Insurance Planning With New Canadian Tax Laws

When the announcement came that changes to the Tax Act would shake up income sprinkling and passive income in a way that was disadvantageous to business owners, the reactions were swift, emotionally charged, and very divided.Those that were building a business to generate wealth for their family and their future generations were outraged.  Those that failed to understand that companies are not hoarding vast sums of wealth through so-called “loopholes” were delighted.

No matter where you fall on the spectrum, the changes to the Tax Act affect you, either directly (business owners), down the line (generational), or indirectly (employees of small businesses).

While business owners cannot escape the ripple effect that happened when the revised Tax Act hit the desk with a resounding thud, they can mitigate its impact.

In this article, we’ll look at income sprinkling and passive income, how they affect your business, and alternative tools to help business owners manage and save the money they have earned.

What is Income Sprinkling?

Income sprinkling is a tax-advantaged method where high-earning business owners divert part of their income to lower earning family members. The family members pay a lower tax rate on the income.

That’s the simple explanation. Incoming sprinkling comes with a plethora of rules and involves taxable dividends, capital gains, trusts, and other sources of income. Exceptions apply for inheritances and some non-resident statues.

The New Income Sprinkling Rules

The initial proposed changes to the income sprinkling rules were released on July 18, 2017. After much feedback, backlash, and advocacy from the Canadian Federation of Independent Businesses (CFIB) and its members, and others, the proposal was revised in December 2017.

The current changes are summarized as follows:

  • Tax on split income (TOSI) currently applies to the highest marginal tax rate (33 per cent) of income split with an individual under the age of 18. The proposal states TOSI rules shift to those over the age of 17 and only applies to income from related business. Some exclusions
  • The definition of split income is proposed to expand so that it may include income received from satisfaction of debts, taxable capital gains, and the profit from some types of disposed properties.

In a nutshell, business owners will have fewer opportunities to share and keep business income within their family.

What is Passive Income?

The changes to the Tax Act also target passive income that is held inside corporations.

Passive income is revenue generated inside corporate investments instead of income from active business activity. Tax on passive income within a corporation is due at the top marginal rate.

New Passive Income Rules

The new passive income rules for corporations will reduce the amount of business income available for the preferred lower small business tax rate.  This rule is applicable to businesses with more than $50,000 of passive income annually.

According to CRA, “For tax years that begin after 2018, the business limit of a Canadian-controlled private corporation (CCPC) will be phased-out on a straight-line basis if the CCPC, and any other corporation with which it is associated, earn combined income from passive investments between $50,000 and $150,000.

Currently, the business limit is phased-out based only on the taxable capital employed in Canada. The reduction in the CCPC’s business limit will be the greater of its taxable capital business limit reduction and its passive income business limit reduction for the year.  See What’s new for Corporations for more info.

Are Income Sprinkling and Passive Income Fair Practices?

The benefit of income sprinkling and holding passive income inside a corporation is that money is taxed at a lower rate: more of the business owner’s wealth remains within his or her family’s coffers.  So, what’s the controversy?

Some feel that businesses have too many tax breaks to begin with, so being able to save even more money on taxes is a case of “the rich getting richer while the poor get poorer.” To understand why this is not the case, let’s rewind back to why these tax breaks were introduced in the first place.

Canada thrives on natural resources, particularly energy and agriculture. As any long-term resident of Canada knows, this is great when the economy is booming, but it’s terrible when the economy is shaken up.  Natural resources – especially oil – are extremely volatile, and it doesn’t take much to affect market prices (**cough Kinder Morgan debacle cough**).

Due to the cyclical and volatile nature of Canada’s market, we frequently experience boom and bust cycles.  In fact, we’ve had three major recessions since 1981.

A constant reliance on big companies with deep pockets on foreign soil is not a long-term strategy for local economic growth, so tax relief was introduced for Canadians who were willing to take the risk of starting their own companies.  Income sprinkling and passive income investment were a part of that.

The thought was to incentivise Canadians to help diversify the economy and grow more local companies, which would create more stable jobs.  This would have a very positive effect on the middle class.

However, it was never a free-for-all.  You may have heard the that current small business tax rate is 10 per cent.  Well, it’s actually 28 per cent. In order to pay less, a small business corporation (with 100 or fewer employees and under $500,000 in annual income) must qualify for and claim the small business deduction.

