Canadian Controlled Private Companies (CCPCs), such as professional corporations, are excellent tax-deferred investing vehicles. However, to withdraw money from a corporation to spend personally, you must still pay tax. There are good reasons to do that. Smoothing cash flow to reduce taxes is one of the benefits of incorporating a business. For large withdrawals of money from your corporation, plan in advance to minimize the tax hit.
That means more money left in your hands to pay down your debt, buy a house, fill up your TFSA or RRSP, or whatever big splurge you are planning for. You should consult your accountant in advance of a big spend to help you plan. However, some basic education will help you understand what they are talking about or suggest options that they may not have considered. Learn six strategies to tax plan and efficiently move money out of your corporation to spend personally.
Withdraw Money, Get Corporate Tax Refund
It is very common advice to leave as much money as possible in your corporation. That allows for more partially-taxed capital to invest and grow. However, there are also tax measures in place to prevent us from having a major passive income tax deferral advantage. Interest and dividends received by a corporation are taxed at close to the highest personal tax rate upfront. About 50% for interest and foreign dividends and 38% for Canadian eligible dividends.
You may have an unclaimed tax refund.
Fortunately, you get some of that refunded back to the corporation when you pay out the money as dividends (and pay personal tax). That is tracked using a notional account called refundable dividend tax on hand (RDTOH). It is “notional” because it only exists on paper as part of corporate tax filing. However, it represents real money held by the government instead of your corporation. You can find out your RDTOH balance by asking your accountant. Or if you are masochistic and can translate Klingon, by checking your corporate tax filing.
Are you passing up the tax refund for no good reason?
If your personal income is less than in the tables below, then the tax you pay personally to take out a dividend is less than the tax already collected as RDTOH. So, if you are below those incomes and have nRDTOH or eRDTOH sitting in your corporation’s notional accounts, then paying an ineligible or eligible dividend respectively is very tax efficient. Your corporation gets refunded more tax than you pay personally. Even if you don’t need the money personally, it makes sense to pay out dividends. You could invest the excess personally, or save more of your spouse’s income to income split. I would be having a chat with my accountant if I unearthed this issue.
A big spend to release trapped RDTOH and prevent or relieve corporate bloat.
If your income exceeds the levels above, then it doesn’t make sense to pay out dividends to release the RDTOH if you don’t need the money. You would pay more personal tax than is refunded to the corp. That RDTOH is trapped and it can happen if you build a huge passive income-spewing corporation with little personal spending. You don’t want to have trapped RDTOH. However, if you are planning a big spend, then that is an opportunity to set it free. This is illustrated below.
The other way that tax law discourages you from generating too much passive income in a corporation is the passive income limit. If you exceed the threshold, then your corporation pays much more tax. One dollar of passive income bumps five dollars of active income to the higher tax rate (5 X ~15% = ~75% higher tax rate). You cut that in about half, if you are paying out excess dividends, but it is still pretty bad (except in Ontario and New Brunswick). So, decompressing your corporation to spend personally not only helps to prevent bloat by growing less passive income in the corporation moving forward. It also helps you pass some gas, if you already have some bloat.
Use a Tax-Free Capital Dividend
This is probably the most tax-efficient and least risky way to withdraw a chunk of money out of your corporation. However, to do this, you must build up a positive balance in your capital dividend account (CDA). There are several ways to do that and it takes some paperwork to get the money. Hence, you should plan the withdrawal from the corporation in advance.
What is your corporation’s CDA and a capital dividend?
The capital dividend account is a notional account. That means it only exists on paper to be used as part of the tax filing for your corporation. When you sell an investment that has increased in value, you have realized a capital gain. Only half of a capital gain is taxed and the other half is excluded. That is intentional to account for inflation and encourage the risk-taking required to grow our economy.
In a corporation, the excluded half of the realized capital gains or losses are logged in the capital dividend account. If the gains and losses add up to a positive balance, then you can have your accountant file a special election for a capital dividend. You can then pay yourself or a non-voting shareholder (like a spouse) a tax-free capital dividend. Not only useful for spending, but also for income-splitting.
Capital Gains Harvesting To Build A Tax-Free Capital Dividend
One way to build your CDA is to harvest capital gains. If you have investments in your portfolio with large unrealized gains, you can sell and then immediately re-buy them. That means that you won’t miss time in the markets, but the gain will be booked and taxed.
The taxes paid on the capital gain are much less than the tax saved by giving a capital dividend instead of regularly taxed corporate dividends or salary.
