When does corporate cash become investible?

Operational efficiency to investible surplus

Apart from pursing a passion, the purpose of running a business is to generate income. To the point, eventually you intend on spending what your hard work produces, and using the excess to invest in yourself and your future.

Sometimes the route from contributed capital to surplus cash is quick, direct and transparent. More often though, invested cash takes on a variety of forms as it travels through the enterprise before emerging as profit. How complex that route is and how long it takes depends on the scope and scale of the business.

That being the case, it can be difficult to determine when, where and how to use portfolio investments in a corporation.

It may help to use the analogy of the earth and its gravitational pull to follow the movement of cash through a corporation.

Operational efficiency –
Running the business

1. Inner core

Cash cycles through current assets such as prepaid expenses, inventory, and accounts receivable, and is applied to current liabilities as they come due. Some may be held in physical currency, but its use is more practically facilitated through deposits and short-term credit tools.

2. Outer core

Working capital is the continuous float – the ebb and flow between current assets and liabilities – that keeps a business running. Usually it is supported by a revolving line of credit so that the owner can focus on the business, and not accounting balances.

Working capital is not itself investible, but to the extent that efficiencies are applied (eg., timely use of payment terms, prompt account collections, optimal inventory levels, smart foreign exchange practices, etc.), more cash may be freed up to move up and out of a corporation.

3. Mantle & crust

Long-term assets are the structure within which the business produces its wares. They last for many years, but eventually have to be replaced in order to sustain productive capacity.

The cost of replacement is commonly managed through a combination of asset-backed loans and capital reserves. To assure that reserves are available when needed, safety and liquidity are the top priorities.

Investible surplus –
Breaking the business’ gravitational pull

4. Surface

Retained earnings is the after-tax money of the corporation. The portion of it that is not needed for business operations or capital reserves may be appropriate for passive portfolio investment.

5. Orbiting

A holding company may receive tax-free inter-corporate dividends on shares it holds in an operating company. This puts the extracted funds beyond the reach of operating company creditors, so may be a preferred place for portfolio investments. Where there is more than one business owner, each might establish a holding company so that respective funds and investment portfolios may be isolated.

6. Beyond gravity

Dividends to a shareholder may be placed in a personal non-registered investment account. Such dividends are taxable, meaning the personal investible amount is less than if it remained in a corporation. On the other hand, investment returns are taxed less favourably in a corporation, and sooner or later will have to cross that threshold for shareholder personal use. Tax advice is a must.

Business corporation and shareholder taxation

How tax integration protects against double-taxation

As a business owner, you have a few options when choosing the legal structure for providing your goods and services – most commonly a sole proprietorship, partnership or corporation.

There can tax benefits using a corporation, but there is also more complexity to understand and manage.

Business structures

With a sole proprietorship, you are taxed on the net income from the business after deducting expenses. The net income is taxed to you personally, at progressively higher rates as your income rises, as is the case when you earn other types of income personally. A business loss can be deducted against current income, or be carried to past or future years. (The details of loss usage are beyond the scope of this article.)

A partnership does not pay tax. Rather, the partners report their respective share of the partnership’s income or loss as their own.

Unlike a sole proprietorship or partnership, a corporation is clearly distinguished as a separate legal entity from those who own and operate it. It is taxable on the business income, and the distribution of that income to its shareholder/owners is subject to further tax, with rules in place to protect against double-taxation, as discussed below. Losses can be used by a corporation (again with carryback and carryforward rules), but cannot be transferred to shareholders.

Limited liability of corporations

Leaving aside tax for the moment, the fact that a corporation is a separate legal entity from its owner/shareholders means that it can potentially limit the liability of its owners. If a corporation accumulates large debts or is sued, shareholders’ personal exposure is generally capped at – or “limited” – to losing their investment in the corporation. If the corporation’s assets are exhausted, creditor/claimants cannot pursue shareholders personally.

Even so, it is not uncommon that shareholders of a new or small corporation will be required to give personal guarantees to obtain financing or trade credit, so limited liability has its own practical limitations.

Incorporated professionals

Incorporation is available to many professionals, including accountants, medical professionals, engineers and lawyers. The provincial governing body for the profession should be consulted to determine its availability and any restrictions.

Professional corporations also limit liability for general business dealings, but there is no such shield against malpractice claims. The professional remains personally responsible for the services and advice given, for which the professional will be required to carry appropriate liability insurance as a condition of the license to practice.

Tax aspects of incorporation

As noted, a corporation is taxed on its business income, then tax is also levied when it distributes its income to its shareholders. To the extent that the net income is not needed for current personal needs, the excess could be left in the corporation, deferring the tax eventually applying to a dividend. If the individual’s marginal tax rate is higher than the applicable corporate rate, more is available to be reinvested in the business.

To give that some context, top personal tax rates are near or beyond the 50% mark, but general corporate rates are in the area of 26% to 31%, and small business corporate rates (on active business income up to $500,000 in most provinces) range from 9% to 15%. The variance depends on the provincial rates where a corporation is resident, with federal rates being consistent across the country.

Our tax system integrates the corporate and personal tax rates to protect against double-taxation. Specifically, it is set up so that roughly the same amount of tax is paid whether income is earned personally, or through a corporation then paid as a dividend to a shareholder.

There are two main devices used to achieve this integration.

Dividend gross-up

- When a dividend is paid, it is grossed-up by an arithmetic factor that approximates the original income the corporation earned.
- This grossed-up amount is added to the shareholder’s other income, essentially emulating the shareholder as being the original earner of that income.
- An initial tax figure is derived by applying the tax rates at that individual’s progressive tax brackets.

