Many incorporated business owners are wondering whether to realize capital gains before the proposed June 25, 2024, tax hike on capital gains. It is a complex question spanning tax and financial planning. I did a deep dive on the relevant variables elsewhere. The optimal strategy is very situation-specific and not always intuitive. So, I built a capital gains harvest simulator with detailed annual calculations running in the background to model it.
In the first case study, I detailed how a capital gains harvest works. Realizing the gain, paying out a capital dividend and investing that personally. Next, non-eligible dividends are used to clear out the RDTOH from the taxable half (soon to be two-thirds) of the gain. When that is done, either the invested personal cash is either spent (harvest & spend) or kept invested (harvest & invest). If spent, that allows the corporation to pay out less salary or dividends to fund personal consumption and retain more in the corporation.
The other factor that may arise with a large capital gain is exceeding the corp passive income limits. That first case was in Ontario. Ontario and New Brunswick have a different approach to using passive income limits to incentivize moving money out of a corporation. A small carrot instead of a big stick. Harvesting a capital gain with over $50K included as taxable income may trigger that. What happens in other provinces without that added benefit? Today, I will run the same scenario using BC’s fairly tight tax integration and no passive income limit anomaly.
Assumptions & Disclaimer
I am trying to be transparent. Details about the strategies, optimal compensation, and return assumptions were described previously. I will focus on the strategy results for this specific scenario. Also, if you don’t want the details of what is happening under the surface, you can skip to the executive summary.
I updated the model on May 21, 2024 with some tweaks to RRSP treatment. It made the results very close regardless of strategy. Not surprising, with BC’s tight tax integration.
None of this is specific tax or investing advice. It is just food for thought for you to discuss with your advisors. Also, the nuances could change if the proposed legislation changes. Do not do anything rash.
Comparison of the Strategy Results
Scenario Description
This case is a 40-year-old BC corporation owner. They are single with no other income from outside of their corporation. They have no unused RRSP or TFSA room but will use whatever is generated moving forward during the 20-year study period. Their corporation earns $500K/yr before paying the owner’s salary. They spend $150K/yr on personal consumption using a dynamic mix of salary and dividends. How that changes over time will be shown in this scenario.
Their investment accounts have an 80:20 stock:bond mix of globally diversified ETFs with no fees and no advisor fee. The mix and projected income mix is detailed here. They currently have a $1MM portfolio with $500K as an unrealized capital gain.
How Pay Mix Changes
Short-Term Compensation Change With a Harvest & Spend Approach
For the harvest and spend strategy, it takes about 5 years for the salary and dividend mix to get back to baseline. First, a large capital dividend is paid out and invested personally. The following year, is mostly non-eligible dividends to clear out the nRDTOH. The large investment income from the taxable half of the capital gains plus only using dividends in the second year means that all corporate active income in that second year is taxed at the general corporate tax rate. Fortunately, that also generates GRIP and the corporation pays out mostly tax-efficient eligible dividends for the following year and a half. At that point, they start supplementing their spending needs with money from their personal investment account and paying salary again.
Short-Term Compensation Change With a Harvest & Invest Approach
The short-term compensation strategy changes are similar with the harvest & invest approach. The main difference is that instead of tapping the personal investment account, that is left invested long-term. The result is a resumption of regular salary into the mix sooner.
How Does That Fit Into The Big Picture?
Below is a comparison of how a dynamic compensation strategy to optimize salary and dividend mix unfolds over a longer time frame with the different strategies. Regardless of strategy, the corporation starts hitting the passive income limits and shifting to a dividend-only strategy in their early to mid-50s. With the “spend” strategy, the personal capital is accessed in years 3-5. In contrast, with the “invest” strategy, that personal investment account grows slowly in the background and produces a small amount of personal investment income. The sliver is too thin to see.
The other big difference is that there is a lot more salary used over time without harvesting a capital gain. That translates into less RRSP (or IPP) room and fewer CPP contributions. I will examine that further in the portfolio value and composition section.
Corporate Tax Nuances For BC
BC Tax Integration & Tax Deferral for Active Business Income
One of the reasons why I did this case is because BC has tighter tax integration than Ontario does. Tax integration is the notion that income earned personally vs through a corporation should have similar total taxes owing. Integration is not perfect, but in BC it is pretty tight. Only a 0.3-1% tax cost for active income flowing through a corporation at the SBD rate and a paltry 0.1-0.5% tax cost for general corporate income and the subsequent eligible dividends.
