, meaning you can rebalance your portfolio as the market fluctuates. You’re only taxed when you sell and redeem funds.
>Managed-yield mutual funds invest in short-term instruments, such as certificates of deposit. But instead of earning, say, 3% interest that’s fully taxable, that 3% is treated as a capital gain, so 50% of it is exempt from taxes. That means your overall yield could be quite a bit higher on a very conservative investment.
>Flow-through shares: These shares are issued by resource companies to finance their exploration activities. Without revenue, such firms can’t use the tax deductions they would incur as income-generating companies, so they are “flowed through” to investors, who can deduct 100% of their investment. Beware: it’s a high-risk strategy. “You may not ever recover anything from an investment perspective,” says Waters, manager, tax planning at BMO Nesbitt Burns in Toronto. “But you have a potential tax advantage for doing it.”
Buy a Universal Life insurance policy: Insurance may not be the first thing that comes to mind when you think of tax savings, but purchase a universal life policy and you’ll get life insurance coverage plus a tax-deferred savings plan. Here’s how: you pay more than the cost of the premium. Once the insurance and management fees are deducted, the rest goes into a tax-sheltered investment fund of your choice. You can withdraw funds (they are taxed as income) or you can use the policy as collateral on a bank loan, which is tax-free cash. When you die, the loan is repaid, and the remainder is paid to your beneficiaries.