In this post, I describe how the money that we earn can optimally flow to maximize our investment growth and personal cash flow using a Canadian Controlled Private Corporation (CCPC), such as a Medical Professional Corporation (MPC). The information and terminology in this post will give us part of the basic knowledge base needed to plan. It affects how we pay ourselves, how much we lose to taxes, and how we can optimize our portfolios.
Cash Flow Is Like A River
When we earn income as professionals, we need to channel that money to grow our businesses and to fund our lifestyles. Business income fluctuates like the water level of a river. This results in surplus cash flow sometimes, and not enough at others.
This hazard is accentuated by our aggressively progressive personal tax system. As you earn more money, the percentage of personal income that you lose to tax jumps quickly, and can escalate to over 50% of income earned. If we simply took all of our actively earned professional income directly as personal income, then we could have problems.
In bumper years, our cash flow river would over-run its banks and much would be lost to taxes. In lean years, we would pay less tax. However, the income previously lost to tax would have already have soaked into the ground and been absorbed by our government – not to be recovered. Gee, that made our government sound kind of like money parched dirt. Totally unintentional.
We need to be able to regulate cash flow
This ebb and flow can hit businesses which have cyclically good and bad times. Some high-income professionals (like doctors and dentists) appear to have a fairly steady business income stream year to year. With a broader view, however, it does fluctuate wildly over our career spans.
We earn very little income and/or have to manage debt for the first 10-15 years while we train and establish a practice. Then, we experience a huge income increase in our peak earning years. This is followed by little, or no income, as we age and need to scale back or retire. Other than what we have saved for ourselves.
Everyone faces these types of changes in earning income through their lives, and need to smooth it out. For most Canadians, RRSPs, TFSAs, and other pension arrangements smooth out that life cycle cash flow. However, with high-income professionals, the level of fluctuation is much larger, overcoming these instruments. We need a bigger dam.
A CCPC Is Like A Dam Between Our Business & Personal Money
We can allow money to pool in our corporation when we have high-income years. During lower income years, such as a parental leave, work hour reduction, or retirement – we can release it in controlled amounts from that reservoir.
For Canadian professionals, the structure of a CCPC (like an MPC), has much more capacity than an RRSP or TFSA. However, it also comes with some more complexity. We will need to understand how to properly operate the controls of this dam.
Cash Flow Through Corporate Accounts To Your Personal Accounts
Below is a detailed diagram that we will spend the rest of this post and the next couple of posts explaining. For this post, we will focus on the flow of active business income. In the schematic below, this will be the money flow through our corporation’s operational account, the payment of business taxes, and release of money from the corporate reservoir into our personal accounts via salary and dividends. You can click on the picture to open it in a new browser tab to easily reference it.
These are owned by the corporation, which is considered a separate legal entity to you. This is important because it means that you cannot just put your money into the corporation or take money out of it whenever you feel like it. That would have tax consequences.
Your corporation will have an operational account. This is a business account at whatever bank you use. The money from your professional practice (like clinical billings and stipends for admin/education) gets paid to your operational account. You also pay your business expenses and taxes from this account.
The corporation’s investments will be held in one or more investment accounts. These are accounts at a brokerage through which you invest. That could be at a discount brokerage as a DIY investor, or via an advisor affiliated brokerage house. Corporate investment accounts and taxation will be covered in the next post.
Taxation of Corporate Active Business Income
The income earned from operations minus the practice overhead and salary expenses is considered the net active business income.
The biggest advantage of incorporation is that you pay the business rate of tax on the net active income. This allows your corporation to have more capital to invest than you would if you took the income directly.
There are two different corporate tax rates. Historically, the low small business deduction (SBD) rate applied to the first $500K/yr earned (shown in yellow in the chart below). If a CCPC earns income over the SBD threshold, then that portion of the net active business income is taxed at the higher General Corporate Tax Rate (the red zone of the chart).
Starting in 2019, the SBD threshold will be determined by a combination of the corporation’s active income and its passive investment income. This newly introduced sliding business tax threshold is illustrated below. Basically, every dollar of adjusted aggregate investment income (AAII) above $50K/yr lowers the active income SBD threshold by $5.
Example: An Ontario-based CCPC that earned $100K of passive income this year and next year makes $300K of active income. Its SBD threshold is $250K. That means the first $250K of income is taxed at 12.5% and the remaining $50K of active income is taxed at 26.5%.
Getting Money From Your Corporation Into Your Personal Hands
You primarily take money out of your corporation using salary, dividends, or both. There are some situations where you may be able to use a shareholder loan or a capital dividend. Those are special situations that we will discuss in other posts.
Whichever method you use to remunerate yourself via your corporation, the amount of tax paid should be similar. The total tax paid should also be similar whether the income was paid directly to you, as an individual, or indirectly via a corporation. That concept is called tax integration.
However, tax integration in practice is not perfect. How well it works varies by province. Generally, the mismatch of tax integration favours paying salary rather than dividends when channeling earned income. The exceptions to that are in Saskatchewan and Newfoundland, where there is a slight advantage for dividends. We will explore this in detail in a separate post.
