The key to tax-free investing for small business owners.
Are you an incorporated entrepreneur?
Are you saving for retirement?
Are you planning on leaving a legacy for your children and grandchildren?
Then keep reading, because if you live in Canada, you’ve got a problem:
Let’s follow the story of Tom and Tammy, a couple that owns a successful, incorporated, small business that is building up excess cash reserves.
Tom and Tammy, both 40, non-smokers, and in good health, want to use these cash reserves to:
- Pass an estate on to their children
But, like any successful small business owner in Canada, they’re acutely aware of the effect tax can have on their ﬁnancial situation.
Taxes are the number 1 drain on their ﬁnancial goals as a high-performance entrepreneur. In fact, they are potentially subject to 6-LAYERS OF TAXATION.
- Tax on corporate profits at the small business deduction rate of 12.2% or the general rate of 26.5%
- Tax on retained earnings growth of up to 50.17%
- Additional tax via the loss of the small business deduction if corporate investments generate income more than $50,000 (you can thank Mr. Trudeau for this one)
- Personal tax on dividends of up to 47.74%
- Capital Gains taxes on the value of their company to their estate of up to 26.7%
- Dividend taxes for corporate beneﬁciaries of up to 47.74%
This blog post will cover the following:
- Why taxes are the #1 drain on a small business owners’ investment and retirement plan
- Why taxes can lead to a sub-par retirement and estate transfer
- How to ﬁx this with proper tax planning
If you’re interested, keep reading…
So, What Does This Actually Look Like?
Let’s keep this simple, Tom and Tammy are a high-income earning entrepreneurs paying tax at the highest marginal bracket in Ontario. $1,000 of their investment income will be taxed in the following manner:
They can lose the MAJORITY (53.53%) of their investment returns to taxes alone!
Let’s put this into perspective. If they’re earning $20,000 of interest income per year from age 40-65 they’ll be losing $10,706 PER YEAR to taxes.
But there’s more.
That $10,706, if invested annually at a 6% return on investment would equal a lost investment opportunity of $587,379.
That’s like throwing money in the trash, and it’s what so many small business owners are doing year after year after year.
But It Doesn’t Have to Be Like That.
Tom and Tammy can allocate their corporate cash to different asset classes with different tax treatments. The choice is important as investment income doesn’t just attract immediate tax to their corporation, it can also affect their corporation’s access to the Small Business Deduction on active income (see tax layer 3 above), effectively more than DOUBLING their company’s normal tax rate.
So how do they decide?
Well, the obvious choice is to minimize taxation. But that’s not so simple.
Capital gains attract the lowest amount of taxes when dealing with traditional investments. But when investors are seeking ONLY capital gains they often look ONLY to equities or company stock. Many well-developed companies (think “blue-chip”) also pay dividends, often to the tune of 3-5% per year.
Now, this can be attractive in some cases, but as they build their corporate portfolio up, these dividends, in combination with other investment returns, can quickly lead to a tax situation that spirals out of control.
Let’s Cut Out the Tax Using Life Insurance.
Stay with me.
Remember those 6 layers of tax above? Well, we can effectively cut out layers 2-6 with proper tax planning.
- Tax on corporate profits at the small business deduction rate of 12.2% or the general rate of 26.5%
Tax on retained earnings growth of up to 50.17% Additional tax via the loss of the small business deduction if corporate investments generate income more than $50,000 (you can thank Mr. Trudeau for this one) Personal tax on dividends of up to 47.74% Capital Gains taxes on the value of their company to their estate of up to 26.7% Dividend taxes for corporate beneﬁciaries of up to 47.74%
Here’s the strategy: CORPORATE OWEND LIFE INSURANCE
A private corporation that owns, pays for, and is the beneﬁciary of a tax-exempt life insurance policy can use the funds it accumulates in that policy to achieve a variety of ﬁnancial objectives:
- Tax-free savings and growth
- Tax-free access to the proceeds for owner-manager retirement
- Tax-free death beneﬁts for estate transfer
The Accumulation Phase:
Tom and Tammy’s private corporation can purchase a life insurance policy on their lives. Over time, they will transfer the corporation’s surplus cash savings into the policy where it can grow on a tax-advantaged basis.
This is achieved by purchasing a PERMANENT life insurance policy. More on that later.
Ideally, they’ll want to ensure the policy is maximally funded to accumulate excess funds whilst maintaining the tax-exempt status of the policy.
