Choose Your Weapons – Financial Tools and Strategies For Incorporated Professionals to Repel Tax Pirates

I previously gave some illustrative examples of how crossing the new sliding active-passive income threshold into the higher general corporate tax rates could have an adverse impact on physicians and other high income professionals. Even a more moderate income physician who is a good saver.

It is important for those affected, to realize that they are affected, because they will need to learn the new active-passive income small business tax dance. At our previous-post-dance-party, we introduced the basic moves.

• First move: consider a salary to lower active income.
• Second move: consider an investment portfolio shuffle to minimize passive income in the CCPC while maintaining the desired investment asset mix.

A simplified example of a 60:40 equity:bonds portfolio shuffle was discussed as illustrated below.

That conceptually seems simple, but there are a number of potential practical difficulties to doing this if you anticipate a high savings rate that will overwhelm your registered tax-sheltered accounts or have high dividend-paying equities. Some professionals may have already built large portfolios in their CCPCs. With the sudden rule change, they now find themselves already in hostile uncharted tax territory.

If you wander off course into rougher tax waters despite some basic navigation, then prepare to be boarded…

Unfortunately, surviving the rougher tax waters will require more advanced planning, effort, and possibly some special tools.

Most of these come with some increased fees and/or risks. Getting a sense of how much of a negative impact (if any) that the rules will have on you and the risks/benefits of the tools to mitigate that impact is vital.

It is a prerequisite to making informed decisions on the degree of effort/expense/risk worth incurring to navigate around in pirate infested territory.

Firing at those after your loot isn’t without its hazards. Just ask this lady.

Let’s take a quick inventory of the potential weapons in our arsenal for repelling an unwanted attempt to tax grab our corporate booty…

#1 Target your stocks and ETFs with low or no dividend yield to your corporate account.

This one is the low-hanging fruit with no special risks or costs.

#2 Use swap-based ETFs in your corporate account.

Horizon is the only company in Canada who sells this product which passively tracks an index based on its total return (capital gains plus dividends/interest) and converts that to capital gains only. They have low effective fees (0.03%-0.5%), but carry some other risks. Disclosure: I use some of these products in my portfolio. Update: These were targeted in the 2019 Federal budget and changed to a more robust corporate class model.

#3 Use corporate class or T-series mutual funds in your corporate account.

Similar to swap-based passive ETFs, these actively managed products convert most income into capital gains.  This comes at the cost of having significantly higher mutual fund level fees (1-1.5% plus advisor fee for high net worth clients to 2-3% retail). Generally, fees kill actively managed fund performance relative to their passive ETF competition. However, T-series mutual funds also allow for accessing money as “return of capital” which further delays triggering capital gains taxes during the draw-down phase of a plan. Like swap-based ETFs, there is some legislative risk (governments have a habit of changing the rules governing tax deferral investment structures to hobble or eliminate them).

#4 Target eligible dividend paying stocks towards a taxable account.

If you don’t have enough room in your corporate account and tax-sheltered accounts, but you need to put more equities somewhere. Target those with higher eligible dividend yields to a taxable account. They receive favourable tax treatment. This is particularly useful if the taxable account is solely attributable to a lower income spouse for tax purposes – who may even get an negative effective marginal tax rate on it.

The benefits of this approach need to be weighed against the opportunity cost of taking money out of the corporation and potentially losing that tax deferral advantage.

[2019 Update: It is also not universal. In most provinces, the tax rates have now risen so much that lower dividend-paying US or emerging market ETFs have less tax drag than the overall Canadian market. Even with the eligible dividend tax credit.]

#5 Use an Independent Pension Plan (IPP) to make up for insufficient RRSP room.

This is an insurance-type product. It is a potential way to make RRSP-like room over a shorter time frame. That can be done de novo, or by rolling over an existing RRSP into an IPP. The earliest you could open one is age forty and the earliest that you could punch out of work is age 55. It can allow pension-splitting at age 55. That is earlier than the age 65 rules for an RRSP. You need to pay a salary to access this tool. Plus, how much you are able to contribute initially and annually will depend on factors like your age and years of service (receiving a salary).

Generally, the benefit relative to RRSPs takes off around age 45 and for salaries >125K/yr. Not only does this approach shelter some passive income, but the cost is deductible against active business income. It would be very individual specific and requires an actuary initially to set-up (~$5K) plus a re-value every 3 years. There may be other management fees and restrictions depending on how the money is invested.

#6 Permanent (Whole or Universal) Life Insurance could be a way to hold a “fixed income-like” product within your corporation. 

These products are usually structured to be “excluded life insurance” which means that they don’t count as passive income. Like all insurance, there are premiums paid. A portion of the premium covers the life insurance aspect (at a much higher cost than term-life). You can also pay larger amounts to have the excess invested.

You are stuck with their performance net of fees – for better or worse [spoiler – it is often worse]. The main gains in performance are later in life and the overall return is lower than investing in equities. Of course, the risk is also lower. If used, it should be a long-term relationship with fixed income-like return expectations.

You could borrow against the cash value of your policy before death and/or there are potential estate planning advantages since the pay-out at death is tax-free.

Weighing the pros/cons of whether to use this one is important. White Coat Investor has done the most balanced description of when to consider permanent life insurance that I have found so far. With our new tax considerations, there may be some renewed interest in Canada. You would definitely want someone other than the insurance salesperson to do that with you, since these products are attached to highly motivating commissions. You also need to be careful to structure the policy properly. An expert & impartial financial planner would be strongly advised for someone considering this.

#7 If you are a double professional household, you might re-examine your corporate structure. 

I know a number of double doctor families. Some of have one shared CCPC. Others have two separate ones. It previously didn’t matter too much for most. However, with the threshold now potentially shrinking, it may be more important to have two CCPCs with access to two small business deduction limits.

For that to work, the ownership structure and control is important. Because they are married, both CCPCs would be “related”. If there is cross-ownership of 25% or more, then they would also be “associated” and need to share their SBD. You can read more about associated versus related CCPCs, but it may cause vertigo and is best done close to the ship’s railing.

For those using real estate investments to build income, the corporate structure for holding those real estate ventures in relation to your CCPC is important and well described by Dr. Networth.

#8 Work less. Spend less if you need to.

One unintended consequence of taxing productivity is that it can dis-incentivize work. Reflect on your work-life balance and consider working less. With progessive marginal tax rates and this progressive tax on professional corporations, you earn less per hour of work if you work more. If you spend everything that you make, then you would need to re-consider your spending also. What your are spending for either is your time, and your Time-Money Exchange Rate worsens as you earn and spend more.

There will not be a one-size-fits-all strategy

If you are a DIY investor/planner, then you definitely want to pay attention and learn. Most busy professionals probably won’t take on that effort (even though it pays well if done properly) or responsibility (being able to blame someone else if things don’t go well is an underappreciated perk of using an advisor;)). For most high-income professionals, finding a good financial planner and tax planner will be vital to help them navigate.

Even for those using professional planners, working knowledge of the main strategies and where they may fit into a comprehensive plan will help them be educated clients. That is especially vital when dealing with strategies or products that may have motivating commissions/incentives associated with using them.

Hopefully, you will join me in learning more about these strategies and tools with the upcoming blog posts.