RESPs For Corporate Kids – Part 2

In the preceding post, we compared using an RESP vs a corporation to help fund post-secondary training for our kids. In contrast to those with a large lump sum in a personal account, for corporate kids, moving just enough out of the CCPC and into the RESP to get the Canada Education Savings Grant (CESG) was the winning strategy. Except, for those with high personal incomes. The CESG was not enough to recover from the initial tax hit for that group.

Much of that result is due to a corporation already being an effective tax deferral vehicle. However, what happens for those whose CCPC gets torpedoed by the new passive income tax rules for small business corporations?

A quick review of the active-passive corporate tax rules is needed for background understanding. Then, I will examine whether an RESP can be used as an effective tax-saving maneuver for those hitting the passive income limit.

The Active-Passive Corporate Income Tax Rules

The new tax rules, unveiled in the 2018 Federal Budget, were an attempt to limit how much tax deferral on passive investment income that small business owners can benefit from. The private corporation owners most likely to be affected are those with high incomes, long careers, or a more moderate income with a high savings rate.

What counts as passive income is fully described elsewhere. Basically, it is investment income that is not directly related to the active business. Active income is the income earned doing business. For a doctor, active income would largely consist of clinical earnings minus overhead expenses.

When a small corporation has passive income that exceeds $50K/yr, the threshold for its small business deduction (SBD) shrinks. It shrinks by $5 for every $1 of passive income over $50K. The threshold and relative corporate tax rates are shown below.

active passive business income tax

An example to illustrate the active-passive business tax threshold:

An Ontario corporation with $100K/yr of passive income would see the SBD threshold shrink to $250K/yr from the usual $500K/yr. This means that corporate earned income (active income) above $250K is bumped up to the higher general corporate rate. If it earned $300K active income, $250K would be taxed at 12.5% and $50K would be taxed at 26.5%.

There are easy ways to minimize the impact.

It may seem bad to get bumped from 12.5% to a 26.5% tax rate. That is more than double. However, it is not as bad as it seems. A corporation still has a tax deferral advantage at the general corporate rate if the personal tax rate is higher than the corporate one (it usually is).

It may be a stimulus to work less and live more.

For those who can’t or don’t want to work less. Well, it means taking more of your money out of the corporation now rather than later. That can be readily done by paying a larger salary (and personal tax on that). Salary is a corporate expense which reduces the corporate active income, dollar for dollar, to bring it down below the SBD threshold.

Another approach is to pay yourself eligible dividends.

When a corporation pays tax at the general rate, it generates GRIP. The corporate GRIP balance allows it to pay out eligible dividends. Eligible dividends have a lower personal tax rate (due to a tax credit) compared to regular income or ineligible dividends.

The dividend tax credit serves to make up for the tax already paid by the corporation. It does not perfectly do so. In most provinces, the total corporate and personal tax paid is slightly more than if the income were taken directly by the individual instead of passing it through a corporation.

For example, it is ~2% more tax in Ontario for the top tax bracket (55.54% via corp vs. 53.53% directly). The net tax integration for the various provinces is here. For those who like to scramble their brains with tax details, the movement of $100 active income earned through a corporation over the SBD threshold is shown below.

corporation GRIP

How does this impact investment tax drag within a corporate account?

In essence, passive income above the threshold forces an increase in the overall tax paid if one is not retired. While the tax on the passive income itself does not change, it increases the corporate tax on active income. If one is retired and no longer earning active income, then there is no effect. For those of us still earning an active income, the overall corporate tax goes up. We recoup some of that through the tax savings of an eligible dividend as described above.

Since the increase in overall tax is forced by investment income over the $50K/yr limit, it is reasonable to consider the increased tax as part of the investment tax drag. If we can reduce the corporate passive income by investing via an RESP instead, then there could be tax savings.

How big of an effect could re-routing investment income to an RESP have?

The effects will depend on the amount and nature of the investment income. Plus, the amount of tax saved from dispensing an eligible dividend instead of an ineligible one from the corporation.

The chart below shows the baseline portfolio assumptions and investment income of our model. The baseline tax drag of this portfolio in a corporation is 0.41%/yr, assuming that enough dividends are dispensed from the corp to release its RDTOH refund.

