Tax Planning Strategies for Canadian Small Business Owners
Contrary to the image of a fat business man, spread eagle on a yacht in the Bahamas, tax planning is beneficial and crucial for ALL business owners and entrepreneurs. In this post, we will delve into different tax stratagies for small business owners, that will significantly reduce tax liabilities and help build wealth.
TFSA and RRSP
Tax-Free Savings Account (TFSA)
The Tax-Free Savings Account (TFSA) is a powerful tool for every one. Unlike RRSPs, contributions do not provide immediate tax deductions. However, the magic happens when you withdraw funds.
A great thing about about TFSA, is that withdrawals are not added to your taxable income. This means you can grow your investments tax-free and enjoy the benefits in the future. Depending on your risk tolerance and time horizon, a TFSA can be an excellent wealth-building tool.
RRSP (Registered Retirement Savings Plan)
On the other hand, Registered Retirement Savings Plan (RRSP) offers immediate tax benefits. When you contribute to an RRSP, you receive a tax deduction for the year, reducing your taxable income.
This can result in lower taxes or even a tax refund if you’re on payroll. It’s crucial to remember that withdrawals from your RRSP in the future will be added to your taxable income.
To optimize RRSPs, contribute when your tax rate is high and withdraw in years when your income is lower.
TFSA versus RRSP. What’s Better?
What is better? The decision between TFSA and RRSP depends on your unique financial situation.
If your current tax rate is high, contributing to an RRSP can provide immediate tax relief. On the other hand, if you have a long investment horizon and don’t need immediate tax deductions, a TFSA allows you to accumulate wealth tax-free.
However, If possible, consider maxing out both accounts so that you can save for retirement and also build wealth along the way.
Incorporating your business can be a game-changer in terms of tax planning. It can lower your taxable rate on your business income, enabling you to reinvest profits back into the company, fostering growth.
An incorporated company can have more profits, be taxed at a lower rate, and give you the capital to expand and hire.
Incorporation does come with some costs, including setup fees, administrative expenses, and annual reporting requirements. While these costs may seem daunting, they are a worthwhile in the long run.
If your company generates more income than you need for your personal life, the benefits of incorporation will far outweigh these expenses.
Think of it as an investment rather than a cost.
Benefits of incorporating
- Limited Personal Liability: Your personal assets are protected in case of business issues.
- Small Business Deduction: The first $500,000 of active profit in many provinces is federally taxed at a lower rate (11%).
- Lifetime Capital Gains Exemption: Selling your incorporated company in the future can result in tax-free gains.
- Income Splitting: If family members are involved in your company, you can split income to take advantage of lower tax rates. If you are in a high tax bracket, you can split your income between a family member in a lower bracket. That way, you reduce your total tax burden.
- Income Timing: You can choose when and how to pay yourself, ultimately, deferring taxes to a later date, reducing personal tax liability.
Holding companies offer valuable asset protection by creating an additional layer of separation from your operating company. This protection safeguards your assets in case of litigation or other issues.
A key thing to note is that your holding company has to be the one to hold your assets, not the operating company, so that way, you’ll qualify for the Lifetime Capital Gains Exemption. Which we’ll cover in the next section.
Lifetime Capital Gains Exemption (LGCE)
To qualify for the Lifetime Capital Gains Exemption (which is kinda like a tax free check up to a limit of $971,190 when you sell your companies), it’s crucial to keep business assets separate from personal assets, which a holding company can facilitate.
However only half of the profit from the sale is taxable, so you basically can deduct a total of $485,595.
This is powerful. Let’s take an example.
You end up selling your famous BC burger joint, McRicks, for $10,000,000 profit (you’ll be taxed at the highest marginal tax, 53.5%).
Without LGCE, you get taxed on half of this amount, which comes out to $2,675,000
With LGCE, you pay whatever is left after you deduct LGCE ($10,000,000 minus $971,190, which comes out to $9,028,810). But remember, only half is taxable, so you times that amount by 50%. The amount of tax you pay is $2,415,206.68.
LGCE would have saved you roughly $260,000 in taxes.
LGCE can also apply for one or more sales of your companies, so if you sold your company for less than the LGCE limit, you can roll over any unused amount, until you reach the limit.
Health Insurance and Benefits
Health benefits for employees
Providing health benefits to employees, including business owners, is a win-win. These benefits are tax-deductible for the company while being tax-free for employees.
Life insurance can play a crucial role in estate planning for business owners. By structuring a life insurance policy within your company, you can take advantage of tax-deferred growth. This can result in a more substantial payout for your beneficiaries, potentially even tax-free, depending on the policy’s structure.
Let’s look at an example.
John is an owner of an incorporated company and he bought a life insurance policy. A key thing to know is that some life insurance policies let you contribute more than the actual monthly premiums.
What that means is that the money inside the insurance policy can grow tax free. The amount of money that’s available to John’s kids would be higher if he invested it outside the insurance policy.
Tax Havens and Loopholes
Proceed With Caution
While tax havens and loopholes exist, they are complex and often reserved for the super-wealthy. This is because as one tax loophole opens, the CRA will try to close them.
Utilizing these strategies requires a team of tax professionals and legal experts, as they can quickly cross into tax evasion territory when not managed correctly.
So unless you have a boatload of cash to pay a lawyer on retainer, and they respond back before the second ring, then this strategy might be beneficial
Normally, for most small business owners, this is not viable, but don’t let that discourage you.
The previous strategies we discussed are all available to small business owners and will help reduce your taxes significantly over the course of your business journey.
FREE Download: What You Need To Know When Starting A Business In Canada
1 in 5 small businesses in Canada will fail within three years of starting. That’s why it’s important to start out on the right foot. We want to help new (and existing) business owners succeed, so that’s why we wrote an eBook on the accounting basics that ALL Canadian business need to know.
Stay up to date on all things accounting, business, tax-related topics on our newsletter.
Couldn't Find What You Were Looking For?
Give us a call and let’s see if we can get you in the right direction.