Corporation Account Types: Know Where The Money Is

A corporation can function like a large dam to regulate cash flow for a business owner. That enables income smoothing to reduce and stabilize personal income taxes. Larger sums of money can be released strategically to fund personal splurges. However, the main advantage of a corporation is to allow partially taxed money to build up and invest within the corporation. Like a large reservoir. That corporate reservoir has multiple different pools within it. Learn about the different corporate account types to keep your corporation functioning tax efficiently.

Real vs Notional Corporate Accounts

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Real Business Accounts

The “real” accounts hold financial assets that an institution, such as a bank or discount brokerage, acts as a custodian for. For short-term needs, you would likely save cash in a business account at a bank or credit union. To invest for your long-term security, a discount brokerage or regular investment brokerage may hold stocks, bonds, mutual funds, or ETFs “in trust” on your behalf.

Either way, this is money that you can physically (or electronically) access and spend. You can log on to your account, see the balance, and deposit or remove money. Even better, you can usually automate recurring deposits and expenses.

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Corporate Notional Accounts

“Notional accounts” are record-keeping accounts that only exist on paper. They are used to track money that your corporation can get as a tax refund, or how much your corporation can pay you with special tax-advantaged dividends. So, they don’t hold money in an account at some institution for you to access. They are just numbers on your corporate tax filing. However, the money that gets refunded to your corporation from the government and the personal dividend tax credits to you are definitely real money.

Therefore, you must learn about these accounts and how they work. Or let the government keep your money longer while inflation erodes its buying power. The main account types and taxation of the flow of money from your business into your personal hands are illustrated below. Our tax system is a bit of a tangle, but don’t worry we will unpack the pieces in bite-sized chunks.

Real Corporate Business Accounts

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Business Operational Account

When you have a corporation, it is vital to keep your personal income and expenses separate from your business income and expenses. The corporation is considered a separate legal entity. Whether a professional corporation or other incorporated business, there are tax implications when money moves between you and the corporation. To keep this clean, open a corporate bank account. That will be classified as a business account by your bank, and you will need to provide them with your corporate business number and likely a copy of your articles of incorporation. Hardbacon has a nice summary of that process and some commonly used accounts.

Any business income that you earn should go into your business’ operational bank account. Similarly, all business expenses should be paid from that account. If you use a credit card for convenience, it should be registered to your business and paid from this account. Your operational account is likely to have a lot of transactions as money moves in and out to run your business. So, it is best to have an account that has low transactional fees. That usually means it pays little or no interest, and often requires a minimum balance to waive the fees.

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Business High-Interest Savings Account

There may be money that you wish to park to cover an anticipated expense in the next 1-3 years. Or to function as buffer for your cash flow crunches, like an emergency fund. If you are making infrequent transactions, then a high-interest savings account owned by your corporation could be used. Interest earned on this type of short-term operational money would not count as passive income. It would be taxed at the lower small business (~12%) or general corporate tax rate (~27%).

With moderate to larger balances, there are some bank accounts that allow both free transactions and a decent interest rate. However, remember that there is opportunity cost to holding large cash balances that could be invested instead.

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Business Line of Credit

An alternative approach to saving for future cash flow crunches is to use a business line of credit instead. This may cost a nominal fee to maintain. Such as $20/month. Plus, if you use the line of credit then you will pay interest on the balance. Most physicians can get a business line of credit for their corporation at prime minus 0.25%. I have mine linked directly to my corporate business account. So, when I have an unexpected cash crunch, I have a negative balance at prime -0.25% interest. When income flows into my corporate operational account it automatically pays that off until I am back in the black.

The advantage of a corporate line of credit is that you can keep minimal idle cash in your corporation and use the LOC to absorb the cash crunches. Personally, I keep a month or two of normal operating expenses in my account and invest the rest. A more unstable business would likely keep a larger buffer. If I do have to pay interest transiently, then it is deductible against the corporation’s income. That is technically called a carrying cost.