As indicated above, your corporation can pass money onto you personally by paying salary. If possible, you should also employ your spouse. One of the only ways left to reduce your tax bill via income splitting is to pay a lower income spouse a salary. They need to work for it and be paid at market rates.
Paying out a salary means setting up payroll. For some reason, this is often cited by commentators as difficult. However, it is actually easy. You need to track your corporate ins and outs anyway. Payroll simply means paying the salary regularly to the employees plus making monthly remittance of income tax collected to CRA.
Your accountant can tell you how much to remit monthly, or you can use the CRA payroll deduction calculator. My accountant did this for me and I simply set up automated monthly bank payments. Once per year, your corporation will need to issue T4 slips for salary along with T5 slips for dividends paid out. Your accountant will likely do this as part of your corporate taxes and fees also.
When paying salary, you need to pay both the employee and employer portions of employment insurance (EI) and Canadian Pension Plan (CPP) contributions. This attenuates some of the tax integration advantage that otherwise favours salaries over dividends. However, the self-employed can often opt out of EI if they have not made a previous claim. A previous EI funded parental leave counts as a claim. Further, CPP is not a really a tax. You get paid the money later as a pension – whether it is a good value for your dollar invested is a debate beyond the scope of this post.
Many people do release money from their corporate reservoirs partially or wholly as dividends. Dividends offer the convenience of being easily dispensed when you need a personal cash top-up. They also can improve the tax efficiency of your corporate investment income.
Eligible Versus Ineligible Dividends
Your corp may pay out some of the money left after expenses and business taxes as ineligible dividends. If your corporation earns active income that is taxed at the higher general corporate tax rate, or gets eligible dividends from investments, then that generates space in its General Rate Income Pool (GRIP) account. GRIP is a notional account (meaning it only exists on paper for doing taxes). You may be able to pay out eligible dividends from the balance in your GRIP. This will require the help of your accountant to make sure that it is done properly.
Tax Efficiency of Eligible Dividends From Your Corporation
Eligible dividends are taxed at a lower net personal rate than ineligible dividends. This is to account for the fact that they come from a corporation that has already paid tax at the higher general corporate rate. With the imperfections of tax integration, the benefit of the lower eligible dividend personal tax rate is more than negated by the higher corporate tax paid. So, it is still best to keep your net corporate active income below the small business threshold, if possible, rather than pay more corporate tax so that you can dispense eligible dividends.
The other reason to pay out dividends is to release RDTOH
RDTOH sounds like a Klingon word, but stands for Refundable Dividend Tax On Hand. This is a refundable tax, collected on the investment income of your corporation. The preceding link discusses it in great detail. We will also come back to this when we discuss taxation of corporate investments in my next post.
Documenting Your Corporation’s Dividend Dispositions
When your corporation pays you a dividend, you will need to enter that into your corporate minute book. This is a binder that you, or your lawyer, may have. It is supposed to be updated annually to document:
- the corporate structure
- annual meeting minutes (usually a meeting with your accountant and any other voting shareholders to go over your corporate taxes)
- dividend distributions to shareholders.
The main benefit of incorporation is to regulate cash flow and to defer tax until the cash flows into your personal accounts.
What is left in the corporation after it pays expenses (including salary/payroll), corporate taxes, and dispenses dividends is called its retained earnings. Retained earnings provide a buffer to handle expenses needed for expansion, or keep the business above water in the event of a business downturn. The other benefit of retained earnings is that they have been taxed at a much lower rate (~12% SBD or ~28% General Corp) than your personal tax rate (20-54%).
This tax deferral gives your corporation more money to invest and grow a larger pool of financial capital. You can then access that larger pool of financial capital later when it is needed. You would pay the remainder of the tax at that time if you flow it out of the corporation into your personal accounts. That future personal tax could possibly be at a lower marginal rate if you are drawing it slowly. It is a similar concept to an RRSP, except that an RRSP has 100% tax deferral and a more limited size. The tax deferral advantage is illustrated below:
What does this all mean for planning our corporation and personal cash flow?
- Incorporation is most beneficial when there are enough retained earnings to invest. That is a balance between the tax deferral advantage against the extra costs and hassle. The exact number that makes it worthwhile will depend upon your costs, hassle, and investment return.
- How much money you need personally should be the primary determinant of the amount of money to draw from your corporation. The more slowly that you release money from your corporation, the more you preserve for tax-deferred growth. You may also lower your current personal tax burden by keeping your personal income lower.
- Salary can be useful to lower your corporate active income if it is above the SBD threshold.
- Tax integration is imperfect and favours keeping corporate active income below the SBD threshold.
- Tax integration generally makes it more tax efficient to pay yourself salary than dividends. The exceptions are Saskatchewan and Newfoundland.
- Paying dividends out of your corporation triggers the release of RDTOH and decreases the tax drag on investments in your corporate investment account.
- To support your lifestyle: pay enough dividends to release RDTOH, the rest as salary, and then keep the money that you don’t currently need inside the corporation.
- These are rules of thumb. I would recommend discussing your corporate cash flow plan with your accountant. In my opinion, a well-fitting supportive accountant is mandatory for incorporated professionals. Like underwear.