Dividend tax credit

- The shareholder is then given a credit (a reduction in personal tax) based on the estimated tax the corporation paid on the income that resulted in the dividend amount.
- In effect, the shareholder pays the difference or top-up to the tax already collected from the corporation.
- At very low personal tax brackets it is possible that the tax credit is less than the initially calculated tax due.
  In such situations, the effective tax rate is negative, allowing the excess credit to reduce tax on other income.

Illustrating integration between corporation and shareholder

Detailed integration comparison

In principle, the process works at all income levels, but it can be most clearly illustrated at top tax bracket. To show this, we’ll use the 2024 Alberta rates.

Net integration summary, all provinces

The gross-up is the same for all provinces, as is the federal tax credit. The provincial tax credit varies by province. Table 2 shows the net after-tax personal cash for all provinces at top bracket, showing for example the final row H from Table 1 as the Alberta column in Table 2.

As Table 2 shows, the net tax difference when earning through a corporation then paying a shareholder dividend is negative 1.7% to positive 0.7% as compared to paying a salary to that same person as an employee. While this is not the whole story, the small difference in result emphasizes that tax alone should not be the determinant whether to incorporate.

Cost considerations before incorporation

As discussed, if not all the income is needed for immediate personal spending, there is a deferral benefit to earning through a corporation. On the other hand, there are higher accounting and legal start-up fees, and ongoing costs to using a corporation. Professional advice should be obtained to get a full picture before deciding how to proceed.

Estate freezing in an economic downturn?

A tax planning prompt for business owners[1]

For a few years beginning in 2020, the COVID-19 pandemic caused tremendous disruption and pain in both the personal sphere and in business activity. Owners of closely-held small businesses were especially vulnerable, with both their primary income source and invested capital at risk.

The stops and starts of multiple waves of the virus wreaked havoc and sewed uncertainty. Ironically though, this strange economic rollercoaster opened a window of tax opportunity for business owners who may have been hemming-and-hawing about succession. At the time it was the pandemic, but any economic condition that causes a dip in business value could present a ripe opportunity to proceed with an estate freeze.

Tax exposure on succession

Think of an entrepreneur who established a business corporation years ago, and now wants to bring adult children into ownership. The problem is that a direct share transfer would be a disposition. The capital gain is calculated as the difference between the fair market value and adjusted cost base (ACB). That could be a hefty tax bill for the parent, with a 1/2 income inclusion on capital gains up to $250,000 in the year such a transfer happens, and 2/3 inclusion on gains beyond that.

Whether the parent intends to make a gift or to have the children buy their way in, quite often the children don’t have the cash at present anyway. That means the parent will have to use other cash to pay that tax bill. A more likely reality for many business owners is that the bulk of their wealth is tied up in the business, so there is little if any readily available cash.

Thus, the prospect of paying that tax could be paralyzing. Business growth would continue to accrue to the parent as current full owner, as would the associated growing tax ty.

Enter the estate freeze

An estate freeze offers a more tax-efficient way to go about it. Future business growth is transferred to the successors, and the past growth is frozen in a way that ensures that no tax is incurred by the current owner in the present.

A familiar scenario is for the parent to exchange their common shares for preferred shares with the same value. These new ‘freeze’ shares won’t increase in value but will usually carry voting control and dividend rights. Often, it’s possible to increase the ACB on the shares using the lifetime capital gains exemption (LCGE), which stands at $1,250,000 in 2024 . Whether or not the LCGE is used in this way, no tax arises at the time of the exchange.

Tax is deferred until the parent disposes of these freeze shares. Sometimes the shares are redeemed by the corporation over a course of years, providing cash to the parent and spreading tax recognition. Otherwise, there’s a deemed disposition at the parent’s death, or on the later death of a spouse if the shares are rolled over to the spouse on that first death.

A new class of ‘growth’ shares is issued to the children for nominal cost. Alternatively, a trust may be set up to hold these shares for the children as beneficiaries, with legal control left in the hands of the parent as one of the trustees. No tax arises on this part of the plan either.

Future growth has been pushed down a generation, allowing for years or decades of deferral before future gains are exposed to tax.

Why freeze on a dip? Or re-freeze?

Apart from the terrible health crisis of COVID-19, it also had a negative impact on the financial value of many businesses. But with that downturn came opportunity. While there was no guarantee when and how much a given business may recover, those who executed a freeze at a depressed value were able to push a greater amount of future growth to their next generation.

Consider as well the LCGE, this time looking at the successors. The exemption applies on a per-person basis, allowing for a multiplication of its total benefit based on the number of new shareholders. And if the value falls so far that the parent is not able to use the full LCGE on the share exchange, the parent could choose to take some of the growth shares and thereby also participate in the upswing.

What about those who undertook a freeze years ago at a much higher value before the economic downturn (pandemic or otherwise) ate away at the business value? In that case, a thaw and re-freeze might be in order, effectively resetting at the current depressed value, again in anticipation of the recovery of the business itself.

As to determining the appropriate value, it needs to stand up to scrutiny should the Canada Revenue Agency inquire, so the best approach is to have a professional valuation.

Implications for life insurance

Upon a freeze, the parent’s taxable gain becomes both known and capped. This is an ideal application for life insurance on that parent, or a joint last-to-die policy on the parent-couple. Of course, less insurance is needed with a freeze at a lower value, but that’s only half the story.

The successor children will now expect to reap a greater proportion of the gain. Allowing that the amount of the gain is unknown (unlike for the parent) and that the LCGE may reduce the tax, this is a still a good time to open the insurance dialogue. If the child’s entrepreneurial drive matches the parent’s, greater growth may yet be ahead, and the insurance put in place today will feel like a bargain in hindsight when the child considers their own estate freeze down the line.

[1] A version of this article appeared in Advocis Forum.