On June 25th the Liberal government quietly passed Bill C-74. This legislation brings new rules on income splitting and limits access to the small business deduction where passive investment income exceeds $50,000 a year. Below is a summary, the impact and advanced planning solutions.
The small business tax rate is 13.5% on the first $500,000 of active business income and 26.5% thereafter. Income from passive investments is taxed at 50.17%. Under Bill C-74, income subject to the small business tax rate will be reduced when passive investment income is greater than $50,000/year. When this income exceeds $150,000/year, all active business income will be taxed at 26.5%.
- Old Rules: Under the old rules, the first $500,000 of income was taxed at 13.5%.
Tax = $67,500 ($500,000*13.5%).
- New Rules: Under the new rules, assuming corporate investments earn $150,000/year, the corporate tax rate is 26.5%. Tax = $132,500 ($500,000*26.5%).
- Difference: $65,000 increase in tax per year.
The status quo of continuing to invest your corporate funds in mutual funds, stocks or bonds (“passive investments”) now costs up to $65,000 per year in additional tax. Over 20 years, assuming a 5% rate of return, this accumulates to $2.1M that your corporation has lost to Canada Revenue Agency (CRA). Furthermore, the new income splitting rules restrict you from paying dividends to your spouse and/or adult children (age 18-24).
Participating whole life insurance is not considered a passive investment by CRA and is an attractive asset class for corporate funds to help fund retirement and for estate planning when combined with advanced planning the corporate implications are significant.
There are three reasons physicians use participating whole life as an asset owned and paid for by their Medicine Professional Corporation.
- Tax free growth. Similar to an RRSP, money inside a whole life policy is deemed by CRA to be tax-exempt, grows tax-free and is not considered a passive investment under the new tax rules.
- Performance. Dividends, once paid, are guaranteed and vested. So too is the increase in annual cash values and death benefits. The current dividend interest rate is 6.25%.
- Guarantees. With participating whole life, every year you get a policy statement the cash value and estate benefits are guaranteed. Unlike your regular investments (stocks, bonds, mutual funds) which fluctuate year by year, every year dividends are paid in, these values guaranteed and vested.
Rick is a 50 year-old Physician, married with three children and his spouse works part-time at his office. His Medicine Professional Corporation earns $600,000 per year, he saves $100,000 per year in corporate investments where he has accumulated $1.7M and earns an average 6% rate of return. His home is worth $2M and has a mortgage of $500,000. Rick plans on slowing down at 65 and retiring at 70.
Assuming no more deposits to his corporate account, by age 70, Ricks’ portfolio will reach $4.7M (assuming a 5% annual return) which he feels is more then enough to provide for retirement. Therefore, Rick reallocated the $100,000 per year that was going into his corporate savings into a participating whole life policy to provide funds flexibility with his retirement and estate planning.
There are three advantages for Rick in using participating whole life as a corporate asset; two while alive and one for his and his spouses’ final estate.
While Rick is alive…
1. No Impact to the small business tax rate.
Life insurance is not considered a passive investment, funds grow tax-free and the money earned inside the policy is not included in the small business tax rate reduction. The $100,000 reallocated to the whole life policy is not subject to the passive investment rules and accumulates tax-free.
2. Retirement planning.
Capital built up inside Rick’s whole life policy can be used to help fund retirement if need be. Using a corporate retirement plan, Rick can access the cash value through a withdrawal, a policy loan, or by assigning the policy to his bank as collateral for a line of credit.
Unlike his other investments that fluctuate over time (Rick remembers the market crash of 2008), the cash value and life insurance values, once credited to his policy on its annual anniversary, are guaranteed, vested and continue to grow as dividends are paid.
The cash value of Ricks life insurance at age 70 is projected to be $3M. Rick’s corporate portfolio would have to have earned a pre-tax equilvalent rate of return of 8.2% per year to have the same tax free cash value ($3M) PLUS he has permanent life insurance for estate planning. This shows very good value in using the whole life insurance as an asset class and provides Rick with additional access to funds.
Once Rick and his spouse pass away…
3. Estate planning
Rick realizes his current corporate portfolio is projected to be $4.5M at 70 which he feels will be more than enough for retirement. However, since he is still working and saving money inside the corporation, he recognizes that his savings will flow to the next generation; the question becomes how to do this tax efficiently. First we looked at the estate tax rules then we compared doing nothing vs advanced planning.
On death a taxpayer is deemed to have disposed of property at its fair market value. Generally, when the owner of the corporation dies (Rick) and is survived by their spouse, the shares can be transferred to a spouse or spousal trust tax-free. When Rick and his spouse both pass away, the next step is to distribute the assets out of the corporation to the children.
Corporate assets are subject to three levels of tax when you pass away and the assets are distributed to the children.
- Personal capital gain on the disposition of shares of the corporation,
- Corporate tax on the liquidation of corporate investments,
- Dividend tax on distribution of assets out of the corporation.
Some physicians feel they don’t need life insurance because they have enough assets for retirement. However, with advanced planning the difference to your estate can be significant as illustrated with Rick.
For simplicity purposes, we assumed that the value of the investments remain level from age 70 to life expectancy as Rick draws down the corporate portfolio. The market value of the investments is less in the advanced planning scenario as $100,000/year is being reallocated to insurance.
|Corporate Investments at age 70||8,200,000||4,735,000|
|Life insurance proceeds at life expectancy (age 85)||0||7,440,000|
|TOTAL CORPORATE VALUE||8,200,000||12,175,000|
|Less: Capital gain tax on deemed disposition of MPC shares||2,196,888||1,267,627|
|Less: Net corporate tax on liquidation of investments||1,808,142||0|
|Less: Dividend tax on distribution||1,827,343||0|
|Net funds available for distribution||2,375,689||10,970,373|
Corporate investments at age 70 illustrated with a 5% return.
Do you want to lose 71% of your hard earned money?
When we add life insurance and advanced tax planning (redemption loss carry back planning and/or pipeline planning), Rick’s estate tax burden is reduced and his net estate value is significantly enhanced.
Elliott Levine, MBA, CFP is the President of Levine Financial Group in Toronto
416-222-1311 I firstname.lastname@example.org
The above is for conceptual purposes and is not to be relied upon for definitive legal, tax or financial advice. Those interested in exploring these topics should consult with the appropriate tax advisers to discuss their specific needs and circumstances. E&OE.