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Corporate Investment Accounts

Excess money in your corporation after paying out salaries, taxes, and operating expenses is called retained earnings. You may pay some of those retained earnings out as dividends to support your personal spending. However, retained earnings that you won’t need in the near future should be invested to increase long-term returns. That is what a corporate investment account is for.

You can open a corporate investment account at most brokerages. Similar to a corporate bank account, there will be extra steps and documents compared to opening a personal account. I have simplified that process to open a corporate investment account at QTrade with a guide page containing links to the relevant forms and process. It is part of a larger step-by-step interactive guide to DIY investing.

It is important to note that there are no tax consequences for moving money back and forth between your corporate investment account and operational accounts. When you earn investment income, like dividends or interest, that income is taxed as corporate passive income whether you re-invest it or move it out of your investment account.

Corporate Notional Accounts

There are four main notional corporate accounts to be aware of. The Capital Dividend Account (CDA) is part of tax integration for capital gains. There are two Refundable Dividend Tax On Hand (RDTOH) accounts to track refundable taxes from investment income. The General Rate Income Pool (GRIP) account is part of tax integration for the active business income of larger corporations.

Capital Dividend Account (CDA)

People often first hear about the CDA when someone is trying to sell them whole life insurance as a way to move money out of a corporation tax-free. However, it actually applies to all capital gains. Even for investments with lower costs and higher expected returns. Like asset allocation ETFs.

Capital gains occur when an investment increases in value. You realize that gain when it is sold to get the actual money in hand. When a person does that, half of the gain is “included” and subject to regular income tax. The excluded half of the gain is tax-free to account for inflation and encourage capital investment. For a corporation, that excluded tax-free part of a capital gain is tracked by the CDA.

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Tracking & Using Your CDA

When a corporation sells an investment and realizes a capital gain, half is taxed at the corporate passive income rate (half of ~50% = ~25%). The other half adds to the corporation’s CDA balance. Conversely, if the corporation realizes a capital loss, then half is subtracted from the CDA balance. If the corporation donates appreciated stock to a registered charity, one bonus is that the full gain is added to the CDA balance. Not just half. Big bonus.

The balance of a CDA carries forward from year to year. When there is a positive balance, your corporation can file a special election to give a tax-free capital dividend. That requires some accounting paperwork. So, depending on the accountant fee, this can be worthwhile with different amounts of money. You may even harvest a capital gain on purpose to pay a small amount of corporate tax and enable a big tax-free payout.

When your corporation gives a capital dividend, the CDA balance is reduced by that amount. If the balance goes negative, you cannot give more capital dividends until it is positive again. There is often a couple of week delay from filing the election and being approved to actually pay a capital dividend out. So, avoid realizing a capital loss during that window if you are paying out a capital dividend.

Refundable Dividend Tax On Hand (RDTOH)

Investment income (such as interest, dividends, or passive rental income) is taxed at a high rate upfront. The tax rate varies by province but is just over 50% for regular income and 38.33% for eligible dividend income. That frontloaded tax collection approximates the highest personal tax rate. That is intended to prevent corporations from having more tax deferral on investment income than a person would have.

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Non-Eligible Refundable Dividend Tax On Hand (nRDTOH)

Part of that tax is refundable and tracked via RDTOH. For interest and foreign dividends that is called non-eligible RDTOH. You may see it referred to as nRDTOH, or NERDTOH, depending on your level of Klingon vs geekiness. Only part of the taxes paid for that investment income is refundable. About 50% is collected and 30% is refundable. That 30% gets refunded when your corporation pays out ineligible dividends.

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Eligible Refundable Dividend Tax On Hand (eRDTOH)

For eligible dividend income that your corporation receives, the refund is the same as the tax collected (38.33%). That is why you may hear that eligible dividends flow tax efficiently through a corporation. That refundable tax is held as eligible RDTOH (eRDTOH). The refund gets released from that notional corporate account at the time of corporate tax filing. To be released, your corporation must have paid out eligible dividends equivalent to what your corporation received.