This is only for Canadian controlled private corporations’ active business income (up to a pre-defined limit) during their fiscal year. This deduction has been as high as 12 per cent (2006) and is currently down to 10 per cent (2018) for qualifying corporations – and make no mistake, the reductions were not all the kind thoughts of a benevolent government.

For decades, the (CFIB), its members, and many others have worked very tirelessly to advocate for small business tax reductions.

Additionally, employees that work for a company and receive a T4 have the benefit of their company paying half their required Canada Pension Plan (CPP) tax.  Self-employed individuals pay 100 per cent CPP… both the employee and employer portion.

Everyone knows the best way to attract and retain quality staff is to offer perks, like group health and dental insurance, pension plans, and robust vacation time.  Well, that further impacts the employer’s bottom line – a lot.  While good business owners are happy to offer these perks to their staff, those perks are largely paid for out of the company’s coffers.

Administration for the employee benefits program comes at a cost, too, which the company also bears.

The point is, running a business is not a shortcut to wealth and an easy life.  In fact, for nearly half of those that try it, launching a small business is a path to debt and finanical distress. Business ownership is incredibly risky. The larger the company, the greater the finanical risk (not counting the physical and emotional toll).

The tax breaks were created as a way to encourage Canadians to start and maintain businesses.  Without an incentive, the thought of constant 12+ hour days, the toll of knowing that your every decision affects all your employees, the high overhead, and the huge risk deter many from taking that business ownership leap.

So, are the tax incentives fair?  It really depends on which side of the table you are on: the employer or the employee, the middle or the below-middle class.  In any event, change is now here, and everyone has to adapt.

However, all is far from lost. Income sprinkling and passive income investing are just two tools entrepreneurs can use to preserve the money they earn. Now we’ll look at other options for using profit to build, retain, and keep money in the family.

New Ways to Think of Old Money

Most people think of life insurance as that thing you get so your loved ones are taken care of when you die, but it’s so much more than that!  For decades, business owners in the know have used life insurance accounts to grow and shelter personal and family wealth.

#1 – Cash Value Life Insurance Accounts

Here’s how it works: whole life insurance policies have two components.  Part of the premium you pay covers the cost of the policy and the the remainder (Cash Value) is managed by the insurance company.

The cash values grow tax exempt within the policy which means you can grow corporate wealth without paying tax on passive income and possibley preserve small business tax rate.

It’s a win win win win:

  • You have the insurance for risk managent.
  • Your corporate wealth grows tax efficiently.
  • You still have access to the cash as needed for retirement or other endeavors.
  • Whatever you don’t spend in your lifetime comes out of your corporation with minimal tax for your beneficiaries.

#2 – Split Dollar Critical Illness

This strategy is for a corporation that want to manage their financial risk of a shareholder becoming critically ill.  The corporaation buys a critical illness policy on the shareholder – (owns, pays the premiums and is the beneficiary).  The shareholder buys a ‘return of premium’ policy rider that entitles them to a 100% refund of all policy premiums if they do not become critically ill.

The policy is paid for by the corporation and the ‘return of premium’ rider is paid by the shareholder with after tax dollars.

Once the corporation no longer needs the coverage, the shareholder is free to excersise the rider and receives 100% of all premiums paid on tax free basis.

Of course, nobody wants to think of their loved ones or business partners getting drastically ill, but it happens. Critical illness insurance is not a loophole to receive a pile of tax free cash, but it can be used legally and efficiently as a way to protect the corporation when life gets in the way of even the most careful plans.

The fact that it can be structured so advantageously is simply a bonus and a great way for savvy business owners to manage risk.

Think Outside the Box

Tax laws will come and go and will change and change again. Business owners do not have to feel helpless while they watch their hard-earned profits slip through their fingers and get eaten up in extra taxes. There are logical, legal ways to leverage profits and retain more of your hard-earned dollars.

Many people don’t think of insurance as a way to maximize dollars, but insurance is far more than a “death payout”.  Insurance planning is part of a complete financial profile for business owners, companies, individuals – anyone that needs a reliable cash flow, regardless of what life brings.

Likewise, many life insurance professionals are licensed to help you with these and more tax-saving strategies.  Some insurance professionals also carry a certified finanical planner designation, to ensure 360 degrees of finanical knowledge and care for their clients.

To learn more about this and other ways business owners can leverage their earnings, contact Shelter Bay Finanical Corp  We have the knowledge and experience in helping business owners like you protect their income, families, and future.