If you are also paying out some regular dividends to live off of, then the RDTOH makes the net corporate tax only 10%. Even if not releasing the RDTOH now, that is a 25% combined personal tax bill now. Usually much less than your personal marginal rates you would pay to withdraw money from the corporation normally.
The other nuance to consider is that the included half of the gain, if really large, could bump the corporation over the active-passive income limit. As mentioned in the previous section, that could raise the corporate tax rate substantially (or provide a net tax benefit in Ontario or New Brunswick). We actually do harvests routinely when our capital gains are in the 60-70K range since it keeps it small, but large enough to offset the accountant fees of electing a capital dividend (a few hundred bucks for us).
Corporate Donation of Appreciated Securities
If you make giving to charities a regular financial habit, it not only makes you happier. It has tax benefits. For a corporation, donating stocks, ETFs, mutual funds, or other publicly traded securities to a registered charity has triple the benefit.
The tax liability from the capital gain disappears and the donation is a deductible expense. That deduction can be applied against investment income (50% tax rate) or against active business income tax rate. Here is the big bonus – you get the full capital gain (not just half) added to your CDA.
Wow. A massive tax break and maybe even a plaque on the wall of an institution.
Shareholder Loans: Withdraw Corporate Money Now. Pay Less & Later.
If you are not constantly in the highest tax bracket, then spread income out over several years using shareholder credits and loans. That reduces the amount that is bumped up into the higher tax brackets. This requires planning, but can usually be done in close collaboration with your accountant. Even if you want all of the money in the near future. Here are some ways how.
If it is January or maybe February and you are planning a big spend this year, then you may be able to shift some of the income into the previous personal tax year. This would need to be done as your T4/5 slips are prepared for your corporation’s payroll.
Income is considered taxable when it is received. So, to avoid this problem when you get the cash in Jan/Feb, it needs to be recorded as being “paid by way of a credit to the shareholder’s loan account” for December 31st of the year just finished. If it is not recorded that way, then it will be taxed in the current year.
When you withdraw the money from the corporation in Jan/Feb that simply brings the shareholder loan account back up to neutral. That is best done using a dividend. If a bonus (T4 income) is used, then CRA may get antsy if payroll tax remittance isn’t sent in on time (with big late penalties). The one time to consider a salary bonus is if it is to max out your RRSP and deduct that from your income (talk to your accountant first).
A shareholder loan can also be used to temporarily advance funds. You can take a shareholder loan from the corporation to withdraw money now and not immediately count it as income. You must log the loan in the corporate minute book. It gets reported on the next corporate tax filing and must be fully repaid before the subsequent corporate tax filing. If not, then the remaining balance is considered to be taken as personal income. This is one of the reasons why having a corporate year-end staggered to the personal (calendar) year-end is helpful for tax planning. Plus, you want a happy well-rested accountant by avoiding tax season.
Optimally, you could conceivably use shareholder loans to spread personal tax over four years as illustrated below. If your timing isn’t perfect, you could still likely spread the income and taxes over two years. Hence, planning can save you money.
Book-Keeping & Interest
You do not need a formal loan agreement. However, it is vital to work with your accountant to make sure that the T4/5s are done properly. You must also ensure that the nature of the loan, credits, and dividends are logged in your corporate minute book properly whether by you or your lawyer. Interest must be paid on the loan at CRA’s prescribed rate for each quarter. You may opt to do that with cash or your accountant can usually reconcile that when they do your corporate filing. Unpaid interest is deemed a personal taxable benefit.
Avoid a Double Tax Penalty
It is vital that you repay the shareholder loan on time. Either with cash or by taking it as a salary or dividend. If you do not, then not only is the loan amount taxable as personal income anyway. Your corporation also does not get that salary/wage deducted as an expense. So, effectively, there is a full corporate tax on the original business income plus full personal tax. This is easy to avoid by handling it properly, but nasty if you do not.
Specific Purpose Employee Loans
It is possible for a corporation to loan money over a longer repayment period than a shareholder loan. However, the criteria are fairly complex. So, it requires planning in how you set up and run your corporation. It is an employee loan. Hence, it must be available to all employees and not just you. Further, you must be an employee (collect salary) and not just be a shareholder.
CRA has taken a pretty hard stance on these and the burden to demonstrate that this is due to an employment role and not a shareholder benefit is high. If you have significant influence over the business’s policies, then it is likely to be deemed a shareholder loan. Unfortunately, that is most professional corporations or small businesses.
