Incorporating Your Business
Are you a business owner looking for more ways to save taxes and accumulate more assets? If you are self-employed or have a profitable business, your accountant will usually recommend you get incorporated. Why? Because of taxes. Imagine if you make $500 in personal income; you could easily have to give half of that money to the CRA as taxes. But if you have a Canadian-controlled private corporation (CCPC), under the Small Business Act, any active business income lower than $500,000 will only be taxed at 10% to 14%, depending on your province.
Significant Tax Savings
Right from the get-go, that’s $50,000 compared to a $250,000 tax bill—a big difference. Additionally, as the business owner, you control how much money goes back to you personally, allowing you to control when to pay that tax bill.
The Catch with Passive Income
However, there is a catch. The CRA is always the smartest entity in the room. While active business income enjoys lower taxes, any passive income you make in the corporation will be taxed at 47% to 54%, again depending on the province. For simplicity, let’s assume a 50% tax rate. Every dollar you make on your corporate investment is taxed at 50%.
Impact of Passive Income on Small Business Deduction
Starting in 2019, if you make more than $50,000 in passive income, your $500,000 small business deduction room decreases. If you have multiple properties in the corporation and collect more than $150,000 in rental profit, you lose all the $500,000 room, meaning all income has to pay 27% to 30% instead of 11%. The CRA enforces this to prevent business owners from shuffling their assets under the corporation to pay fewer taxes. Unlike the personal side, there is no such thing as a corporate-owned tax-free savings account.
Utilizing Life Insurance for Tax Savings
Life Insurance as a Solution
To save more on taxes, life insurance can be a solution. Here’s some data from a 2022 report by one insurance company: There were at least 1,700 new life insurance cases where clients put down between $10,000 to $25,000 per year. Additionally, there were at least 400 new policies where clients contributed $100,000 to $250,000 annually, and at least 40 cases with clients willing to put $1 million and above every year.
Understanding Life Insurance
Most people (84%) think of life insurance as a product that pays your family if you pass away. However, wealthy individuals invest in life insurance for several reasons. There are two kinds of corporate-owned life insurance: term life insurance and permanent life insurance, similar to personal insurance.
Term Life vs. Permanent Life Insurance
Term Life Insurance
Business owners often buy term insurance for key employees to provide financial security for the company if something happens to them. The cost is similar to personal term insurance.
Permanent Life Insurance
Permanent life insurance is for life, including both a death benefit and a cash value component that grows over time. Under the Insurance Act, these savings (cash value) are tax-sheltered as long as the death benefit is reasonable. This creates a tax-sheltered account to grow your savings without triggering passive income tax.
Advantages of Permanent Life Insurance
Tax Advantages
While there is no immediate capital gains tax on stock portfolios or real estate, dividends or rental income are subject to a 50% tax rate. However, with life insurance, borrowing against your cash value instead of withdrawing it can prevent triggering taxes.
Financial Flexibility
Insurance policies can provide a line of credit based on the cash value, which banks are happy to approve as the money is secure even if you pass away. Borrowing against the cash value offers flexibility to reinvest in other projects, and the interest becomes an expense, further reducing your tax bill. The policy continues to increase in value even as you borrow against it.
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- What is the primary purpose of insurance?
Retirement Planning and Life Insurance
Accessing Funds in Retirement
For retired business owners needing money for personal use, withdrawing from the corporation is subject to personal tax brackets (20% to 40%). However, with a corporate-owned life insurance plan, you can potentially skip the salary/dividend tax by borrowing directly from the insurance.
Handling the Policy After Death
If you pass away, the death benefit pays off all loan balances and goes to the corporation, which must be the beneficiary. The majority of the death benefit goes into a capital dividend account, allowing shareholders to withdraw it tax-free.
Considerations and Planning
Keeping the Policy Within the Corporation
Once a permanent life insurance policy is placed within a corporation, it is generally best to keep it there. Moving it, especially after many years, can trigger additional taxes.
Utilizing a Holding Company
For operating companies, it is advisable to place the life insurance policy in a holding company that owns the operating company.
Understanding Canada’s Lifetime Capital Gain Exemption
Tax Planning Advantage
The Lifetime Capital Gain Exemption allows business owners to sell or dispose of shares from an eligible corporation and obtain a tax-free capital gain close to a million dollars, which is advantageous when selling your corporation or shares.
Types of Permanent Life Insurance
Universal Life Insurance
Universal life insurance offers flexible premiums and death benefits, combining insurance with a market performance-based savings component.
Whole Life Insurance
Whole life insurance provides fixed premiums and guaranteed death benefits, offering predictable growth with guaranteed returns.
Conclusion
Corporate-owned life insurance offers a strategic solution for business owners to save on taxes, accumulate assets, and plan for the future. While complex, the benefits are substantial. Consult with financial experts to choose the right policy that aligns with your long-term financial goals.