The general corporate tax rate is higher. So, there is less opportunity for tax deferral at the general corp rate by investing retained earnings instead of paying them out and triggering personal tax. However, if you spend enough personally, the flow through is efficient. This is shown in the table below (from my dynamic tax integration tables).
BC Passive Income Limit Effect
In Ontario, there is a small tax efficiency carrot for moving income out of the corporation when the passive income limit is exceeded and bumps active corporate income to the general corporate tax rate. The current scenario with a $250K taxable capital will do that. In BC, there is a slightly improved tax integration when the income is fully flowed out as eligible dividends (as shown above). However, that is not enough to overcome the loss of tax deferral from both realizing the capital gain and bumping income to the general corporate tax rate. There is also some lost tax deferral with a harvest because the RRSP/IPP room used is a bit less (fully tax-deferred accounts).
That contrasts with ON and NB where the GRIP anomaly from passive income actually boosts tax deferral overall. So, in BC this attenuates the benefit of a large capital gain harvest that exceeds the passive income limit while in ON/NB it is a bonus. There is still a boost to partially taxed corporate money, but it is smaller. The net effect on tax deferral is shown below.
Portfolio Value & Composition
Short-Term After-Tax Portfolio Value (Liquidated)
Understanding the moving parts is great, but what is the long-term outcome for using the different approaches? The difference in after-tax total portfolio value (liquidated) is shown below. There is an initial bump with harvesting due to removing the capital gains tax liability at the lower current inclusion rate. Plus, some extra money retained in the corporation. However, over time the smaller RRSP from the salary decrease from living off of the capital dividend catches up. The tax-sheltered growth in the RRSP eventually allows it to pull ahead.
If the personal cash from the capital dividend is invested, the new capital gain tax liability accrues at the lower personal 50% inclusion rate (assuming <$250K/yr gain). In contrast, there is a 67% inclusion rate in the corporation. Foreign dividends also flow more efficiently personally than via a liquidated corporation. It doesn’t make a big difference. The blue “harvest & invest” line in the above chart is overlapped by the “harvest & spend” one.
Most people would not liquidate their corporation. However, it is a standard way to discount for the tax liability embedded in different account types. Importantly, tax deferral may make up for that with an efficiently run corporation held long-term and drawn down slowly. More on that shortly.
Portfolio Value & Composition at Year 20 (Liquidated)
One of the big potential advantages of doing a capital gains harvest is to diversify tax risks by moving money out of the corporation and using other account types. An RRSP is one example. It is less vulnerable to political targeting. However, an RRSP is also fully taxable as income at the exit. In contrast, a TFSA is tax-free at the exit. Using a personal taxable account to invest may have some extra tax efficiency for eligible dividends at low-income levels. Plus, the embedded tax liability from the capital gains are lower. Not zero, like a TFSA, but also of unlimited size. Having multiple accounts gives options for tax planning and mitigates against future tax changes.
In this scenario, both harvest strategies had a slightly smaller after-tax portfolio value than not harvesting. However, with the “Harvest & Spend” strategy more of that value is concentrated in the corporation. In contrast, the “Harvest & Invest” strategy had slightly more value. Plus, it spread out into a personal cash account rather than concentrating more in the partially-taxed corporation.
Portfolio Value & Composition With Gradual Drawdown
There is a boost in tax deferral on retained corporate earnings in the “harvest & spend” strategy, but less tax deferral in an RRSP. Further, there is more tax deferral loss using the “harvest & invest” strategy. Tax deferral translates into added tax savings when you defer from a high personal tax rate to a lower future one. It is also accentuated by the opportunity cost of lost growth on the money used to pay taxes now instead of in the future.
So, when you draw down the portfolio more slowly (to avoid deferring to a high future tax rate), the difference between strategies changes. There is almost no difference between the “spend” strategy and not harvesting because they both benefit from tax deferral. For the personal investing strategy, there is still the advantage of diversification against tax risk, but the numbers are worse because there is less tax deferral advantage. All the portfolios are worth more when drawn down slowly at lower tax brackets rather than liquidated (mostly at the top marginal rate).