The arrangement must be made and documented properly at the time of the loan, along with a “reasonable” repayment schedule. The sooner you consult and involve your tax professional with this planning, the better. Both to ensure that you can do it (you probably cannot), and that it is done properly. The most sought-after loan would usually be for housing.
A home purchase or relocation loan
The purpose of an employee home loan must be to purchase a dwelling to live in (not a secondary property). It can be made to an employee or their spouse. Interest must be paid at the CRA-prescribed rate at the time the loan was issued. The rate may decrease, if prescribed rates do, but cannot increase past the original rate. The interest rate is reset to the prevailing CRA-prescribed rate every five years.
If the new home is >40km closer to a new work location, then it can be a relocation loan. A relocation loan changes to a new purchase loan if it is not repaid within five years. You cannot hold more than one relocation loan.
Return of Capital
This option only applies to business owners that use a big chunk of personal money to start up their business. There are many nuances. So, this is definitely something to seek professional advice when considering.
Repayment of a credit to a shareholder
The owner may have loaned money to the corporation to get the business running. The inverse of taking a shareholder loan from the corporation. Repaying that loan to the owner would be a tax-free way to withdraw money from the corporation back to personal accounts. Alternatively, you could collect interest on that loan. However, that would be taxable as income. Plus, there could be a triggering of the TOSI rules if it is paid to a non-voting shareholder.
Return of capital from purchase
If you bought your business or practice from someone, or together with a group of people, then you may have an identifiable cost per share of the corporation. The total amount paid for shares in a Canadian corporation is documented as the Paid Up Capital (PUC). The PUC is part of the Stated Capital of a corporation.
Commonly, private corporations issue different share classes as partners buy-in so that each class has an associated PUC. The PUC from a share class can later be distributed back to the owners tax-free as a return of capital (ROC).
Change in the adjusted cost base
The cash that you paid to start your business forms a “hard adjusted cost base (ACB)“. If you return capital from that, then it reduces that ACB by the money taken out. Simplistically, if you paid $100K to start your business and took $75K as ROC, then the ACB becomes $25K. That means when you do eventually wind-down or sell the business, the value minus that $25K becomes a capital gain. Essentially, this means that ROC gives you tax-free money now while increasing the capital gain deferred to the future. That future tax liability could even be attenuated by the lifetime capital gains exemption, if you are running an active qualifying business.
Capital Gain Surplus Stripping
Update March 2023: The Federal government budget signaled its intent to kill this option except for a genuine intergenerational business transfer to new ownership.
Capital gain surplus stripping is a complex tax ninja maneuver to allow retained corporate earnings to be withdrawn into personal hands as capital gains instead of regular income or dividends. This is not to be confused with the capital gains harvesting mentioned earlier in this article. You do not require corporate investments with capital gains for your CDA to do this. However, you do require boutique tax lawyers and accountants and the will to move in the shadowy grey areas of tax planning.
The fees for setting up a capital gain surplus stripping pipeline can range from a few thousand to tens of thousands of dollars. So, you would only want to consider this if the fees will be offset by the tax savings. That generally means moving hundreds of thousands of dollars to be cost-effective.
The other consideration is legal risk which often comes down to a subjective determination of intent. Surplus stripping is currently legal, but the CRA has challenged it in court with mixed results. The government tried to change the laws to prevent it in 2017, but that was abandoned when it caught farmers and fishers in the net. Not good political optics. However, this is in their sights, and legislation was eventually passed to effectively end it (except for some family businesses) on Dec 31, 2023. Further, some physician colleges may also complicate the maneuver by blocking MPC shares from being held by other corporations.
So, when would I consider surplus stripping?
I would need to have an immediate use for the money, have hundreds of thousands of dollars to move, and consult with a tax specialist. Their fees would play a role. As would whether subsequent defending of challenges by CRA are included in the cost or not. It is easy to recommend something and collect large fees if you have no other skin in the game. You will find wildly varying opinions, but that is mine.
We haven’t pursued this because, with our income-splitting strategies and capital gains harvesting, we haven’t needed to. About 2/3 of our money has been slowly and efficiently siphoned out of our corporation over time. However, if we hadn’t done that and needed a large chunk of personal cash, then I would look into it before the government regroups and closes the door.
Summary of Ways To Withdraw Big Money From Corporations
The big six ways to withdraw big chunks of money from a corporation tax efficiently are summarized below. I hope to revisit each of these strategies, with examples, in some future posts. However, use this knowledge to plan in conjunction with your tax professionals because there are many nuances.