These tax-advantaged funds can continue to grow on an annual basis and will be available to them in the future to help supplement their retirement with a tax-free cash ﬂow in addition to a tax-free estate beneﬁt.
The Access Phase:
When Tom and Tammy want to access the funds accumulated in their policy, they can assign the policy to a bank as collateral for a loan or line of credit.
Most ﬁnancial institutions will allow them to access up to 90% of the policy’s cash value.
Accessing these funds is TAX-FREE, as current legislation does not tax loans in Canada.
In most cases, the lending institution does not require them to repay the loan in their lifetime, and interest can be structured to be paid or compounded and added to the loan principle.
The loans can be structured in two ways:
- Corporate borrowings (to fund operations)
- Shareholder borrowings (to fund retirement)
What About Their Estate?
Don’t worry, I didn’t forget about their estate.
Most successful entrepreneurs build up large nest eggs in their corporations. These funds can serve different purposes:
- Funding business growth
- Funding owner retirement
- Funding a legacy to pass on to owner’s children
The primary purpose of life insurance is to pay out at death. And when done correctly this can be very tax efﬁcient.
If Tom and Tammy used the policy’s cash value to obtain a retirement loan, then at death the insurance policy death beneﬁt is used to pay off the loan, with any excess going to the corporation.
Under current income tax legislation, the corporation’s Capital Dividend Account (CDA) is credited with the full amount of the death beneﬁt less the policy’s Adjusted Cost Basis (ACB). A portion of the death beneﬁt will be used to pay off the loan (if taken). The CDA can be paid out to shareholders TAX-FREE.
This favorable tax treatment remains, even though a portion of the death beneﬁt proceeds were paid to the bank to retire the loan, because the corporation did not relinquish ownership of the policy.
The proceeds of the policy can then be used to:
- Pay their ﬁnal estate taxes
- Make a legacy-deﬁning donation to a charity
- Equalize their estate among various beneﬁciaries
So, How Does Life Insurance Double Up as an Investment??
If you’ve made it this far then let’s do a quick recap:
- Investing inside Tom and Tammy’s corporation can trigger up to 6 layers of tax
- Investing in a corporate owned life insurance policy can cut up to 5 of those layers out
- Corporate owned life insurance can be used to achieve a variety of ﬁnancial goals:
- Tax free savings and growth
- Tax free access to funds for retirement or business expansion
- Tax free transfers of wealth to the next generation
But how does this work?
Remember before when I mentioned PERMANENT life insurance?
Life insurance comes in many forms, but to keep it simple it really falls under two categories:
- Term life insurance
- Permanent life insurance
Do You Want to Lease or Own Your Car?
When you walk into a new car dealership you have two basic choices if you want to drive off in a shiny new vehicle: Lease or Buy.
If you lease, you’re getting use of that car for a set term and a set monthly price. At the end of the term, you must hand that car back. Ultimately, you took out a long-term rental contract, you don’t own it.
Now, if you buy the car, that’s going to cost you a lot more up front but, you own the car forever.
It’s the same thing with life insurance.
Most people are familiar with term life insurance. Term insurance is great for covering the risk of early death. Basically, you pay a ﬂat monthly premium for a ﬂat coverage (death beneﬁt), over a pre-deﬁned period (say 10 or 20 years).
At the end of the term the insurance policy is done. If you didn’t die, your beneﬁciaries get nothing.
Term life insurance serves its purpose: a cheap way to mitigate the ﬁnancial risk of an early death for the people who depend on you.
Permanent life insurance is like buying a car; you own the policy for life. The policy will have monthly or annual premiums, just like a term policy. These premiums may be payable for set terms (i.e., 10 or 20 years), or can be set as “life-pay”, meaning that you have the option to pay into the policy every year for the rest of your life.
Permanent insurance is a great tax and ﬁnancial planning tool, especially for owners of private corporations.
Permanent Life Insurance Doubles-Up as a Tax Efﬁcient Investment Vehicle.
Permanent insurance can also double up as a very tax efﬁcient investment vehicle. This is achieved by building up the policy’s “Cash Surrender Value” or “CSV” for short.
Let’s say Tom and Tammy’s corporation takes out a Participating Whole Life policy on their lives. They’ll have to make an annual premium payment, say $50,000 per year. A portion of these premiums cover various cost:
- Mortality costs (i.e., paying out death beneﬁts)
- Selling costs
- Underwriting policies
- Administration costs
- Investigating claims
The remainder goes to boost the policy reserves.