Sensitivity To Drawdown Tax Rate Changes
Using the “harvest & invest” personally strategy spreads out risk against future tax rules becoming more unfavorable towards small corporations. Or higher tax rates on regular income, like from an RRSP/RRIF/IPP. However, that comes at a loss of tax deferral due to a smaller corporate account and smaller RRSP. The “harvest & spend” strategy still has a largely tax-deferred portfolio (skewed more towards the corporation than the RRSP).
In this scenario, taxes are deferred from the marginal tax rates on the income required to fund $150K of after-tax spending. If the future spending rate is lower, marginal tax rates would be too. As you can see below, reducing the future tax rate worsens the outcome for moving money out to invest personally. If the personal cash account was used for spending (while boosting corporate tax deferral), the advantage of doing a harvest was relatively preserved.
The tax deferral of a larger RRSP when not harvesting capital gains and the tax-sheltered growth of the RRSP is very powerful.
Executive Summary
In this case with a CCPC owner earning $500K/yr and spending $150K/yr, harvesting a $500K capital gain prior to the June 25, 2024 inclusion rate increase ultimately results in slightly less after-tax money at 20 years. How much depends on what is done with the excess personal cash from using a capital dividend. With British Columbia’s tight tax integration, the results are very close. How you plan to draw down your portfolio and how much you value diversification of tax risks impacts the strategy decision.
With the model portfolio in this scenario, high levels of consumption (over ~$150K/yr) were required to process the harvest efficiently and be above water at 20 years out.
Processing The Harvest
British Columbia has slightly tighter tax integration than the previous example using Ontario. Plus, both the Federal and provincial SBD threshold shrinks by exceeding the passive income limits. That meant less of a bonus due to the temporary loss of the SBD from the taxable half of the capital gains harvest. Still, harvesting capital gains before June 25th was beneficial. Either in dollars or diversification against future tax changes, depending on how the excess personal cash is used.
With harvesting a $500K capital gain, it took one year to use enough non-eligible dividends to release the extra nRDTOH generated. There was also loss of the SBD for one year and it took another year to use the GRIP generated due to that. This resulted in a slight loss of tax deferral compared to the SBD rate, but in BC the cost of flowing income through at the general rate with eligible dividends personally was also slightly less. So, not a big deal. Salary use then resumed and was back to normal by year 4-5 if the extra personal cash was kept invested. Or Year 6 if the personal cash was spent first before drawing more from the corporation again.
The time frame to work through this would be shorter with a smaller capital gain or longer with a large one. A large capital gain that takes many years to process would become unfavorable. If there is so much nRDTOH that it is trapped and its value is eroded by inflation, that could overpower the initial tax savings and negate the tax deferral. I will examine that more in a future post.
Harvest & Spend Resulted in More Money Concentrated in the Corp.
Using a capital dividend to fund personal spending instead of some taxable income kept much more invested in the corporation. The harvest reset the tax liability from the capital gain, but more partially taxed other income was retained to invest and grow. That resulted in a similar portfolio value after tax. Slightly more in the short-term, but about $25K less than not harvesting after 20 years if the whole portfolio is liquidated in a single year.
With the more likely scenario of a gradual drawdown in the future, the gap narrowed. The boost in corporate money early on was attenuated by losing some tax-deferred RRSP. The net after-tax money was almost identical to not harvesting a capital gain before June 25th, 2024.
Importantly, not harvesting had a larger RRSP and a smaller corporation. That would be less vulnerable to further unfavorable tax changes for corporations but was also materially less money. The advantage was maintained at substantially higher or lower future spending levels (and marginal tax rates).
Harvest & Invest: More numerical disadvantage, but more tax diversification.
If that money were invested personally and preserved, then it is somewhat close after 20 years. If the portfolio were liquidated, there was $20K less money than not harvesting. That is primarily driven by a loss of tax deferral and tax sheltering from some RRSP space. There were slight tax savings and a slight boost to the corporation upfront, but with BC’s tight tax integration, that was not enough. At these income levels anyway. At lower personal investing tax rates, the math may change. I’ll revisit that in some future cases.
