Despite capital gains changes that took effect in June, the extra corporate investment income when investing inside a corporation more than outweighs the higher corporate tax, a CIBC report says.stockworldr/iStockPhoto / Getty Images
Most Canadian small business owners are better off investing their after-tax corporate earnings inside their corporations rather than in their investment portfolios despite the capital gains tax hike that took effect in June, argues a new report from Canadian Imperial Bank of Commerce.
The report, released Oct. 2, states that owners of active businesses who invest capital inside their corporations will have more cash in their pockets thanks to the lower tax rates on corporate business income.
The Liberal government announced in its spring budget that, as of June 25, corporations would have to pay income taxes on 66.67 per cent of all their capital gains annually, up from 50 per cent. The same increase to what’s known as the capital gains inclusion rate applies to individuals but only on more than $250,000 in capital gains each year.
“Even though the integrated tax rate for corporate capital gains is quite a bit higher than the top tax on personal capital gains that are only one-half taxed (below $250,000), the extra corporate investment income more than outweighs the higher corporate tax,” states the report, titled “Just leave it! Corporate versus personal capital gains investing.”
The author, Jamie Golombek, managing director, tax and estate planning with CIBC Private Wealth in Toronto, says his analysis addresses the question business owners have been asking since the new, higher capital gains inclusion rate took effect: Is it better to invest money in the corporation or pull it out and invest it personally?
“There were some suggestions that it was time to collapse the corporations, to take all the money out. Some even said, ‘What’s the point of having a corporation any more?’” Mr. Golombek says.
His report shows that most small business owners earning active business income – regardless of whether they qualify for the small business deduction (SBD) income (which is the first $500,000 of active business income earned in a corporation in a year) – are better off leaving money in the corporation because of the tax deferral of up to 40 per cent, depending on which province they live in.
He notes that the analysis only applies to operating businesses, which include professional corporations for doctors, dentists, lawyers, accountants and consultants.
“If you can afford to leave the money in the company, there’s a bigger pool of capital to invest,” Mr. Golombek says.
The report uses the example of an Ontario corporation that earns $10,000 of SBD income. It shows that after paying $1,220 in corporate taxes, there would be $8,780 of corporate capital to invest within the corporation.
However, if the corporation distributed its after-tax SBD income to the business owner through dividends, the owner would pay $4,190 of personal taxes. They would then have $4,590 to invest in their investment portfolio.
The example is based on business owners who pay taxes at the top marginal rate.
The report shows what would happen if the $8,780 of corporate capital invested were to grow at a 5-per-cent rate of return. After one year, there would be a capital gain of $439 ($8,780 × 5 per cent) before taxes. That leaves $269 in net proceeds after both corporate and personal tax if the new two-thirds capital gains inclusion rate is applied.
When the same rate of return is applied to the personal capital – or $4,590 × 5 per cent – the capital gain is $230 before taxes after one year. If half of the capital gains are included in income (because the annual capital gains personally are below $250,000), the net proceeds would be $168.
“Our report takes you back to the first principle of investing in a corporation: When you earn money in the corporation, you have a significant tax deferral advantage on that income, which means that, effectively, you have more to invest. It’s that simple,” Mr. Golombek says.
He notes that small business owners with private corporations are still worse off than before the tax changes took effect on June 25 because of the increased capital gains inclusion rate.
“However, the corporation is still advantageous because you can invest more starting capital than you could personally,” Mr. Golombek says.
He also says it’s only an advantage if you can afford to leave money in the corporation and don’t need it for business expenses or take it out for personal use.
The report notes the outcome could be different for those who don’t pay the top personal tax rate or who think their tax rates may change. It could also be different for those who split income with family members. It also notes that the SBD limit may decrease when a corporation earns passive income from investments.
Business owners should talk to their tax and investment advisers before choosing to either invest after-tax business income within their corporation or withdraw the after-tax income and invest the remaining funds personally, the report adds, citing “financial and non-financial considerations involved when choosing to leave funds in your corporation.”
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