Should I Contribute to an RRSP if I Own an Incorporated Business?
February 1, 2019
The following article was written by Joe Basque and edited by tax specialist Kevin J. Porter, CPA.
Do you own and operate an incorporated business? If so, have you ever wondered whether it makes sense for you to contribute to your RRSP?
Personal vs. Corporate Tax Rates
Canada has a graduated income tax system, colloquially referred to as ‘tax brackets.’ In BC, the top personal marginal tax bracket of 49.8% is applied to income earned above the $210,371 threshold.
Alternatively, as a business owner, your first $500,000 of active business income (ABI) gets taxed at 12%. Any income above $500,000 is taxed at the regular corporate rate of 27%.
At first glance, a rather appealing tax-deferral advantage is available to business owners when they leave profits (retained earnings) in the company. The chart below demonstrates how $100 would be taxed in 3 different scenarios:
By leaving profits in the company to invest, the business owner has a $22.80 - $37.80 larger ‘starting’ position compared to investing personally on every $100. Traditionally, this tax-deferral advantage has been an attractive incentive for business owners to leave profits in the company.
Corporate Investing: What’s changed?
The present Liberal government has taken steps to crack down on what it considers to be unfair tax advantages (tax-deferral advantage) enjoyed by corporations and their shareholders. Two significant changes could affect how small business owners invest going forward.
1. Income Splitting
According to tax specialist Kevin J. Porter, CPA, “there are now significant restrictions on the ability to pay dividends to family members who are not actively engaged in the business.” If opportunities exist to pay a spouse, the salary or dividends must be for work performed at the business and must be reasonable, otherwise punitive tax measures could be imposed. This is a significant change that could limit the ability to split income.
2. Clawback of the Small Business Deduction (SBD) Tax Rate
Starting in 2019, any passive income earned within a corporation above $50,000 will claw back the small business tax rate of 12% on a 5-to-1 basis. A corporation which earns more than $150,000 of passive income in a year will lose the preferential tax treatment of 12%.
If you’ve been building and storing significant wealth in your company, the loss of SBD tax rate could be significant.
Benefits to Minimizing Retained Earnings Within a Company
Retained earnings within the operating business could be exposed if one’s business was ever sued or exposed to creditors. Limiting passive assets within the company theoretically lowers overall exposure to liability.
Qualifying for the Lifetime Capital Gains Exemption (LCGE)
If part of your succession plan is selling the operating business, a one-time opportunity exists to claim the lifetime capital gains exemption [LCGE]. The LCGE allows business owners a one-time capital gain exemption of up to $848,252  applied against the sale of their shares. Translation: qualifying for the LCGE could save hundreds of thousands of dollars in tax.
Passive assets, such as retained earnings or corporate investment accounts could become a hindrance to qualifying for the LCGE. Thus, flowing profits to a shareholder and avoiding large passive assets is a simple but effective way to increase the chances of qualifying for this special tax exemption.
Why Contributing to your RRSPs Might Be Useful Going Forward
There are good reasons for owner/operators to take income personally and avoid accumulating large retained earnings within their company. This leads to the next burning question: Do I pay myself a higher salary or take more dividends?
One of the significant benefits to paying oneself salary is that it creates RRSP room, whereas dividends do not.
Creating and utilizing as much RRSP room as possible usually increases overall net worth since it lowers the tax bill in the year of contribution. Even if the RRSP room generated in a particular year isn’t used, the room gets carried forward and can be used in the future.
Here are some potential benefits that come with RRSP contributions:
Benefit 1: Tax Deferral and Long-Term Compounding
There are a lot of variations and complexities involved in preparing an ideal tax plan, but let’s consider a relatively simple example.
Janet and her Small Business:
Janet owns and operates a company with annual taxable earnings of $120,000. She plans on paying herself all these earnings as dividends. First, the $120,000 gets taxed at the SBD rate of 12%, which leaves $105,600 to be paid out to Janet as dividends. Once personal taxes are applied, she’s left with $87,648.
Instead, Janet could pay herself a salary of $120,000, resulting in no corporate tax but full personal income tax. If she contributed $25,000 of that wage to her RRSP, the contribution would move her into a lower personal tax bracket, resulting in more investable assets.
According to Porter, “the end result is that in many cases the use of salary combined with an RRSP deduction provides a lower overall tax burden compared to the pure dividend payment strategy.” The reduced taxes are then available to reinvest in future RRSP or TFSA contributions, further compounding the savings over time.
Benefit 2: Income Splitting Through RRSPs or Spousal RRSPs
If the new corporate income splitting rules have affected you, RRSPs provide a great alternative.
Under current pension splitting rules, one is allowed to split up to 50% of their RRIF withdrawals with their spouse as long as they are 65 or older. This is a perfectly legitimate form of income splitting.
One can also contribute to a spousal RRSP and have the assets listed in their spouse’s name. According to Porter, “The use of spousal RRSP contributions is one way to continue moving net worth to a spouse if corporate dividends are no longer an option.”
The additional benefit to the spousal RRSP method is that the spouse doesn’t need to wait until he/she is 65 to take income in their name. Income splitting could therefore be achieved before age 65 (assuming it was beneficial to do so).
John and Samantha:
John has previously accumulated RRSP room of $50,000. In 2019, he pays himself a salary of $200,000 and makes a $50,000 contribution to his wife Samantha’s spousal RRSP. The $50,000 contribution creates approximate tax savings of 45.8% or $22,900. He has thus deferred paying $22,900 in taxes on his income by making the spousal contribution.
Samantha works part time and earns $15,000 per year. She withdraws the $50,000 contribution John made (assume no growth) after 3 full calendar years since John’s contribution, therefore avoiding spousal attribution rules. She withdraws the $50,000 over a two-year period, withdrawing $25,000 in 2022 and 2023. This raises her income in those years up to $40,000, where she pays a tax rate of approximately 20% on those withdrawals, ($5,000 taxes owed per $25,000 withdrawn)
John and Samantha have effectively split his business income, lowering the tax from 45.8% in John’s name, down to 20% in Samantha’s name. This represents a savings of about 25.8 % or $12,900.
Benefit 3: Saving RRSP room for a ‘big year’
Maybe you know a year is approaching that will see substantially higher profits in the business, or perhaps you plan on disposing of a personal asset with a substantial capital gain that will push your income into the top marginal tax bracket of 49.8%. You’ll probably be glad to have some unused RRSP room available to offset at least some of the income landing in the highest personal tax brackets.
Benefit 4: Increased Creditor Protection
RRSPs form part of personal retirement savings and theoretically offer more security compared to those assets remaining in your operating company or a related company.
There is no one-size fits all approach to tax planning for business owners. However, the salary/RRSP route is an effective tax and wealth management tool. If you’re a small business owner and RRSPs aren’t an important part of your overall wealth strategy, you could be missing out.
We love working with business owners on investment and tax planning no matter how simple or complex the case.
Please give us a call; we’d be happy to help you create or refine your long-term investment strategy.
Joe Basque, BA, CFP® | Financial Planner & Investment Advisor
HollisWealth®, a division of Industrial Alliance Securities Inc.
The comments contained herein are general in nature and professional advice regarding an individual’s particular tax or legal position should be obtained in respect of any person’s specific circumstances. This article was written by Joe Basque who an Investment Advisor for HollisWealth, in collaboration with Kevin J. Porter, CPA, a practicing tax specialist. Opinions expressed in this article are those of the author only and do not necessarily reflect those of HollisWealth. HollisWealth® is a division of Industrial Alliance Securities Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.