If that income is earned above the active-passive threshold, it increases the overall corporate/personal tax bill. When all the tax interactions are considered, it functionally causes the investment income tax drag for our model portfolio to jump from 0.41%/yr up to 1.49%/yr. The web of taxes is shown below using 2019 Ontario corporate and top personal marginal tax rates.

corporation passive income tax

How does this impact the utility of an RESP?

For a corporation below the passive income limit, a corporation might sometimes outperform an RESP. This was fully explored in part 1 of RESPs for Corporate kids. With a high personal income ($>150K/yr), the tax hit from taking money out of the corporation to fund an RESP was not made up for by the CESG and RESP tax deferral.

For a corporation above the passive income limit, an RESP can catch up and outperform. This is because the tax-drag in the corporation becomes so high (increases from 0.41%/yr to 1.49%/yr). As shown in the chart below using a strategy to contribute just enough to an RESP to get the full CESG ($2.5K/yr X13 years and the $1K once) can beat not using an RESP. If moving a full $50K to the RESP from a corporation, using an optimized larger upfront lump sum ($17.5-30K followed by $2.5K/yr) could produce a similar result.

resp vs ccpc

The above results are similar to what we see when trying to optimize a lump sum strategy for those without a professional corporation. It does not need to be precise – close is good enough. At a high personal income level (as shown above), it is also pretty close between just getting the CESG or moving a larger lump of money out of the corp.

The lump sum optimization strategy could become even more beneficial to those who are drawing low income from their corporation. This is due to the bad tax-drag in the corp and the low cost of getting money out of it.

How about for Physician Pugicorns?

A physician-pugicorn is someone who has saved so much in their corp (at an age with small children underfoot) that they both hit the passive income limits, and live so far beneath their means that they are drawing little income from it.

These are the physicians who by the time their kids are a bit older will likely be financially independent and free to tailor their careers and lives more. This may sound like a mythical creature – a physician pugicorn. However, they do exist. I have seen them.

Here is how the different RESP strategy outcomes look for pugicorns:

ccpc vs resp

A lump sum optimization strategy outperforms for pugicorns. Why?

  • The tax-hit for drawing money out of the corporation is small.
  • Investment income within the corporation gets ravaged by the new tax rules.
  • You get CESG – that is like free kittens! Or pug puppies.

In the above scenario, a $20K lump sum was optimal. This type of modeling relies on some predictions of future income and returns. Predicting the future is obviously an imprecise endeavor. Fortunately, close is good enough. Lump sum frontloads from $17.5-37.5K were all very close in the end.

What about those who aren’t at the threshold yet – but will be soon?

The benefit of a lump sum is greatest for those with lower income draws from their corporations. Using our model, a CCPC owner drawing $70K/yr could benefit from a lump sum strategy if they are projected to be over the active-passive income limit in the next 13 years. For those drawing >$90K/yr, it is within the next 1-5 years. The benefit drops quickly due to rapidly escalating personal tax rates. Also, the difference between lump sum optimization compared to the full CESG focused strategy is negligible for those drawing incomes >$90K/yr.

Summary

  • Corporation owners under the SBD threshold benefit from RESPs unless in a very high tax bracket (last week’s post). The main benefit is getting the CESG.
  • Corporation owners over the SBD threshold may benefit from using an RESP to move investment income out of their corporations.
  • Those drawing lower incomes from their corp can benefit from using larger lump sum contributions.
  • Even if not over the SBD passive income tax threshold yet, there could be a benefit from a lump sum contribution if they will be over the limit in the near future.

Aid coming for those with corporations over the passive income limits (or soon to be), who fall in between the big spenders and the pugicorns.

Of course, there is a whole range of optimal strategies for incomes between $70K and $220K. Different provincial tax rates or portfolio mixes could also change the results. So, we are making an RESP optimizer for incorporated professionals customizable to income level, projected returns, passive income type, timeline, and province.

I have enlisted the help of my wife for this one. It involved hundreds of individual tax calculations to construct the data-arrays for the coding. That is nerd-speak for “it is mind-numbingly brutal”. I made a down-payment of dark chocolate, but am told that more chocolate is expected.

8 comments

  1. A bit mind boggling, but excellent and informative as always! I feel less bad now for not making front-loaded lump sums to the RESP in the beginning. I do have a question about whether different rates of return affect asset location decisions (RESP vs corp). I see above you assumed an overall rate of 5.6%. What if the investing Gods are good, and we end up a return of 6.6%/yr? Would a potentially higher rate of return favour the RESP even more since there’s more passive income that can be sheltered?