When participating policies generate excess revenues, the insurance company will use some of this excess to keep their policy reserves at levels required by their provincial regulators. However, some or all of these excess revenues may not be needed. That’s when they will make distributions to policyholders as policy DIVIDENDS.
These policy dividends can be cashed out or, if not needed immediately, can be used in a tax efﬁcient manner to purchase paid-up additions (PUA).
Over time, the premiums add up, the dividends add up, and you can potentially build up a very large cash value in the policy.
And that’s the secret, building up the cash value.
Once Tom and Tammy built up a significant cash value, they have several options to drawn on that value to:
- Make a large purchase in retirement (i.e., a vacation home in the South)
- Create a tax efﬁcient income stream in retirement
- Make a tax efﬁcient gift to their children to get them going in life
So Where Do These Excess Revenues Come From?
When Tom and Tammy pay their annual premiums, they are used to pay current policy expenses. The remainder goes into a large investment account that all policyholders participate in.
This account is managed by professional managers and is highly regulated. A typical account will hold a multitude of assets and may look similar to this:
Predictable Returns Through Institutional Smoothing
The most important factor affecting the long-term performance of a participating permanent life insurance policy are investment returns. Certain assets such as equities can potentially lead to large investment gains, however, they can also lead to significant temporary losses.
If a significant investment loss is immediately followed by the death of a life insured this can lead a lower death beneﬁt.
Nobody understands this risk more than an insurance company, and that’s why they maintain a conservative approach to managing the portfolio of the participating account.
This conservative approach has historically led to a dividend scale interest rate that is smoothed to reduce the impact of short-term market volatility, leading to a less bumpy ride over time.
See the chart below for participating account dividends from 2005 to 2021 inclusive (in comparison to the average prime lending rate):
As you can see, even during challenging economic times such as the great recession of 2008-2009 when the Toronto Stock Exchange Composite Index dropped by almost 50% in value, the major insurance companies were able to maintain a smooth and consistent dividend rate in their participating accounts.
It’s also important to note that dividends are vested once they are paid, at that point they belong to the policy owner, there are no negative positions.
So how does this play out over time?
- Tom and Tammy are successful small business owners, both 40, non-smokers, in good health
- They are looking for a tax-efﬁcient way to use their corporate savings to:
- Grow tax free
- Retire tax free
- Pass an estate to their children tax free
- They ﬁnd a solution: Corporate owned life insurance
Tom and Tammy worked out their budget and decided they could easily commit $50,000 per year of their annual corporate surplus to this strategy. Below is an outline of what the strategy looks like:
At the top is a traditional, taxable corporate ﬁxed-income portfolio.
At the bottom is the tax-free, insured solution.
The following chart gives much more detail. In summary:
- Tom and Tammy pay premiums of $50,000 per year from age 40 to age 65
- At age 65 the policy premiums are offset by annual dividends
- Tom and Tammy begin borrowing $155,256, TAX FREE, every year until their projected second death at age 90
- Note: Under this plan, the couple never repays the loan or interest during their lifetime
- At second death, age 90, the couple is projected to obtain a net death beneﬁt (after paying off the entire accrued loan and interest) of $2,269,293
When compared to the “traditional”, taxable, ﬁxed-income portfolio, you can see how profound of an effect tax has on the outcome.
For example, the traditional portfolio is projected to deplete to zero by the couple’s age 71, whereas the more tax efﬁcient solution is projected to last a lifetime and then some. Focus on the “strategy advantage” columns to see the difference.
Now, this projection is based on several assumptions about the couple’s health, maintenance of the current policy dividend rate, current tax rates etc. etc. Small changes in assumptions can lead to big differences in outcomes.
That’s why it’s important to see this type of solution as one of many possible tools in your ﬁnancial planning toolbox. It’s not a panacea that solves everyone’s problems and DIVERSIFICATION of investments is still an important concept to follow in any ﬁnancial plan (more on this in another blog post).
But this example does highlight the importance of tax and estate planning when it comes to personal ﬁnancial planning for small business owners.
Nick Lanaro CPA, CPA and small business owner
At the Campanella Group we help clients like the Tom and Tammy every day. We are dedicated to helping our clients forge the best ﬁnancial path for their families.
Are you ready to take a step forward and secure a lucrative ﬁnancial future for yourself and your family? We are always ready to speak to ambitious entrepreneurs and investors looking for an edge.
Feel free to contact us for a zero-cost, 30-minute, online meeting where we can get to know you and determine if we can help you pave a path to ﬁnancial success.