Ottawa’s proposal to change the tax structure for incorporated businesses has many owners looking at alternative ways to shelter earnings for retirement and estate planning.
Tax experts are fielding a growing number of calls from small-business owners about the pros and cons of setting up vehicles such as Individual Pension Plans (IPPs) and corporate-owned life-insurance policies.
The queries come as the Liberal government proposes to restrict the use of private corporations for making passive investments unrelated to the business. Some business owners are using their corporations as a retirement vehicle by investing earnings inside the company at a lower tax rate than if they were pulled out and invested personally.
While some business owners are being encouraged to first draw funds from the corporation and maximize their tax-free savings accounts and registered retirement savings plans (RRSP) each year, experts also point to IPPs and corporate-owned life-insurance plans as other options if the government changes the rules on passive investments.
Pros and cons of IPPs
An IPP is available to certain business owners and acts like a “supersized RRSP,” says Navaz Cassam, president of GBL Inc., which sets up IPPs.
“It’s for people who want to save for retirement,” Mr. Cassam says.
An IPP is modelled after the defined-benefit pension plan that some salaried employees receive, providing a set annual income in retirement. It’s held in the name of the corporation, which is the plan sponsor. Like an RRSP, you put money into an IPP, the corporation receives a tax deduction and it grows tax-free. You don’t pay tax on the funds until you take them out.
Experts say business owners looking at an IPP should pay themselves T4 employment income of at least $100,000 annually and be between 40 years old and 71 years old to receive the most benefit. Business owners would need to hire an actuary to make calculations on when to start an IPP, based on their individual circumstances.
“It’s not for everyone,” says Tarsem Basraon, a high-net-worth planner at TD Wealth’s Wealth Advisory Service.
In most cases, the older the business owner is, the more contribution room there is available in an IPP versus an RRSP. The maximum RRSP contribution for people earning at least $145,500 is $26,010 in 2017, regardless of age. With an IPP, the maximum contribution depends on numerous factors but at the age of 50, it would be roughly $34,000 and at 60, it would be around $41,000.
“Often, it’s not until you’re about 50 that it makes sense to do the IPP in terms of maximizing deductions,” Mr. Basraon says.
That’s because the actuary has to come up with a number of how much money to put in the IPP to fund your retirement and the potential tax deductions relate closely to your age and past earnings with the corporation, he says.
“Generally, the older you are, the more money you’re going to get to put in because the less time there is for the IPP to grow and generate the retirement income you need,” Mr. Basraon says. “There is no magic number, it depends on your situation, how much money you have in the corporation and what your age and retirement horizon is.”
Other benefits of an IPP are that it’s creditor proof and the administration costs are deductible to the corporation.
The downside is the complexity. “It’s not as simple as an RRSP,” Mr. Basraon says. There are also the administration costs.
Mr. Basraon cautions business owners to wait and see what Ottawa does about passive-investment income before setting up an IPP as an alternative.
“On paper, right now, it looks like a viable alternative as a retirement vehicle to use it, but we don’t know what the final legislation will look like,” he says. “It might account for IPPs and discourage people from using them as well.”
Pros and cons of corporate-owned life insurance
Corporate-owned life insurance is typically used for estate planning. It allows business owners to accumulate investments in the policy tax-free. Upon death, in most cases, the entire benefit can be paid out tax-free to the shareholder through a capital-dividend account, says Jamie Golombek, managing director of tax and estate planning at CIBC Wealth Strategies Group.
“It’s a great way to maximize the value of the estate. If you have permanent capital that you’re never going to spend in your lifetime, that’s sitting inside your corporation, then using a corporate-owned life-insurance policy can be an extremely tax efficient way to pass that money on to your estate in a tax-free manner,” he says. “If you do end up needing the cash later on, there are ways to access the money by borrowing against the policy, but that’s extremely complex.”
One issue with corporate-owned life insurance is that it’s not liquid, Mr. Basraon says. “Even if you’re going to use it as an alternative investment to fund retirement, it’s going to be difficult to put the money in and take out the next year,” Mr. Basraon says, adding that it would typically need to be in the policy for about 10 to 15 years.
The premium may also be too high if the business owner has health issues, making the returns less attractive.
“It’s very much tied to the cost of insurance, which may be out of your control, depending on your health status,” Mr. Basraon says.
Similar to IPPs, business owners are encouraged to wait and see what changes Ottawa comes up with, if any, before buying corporate-owned life insurance as an alternative to passive-income investing.
“There is no guarantee that corporately owned life insurance could not be caught in when the rules are ultimately drafted. You have to be cautious,” Mr. Golombek says. “Don’t do anything yet. We’re still in the consultation stage with this one.”