Prime Minister, Sir Robert Borden, introduced the first federal income tax on business profits in 1916 and personal income tax in 1917. At the time, people were told that this was a temporary measure to support Canada’s efforts in the First World War. What started as a 10-page document, the Income Tax Act has grown to over 3500 pages today and continues to climb. For business owners and incorporated professionals, taxes will be by far the largest expense over their lifetimes. Because of this, I figured I’d highlight one of the most under-utilized tax planning tools at their disposal.
Enter Pension Legislation. If you’re an owner of a business that is incorporated, it’s time to pay attention. Governments around the world have increased their spending at an unparalleled rate in their fight against COVID-19. As a result, taxes are highly likely to increase sometime in the not-too-distant future. If you are a business owner or incorporated professional, it has never been a better time to review IPPs and how they can benefit you and your family.
So what exactly is an IPP? IPPs are registered pension plans with CRA that business owners can set up for themselves and any family members who have earned T4 income from the business. They are no different than a typical defined benefit pension plan from the government or other large employer. IPPs provide many benefits to business owners/incorporated professionals, but for the sake of being succinct, I am going to focus on the benefits that allow business owners to accumulate more wealth tax-deferred while at the same time helping to reduce their corporate and personal taxes.
Pension legislation is more generous than legislation for RRSPs. When individuals reach the age of 40, the contribution room available via pension legislation begins to outpace what is available to individuals via RRSP rules. By age 45 pension rules allow contributions 21% higher than what is offered via RRSPs. By age 55 this difference increases to 46%. This means business owners and incorporated professionals can shelter more of their assets and grow a larger amount tax-deferred which results in more money at retirement.
The last decade has seen several major changes that have caused individuals who own incorporated businesses to re-evaluate their retirement and tax planning. In 2018, the Federal Government changed the rules surrounding passive investments within a company making it much less advantageous for business owners to use corporate dollars to invest passively for the purposes of retirement down the road. Not only is it less advantageous, but it can also be punitive anytime passive investment income earned inside the Corp exceeds $50,000. Beyond this threshold, passive income slowly begins to grind down a business's ability to access the small business tax rate on it is first $500,000 of active business income. In Manitoba, the small business tax rate is 9% and in Ontario, it is 12.2%, both significantly lower than the standard corporate rate (27% (MB) and 26.5% (ONT)). Utilizing pension legislation, business owners and incorporated professionals can shift corporate assets to a pension, reducing income inside the Corp that could grind down the corporation’s access to the small business rates.
Additionally, even when passive income is not grinding down a business owners’ access to the small business rates, all passive income inside a Corp is taxed at the highest marginal tax rate, 50.7% (MB) and 50.2% (ONT). When owners can shift assets from their Corp into a pension structure, all funds within the pension grow taxed deferred. No taxes will be paid until pension income begins to be drawn.
Large corporate tax deductions (past service, regular contributions, and terminal funding)
For business owners setting up their initial pension, there is almost always what we call “past service”. Past service refers to a period that the owner earned T4 income from the company but did not contribute to a pension. Business owners can go as far back as 1991 when recognizing past service. We commonly see past service contributions in the five to six-figure range. This means upon plan setup; business owners can contribute for their past service and receive a large corporate deduction instantly reducing corporate taxes payable.
As mentioned earlier, pension legislation is more generous and allows for significantly higher contribution amounts after the age of 40. All of these contributions are tax-deductible expenses to the corporation. Over the lifetime of the pension, incorporated individuals can expect six and seven-figure corporate deductions, which provides further tax savings.
The last and one of the largest immediate tax deductions is terminal funding. Terminal funding refers to an amount that is required to top up a pension in order for the pension to provide full benefits. In most instances, terminal funding is used to top up a pension at an earlier retirement date. Typically, we see terminal funding amounts that are seven figures in size. This is a huge corporate tax deduction providing the business owner significant corporate tax savings and a full pension at an earlier retirement date.
Today, most investors who have funds invested, whether through an RRSP or some other account, are being charged an investment management fee (IMF). Typically, this fee will range between 1% - 2% per year based upon the total amount of funds invested.
An important difference to be aware of when determining whether an IPP makes sense over an RRSP for retirement purposes is the fact that within the IPP structure, all the investment management fees associated with the investments are tax-deductible to the sponsoring corporation. With RRSPs, this is not the case. Investors have no ability to write off RRSP fees personally.
In addition to this, with an IPP, Investors can fold existing RRSP assets into the pension structure via the qualifying transfer and the Additional Voluntary Contribution (AVC) account creating more tax-deductible fees. The qualifying transfer is an actuarial calculation and is an amount required by CRA to be contributed to the individual’s IPP using assets in their RRSP when purchasing past service. The AVC component is voluntary. Any funds that are remaining inside the RRSP after the required qualifying transfer can be rolled into the AVC account. Both the qualifying transfer and the AVC contributions turn the investment management fees associated with RRSP assets into tax-deductible expenses under the pension structure. Throughout a 20 or 30-year period, this amounts to significant tax savings that would have otherwise been unavailable using RRSPs.
Given the pandemic, it is safe to say the tax environment for business owners and incorporated professionals will continue to be a challenge and possibly even more punitive in the near future. For business owners who take on the enormous risk of starting a business, proper tax planning has never been more important to ensure you and your family’s future is protected.
It is important to ensure that anytime a serious discussion around IPPs or any other specialized tax solutions are being had, that the right professionals are involved. We always recommend engaging your accountants and other tax professionals when evaluating these advanced planning solutions.
- Brandt Butt, Investment Advisor, CIM®
Brandt Butt is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Brandt Butt who is an Investment Advisor for iA Private Wealth Inc. and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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