    1. Hi Mark,

      It is mind-boggling, but fortunately, the conclusions can be distilled down to be a little more straight-forward. I am hoping to look at RESP investment strategy (as opposed to contribution strategy). That gets to your question. I don’t think it is so much the rate of return, but the type and amount of income earned that would make a potential difference. High capital gains would be good in a corp since they can be passed out pretty tax efficiently. Same with an RESP. Conversely, interest income in a corp gets hammered, but would be spared in an RESP. Another topic that I haven’t seen anyone tackle, but I hope to take a stab at soon.
      -LD

  2. Think I understood the gist, though I’d hate to have a surprise pop quiz on the material. I definitely understood the free kittens and dark chocolate bribes. Canadian legislators seem to go to great lengths to screw specific high earner constituencies!

    Thanks for making my brain explode,

    CD

    1. Hey Crispy Doc,

      We have been unusually in the crosshairs with our most recent government. They needed to create some villains in order to be heroes. I should probably add an advisement to always use a screen protector to my blog disclaimer;)
      -LD

  3. Excellent analysis. Thank you.

    Curious. I was under the impression that the passive income limit of $50k (and its effects on SBD) can be avoided with a buy and hold strategy in broad based ETF, and putting your dividend and interest heavy holdings in TFSA RRSP or more likely post tax accounts. If your a saving a high percentage of you income, but keep passive income low (below threshold) by buying and holding index funds, then I assume you contribute to RESP only to get the CESG?

    1. Thanks Marc. You are exactly correct. You can build a multi-million dollar portfolio if you pay attention to how you build your portfolio (I have made the Robocorp Portfolio Builder on this site to make that easy). There are some who will hit this limit by the time their kids are born or very young, but they are very rare – like pugicorns. Usually, it is a combination of dual professional household or a high-income specialist combined with low spending/high saving and having kids a few years out into practice. For the rest of us, contributing just enough to get the CESG is the best strategy for incorporated professionals as explored in part 1. For the unincorporated high-income household, a lump sum strategy may be useful.
      -LD

  4. Hi Loonie Dr,

    I would love to see you do a post on the topic of unwinding a medical corporation or what happens to a medical corporation in retirement.

    Unfortunately, I no longer have access to the small business rate because I am in a group practice. My issue is that my passive income is already the triple of my annual spending (I still live like a resident) and growing, mostly under the form of Canadian dividends. I am taking all those eligible dividends out of the corp each year, since the taxes are already paid for that income anyways and this is mostly a tax-neutral maneuver.

    So I have decided to cut work and enjoy life more. However, I wonder if physicians should plan to gradually unwind the corp especially in retirement. Any topic regarding this issue, estate planning or life insurance (is it worth it in Canada due to our high taxes?) would be of great interest.

    Thank you for the great site.

    1. Hey Bunny,

      That would be a great topic and certainly multiple posts! My wife and I have been personally thinking about it a lot lately. I will likely solidly hit the passive income limit in about 2 years (I flirted with it this year already but was able to sneak under and re-organize a bit). I don’t share my SBD with anyone. So, I plan to start scaling back my active clinical income proportional to the amount my SBD shrinks. That will likely be a further five-year process. Our kids will be done high-school then too – so a good time to re-evaluate what is next in life.

      We also recently met with an estate planner. If one lives way below their means like you do, then how to do this is definitely an important issue. Provided we don’t die prematurely, we plan to slowly unwind the excess money in our estate while we are still alive. We will involve our children (likely adults at that point) in the process. We can progressively do that more as we get older and the uncertainty of how much we will need gets less and less uncertain. That way we can actually see the money being put to good use. We will be using a paid executor so that none of our family has to deal with the complexity and can focus on crying over our graves. The executor gets paid as a % of the estate (same with probate) – so another benefit of melting it down in advance is lowering those fees. Not that we’ll care too much since we’ll be dead 😉 We have a small whole life policy to help mop up the taxes on the remnants.

      I need to learn more and have also made some good contacts to help me write about this area. Hopefully, I will get to it in the fall. I am pretty backed up and summer is almost here.
      -LD

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