If the portfolio is drawn down gradually at progressively lower future tax rates. Then, the disadvantage of giving up tax-deferred RRSP room for a few years is magnified. Yes, there is more diversification across account types, but the cost can be material. It would take some pretty nasty tax changes to overcome that. Of course, nothing is impossible.
Great stuff!
I was wondering, These models seem to indicate a fixed spending need. Since many will have a very large personal liability in a home mortgage. Does it make sense to:
– just draw out excess dividends in the first 2 years to fully release both rdtoh accounts
– and with any excess draw out of the corp, put it towards paying down one’s mortgage?
Would such a strategy be similar to the “harvest and invest”, where the investment is a risk free return asset, and one does not touch the “investment” (or mortgage repayment) in the short term?
If so, would it further advantage the decision to harvest before June 25?
Hey Stevie,
Definitely! I started with these cases where there is a bit of a question for people to wrap their heads around (boost corp by harvest/spend or invest personally at a relatively high tax rate). It is usually beneficial in these cases, but not a slam dunk. Plus, introduce owners and advisors to what the mechanics look like over the course of time.
Where it really shines is when you are taking corporate money and using it even more efficiently than it would have been used in the corp. I will model some of those out later, but they are the “no brainers” in my mind:
1) Paying down a mortgage or LOC with the cash (risk free, tax free return, feels good)
2) Topping up an RRSP or TFSA (a move from taxed corp money to tax-sheltered investing
3) Harvesting gains from high-fee funds or a sub-optimal stock portfolio to move to a lower-cost or more effective investing strategy.
4) To get corp money out tax-efficiently to fund a personal splurge.
5) Possibly personal investing if at a low tax rate or using corp class ETFs (situation dependent).
We have used it for all of those purposes over the years. The benefit is much higher at a 50% inclusion rate, but probably still there with 66.67%. I am still somewhat hopeful that the Federal government will realize that breaking tax integration is bad and allowing a $250K/yr threshold for 50% inclusion for small corporations. I harvested last year to fund some home renos and again recently for the same reason plus to finally simplify from some Canadian stocks to an ETF in my corp.
Mark
Mark, great post. These case study posts are very helpful to get a better understanding of the principles involved.
Harvest to invest at a low tax rate – is there a rule of thumb about what is too high a tax rate for this to make sense? (sort of like dividend trapping when personal tax rate is higher than Corp dividend tax credit).
Thanks Grant. I haven’t fully run numbers on that yet. However, I haven’t been able to come up with a rule of thumb. It is very situation specific because of all of the variables. An efficiently running corporation that is flowing enough money through to live on and gradually draw down is tough to beat. I am also waiting to see what the final legislation shows. One thing that modeling and thinking about this has highlighted for me is that the numbers are usually quite close, but having your money spread out in different account types has a value for spreading risk and having planning options (difficult to put a number to). For example, a perfectly efficient corporation will often out edge ahead, but that assumes that tax rules don’t change and that you draw it down slowly. If the corp gets liquidated (like due to death), it often trails – although I think that could be addressed if donating to charity.
Mark
Mark, when you say, “an efficiently running corporation that is flowing money through”, does that include annual capital gains harvesting? That’s something I haven’t been doing thinking I’d let the gains compound until retirement, so lowering personal taxes, which along with income splitting after 65, helps with OAS clawback. Of course, that ignores political risk.
Hey Grant. I was just talking about releasing the RDTOH. However, in retirement using capital gains harvesting to lower taxable income strategically (for less OAS clawback or to fund a splurge without OAS clawback) is an added bonus. Before retirement too. I left that out of this model because it just delayed harvesting by one year and assumed no accountant costs. Ben’s model went the other way on that (harvesting and flowing capital dividends annually). We have comparable results, but flowing capital gains through regularly is a little more efficient. The other implication of harvesting and flowing capital gains through now is an increase in efficiency now, and more kept in the corporation. The other implication of that is that it is deferring taxes to the future. So, estate planning could also factor in.
If below OAS age and it is fast approaching, I think that the planning flexibility of waiting and using capital gains strategically at that point is an important consideration. It was too hard for me to model. Also, if you plan on donating a bunch of appreciated stock to charity, I would avoid triggering those gains in advance since they would all add to the CDA and avoid the inclusion rate altogether.
Mark