For example, a corporation gets a $10K eligible dividend, it pays $3833 tax upfront. When your corp gives you a $10K eligible dividend, you pay personal tax and the corp gets the $3833 tax refund that was tracked in the eRDTOH account.

We’ll get into the details of whether to pay yourself dividends to release RDTOH and how much in the next post. It can vary by the exact income type and your situation. However, you must be aware that you have paid this tax and some is sitting in these notional RDTOH accounts. Just waiting to be refunded.

General Rate Income Pool (GRIP)

The fourth notional account is General Rate Income Pool (GRIP). GRIP tracks how much your corporation can dispense eligible dividends to you. Those eligible dividends come with a larger personal tax credit. Depending on your province and tax bracket, that makes for a lower net personal tax rate of 8-10% less than ineligible dividends.

That sounds like a tax break, but it usually is not. It simply reflects that part of the tax has already been paid by a corporation at the higher general corporate tax rate (~27% general rate vs ~11-12% small business rate). There are two ways that GRIP can be added to your corporation.

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GRIP Generated From Corporate Active Income

If your corporation has income above the federal small business deduction (SBD) threshold, then that income gets taxed at the higher general rate. For example, if the SBD threshold is $500K and my corp has $600K net income (after salaries/overhead), the $100K is taxed at that higher rate. The SBD threshold is $500K for most provinces, but it can shrink when passive investment income exceeds $50K.

To reflect that, the higher income is added to the GRIP pool at a factor of 0.72. For that $100K, the corp would pay ~$27K tax and $72K gets tracked on paper in the GRIP balance. You could then give yourself $72K of eligible dividends from your corporation’s retained earnings.

When you add the general corp tax and the personal savings of an eligible dividend, it is slightly more tax than you would have paid if it were just earned directly. The tax integration is unfavorably imperfect. Still, if your corp has already paid the tax, you probably want to get the personal savings. When that becomes a conundrum is if you don’t need the money personally and want to maximize tax-deferral. More on that in another post.

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GRIP Generated From Receiving Eligible Dividend Income

The other way that GRIP can be added to a corporation is when it receives eligible dividend income from another Canadian company. That income adds dollar for dollar to the GRIP because the taxes and 0.72 factor were applied to the company that paid it to your corp. For example, if you get a $10K dividend from a Canadian bank, that bank paid taxes at the general rate and could pay 0.72 of their income as an eligible dividend. So, all $10K gets added to your corporation’s GRIP. You can pay a $10K eligible dividend to yourself.

It may be confusing to some people because RDTOH also applies to eligible dividend income. Your corp would have paid the $3.8K tax, but get a $3.8K refund (net zero corporate tax) due to the RDTOH mechanism at the same time. Very tax-efficient when used well. When you pay out eligible dividends, it does not matter whether the GRIP came from active income or passive income. The eRDTOH gets released either way.

Pulling The Levers to Move the Money

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Know Where The Money Is. Ask If You Don’t.

In this post, you learned about the different pools of money within your corporate money reservoir. Knowing where the money resides is the first step to avoid leaving money on the table. For real accounts, it is pretty easy to find how much money you have on your bank or investment statements. Setting up the accounts is a balance between convenience and optimizing interest paid or received.

For the notional accounts, the money is tracked with your corporate tax filing. So, the best place to find that is by wading through the tax return or asking your accountant. I recommend option number two. They should be discussing your RDTOH, CDA, and GRIP balances with you when they review your taxes and help you plan. If not, then hopefully after reading this post, you will ask.

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Use that knowledge to make the notional dollars into real ones.

Ask about your notional accounts and use that to plan how to pay yourself the right mix of salary and dividends. That helps to change the theoretical money in notional accounts into real money in your real accounts. It is like pulling the levers in the dam control room to release money from the different pools. When put together, the money flow is a bit of a tangle. Fortunately, it can actually be pretty simple to get the big movements right. I will share my approach to pulling the levers in the dam control room and moving the money in my next post.