Starting in January 2019, Western Canada’s successful small business owners face yet another tax planning hurdle.
If your accountant hasn’t already told you, a 5-to-1 clawback of the $500,000 small business corporate income tax deduction will soon apply to Canadian operating companies with more than $50,000 of annual passive income in the previous tax year. Quite frankly, this federal action mostly affects a rather specific, wealthy, and usually older demographic. However, budding young entrepreneurs and recently graduated professionals should take note.
In British Columbia and Alberta the clawback means a potential for an additional $80,000 business income tax hit without proper planning.
What does the 5-to-1 Tax Rate Clawback mean to you?
Does it apply to your situation now or will it apply down the road?
See below for links to articles. Long story short of the articles: the greatest impact is on successful operating businesses that do not pay out all profits and passive income to shareholders through dividends.
Time to do some active planning to beat the passive income tax changes
Concerned? Review your situation with your accountant/tax advisor to see how things might be optimized.
One effective action mentioned in the articles is the use of corporate-owned permanent life insurance to which the new passive income rules do not apply since a life insurance policy’s cash values grow in a tax-exempt environment.
Valuable long-term Tax Decisions
Though permanent life insurance delivers less value to your balance sheet in the short term, the long term value is usually preferable to tax-heavy GIC and bond interest since interest income is taxed at over 50% in a passive corporate environment. Interestingly, the introduction of tax-exempt life insurance to a corporate portfolio also enables slightly better tax management flexibility if a corporation also holds equities since more equities can be sold off before the same amount of tax owing is reached as the non-life insurance portfolio.
Please keep in mind that in adding life insurance to combat the small business deduction clawback the tax advantages are only perks. There needs to be an “insurance reason” first. Income replacement, debt coverage, and estate tax planning, for example, are solid insurance reasons. That’s why the examples below illustrate situations where life insurance is already in-force.
Depending on the circumstances, both types of permanent life insurance (universal life insurance & whole life insurance) may be used. Universal life allows for large one-time deposits and greater initial cash value accessibility whereas whole life which generally has slower, stable growth but superior estate outcomes the longer one lives.
5-to-1 Tax Rate Clawback Scenario
Harold and Susan are both 65 and have been happily married for 42 years. They are successful restaurateurs that also own a winery and a catering & events company. They own three different operating companies (Restaurant Ltd., Wine Ltd., and Catering Ltd.) and are now preferred shareholders after completing an estate freeze this fall. As part of the planning they obtained $5,000,000 of Joint Last-to-Die Universal Life to cover taxes on what is expected to be at least a $20,000,000 estate. Owned and paid by Restaurant Ltd. at a planned level annual premium of $110,000 for 30 years, the estate liquidity it provides will allow their adult children (Jane and Jeremy- both active leaders in the businesses) to continue on without needing to liquidate other assets to pay the tax bill.
Happily mortgage-free on all restaurants since 2012, part of Harold and Susan’s wealth includes a $2 million balance in GICs and a savings account in Restaurant Ltd. for the acquisition and renovation of new restaurants. At an average interest rate of 2% this balance generates $40,000 of passive income. Fearing Restaurant Ltd. may be affected by the new rules as interest rates rise they meet again with their accountant and life insurance advisor to see if further planning is needed.
Thankfully, the life insurance advisor had the need for flexibility around the new rules in mind when brokering the $5 million Joint Last-to-Die policy. Harold and Susan decide to transfer $1 million of the savings balance to the universal life policy by fully maximizing premiums over the next three years and doing so partially in the fourth year.
What’s the outcome? Maintained savings accessibility, tax savings, and potentially reduced life insurance premiums.
The $1 million of savings is able to be completely withdrawn from the policy in the fifth year, free of tax. There is also an annual tax savings of about $10,000 since only $20,000 of passive savings and GIC interest income is being generated and taxed at over 50%. The interest rate would then need to rise to 5% before the $50,000 threshold is reached. Finally, the longer the $1 million is not withdrawn from the policy, the lower the annual premium can be after the withdrawal, due to it earning tax-exempt interest in the policy. For example, if there is no withdrawal until the 10th year and the long term interest rate earned on the policy is 2.79%, premiums could be reduced to $100,500 for years 11 to 30. If the long term interest rate is 4.00%, premiums could be as low as $96,500.
Harold and Susan were already on a solid planning path, but making these changes ensured the new clawback rules didn’t derail those plans.
Accomplish Insurance Can Help!
Does this scenarios sound familiar? Concerned? Interested in how corporate-owned life insurance might improve your long term situation? Consult your accountant and financial planning team.
And if you live in BC or Alberta, reach out to us at 250-861-5433 or [email protected] to discuss how to best integrate life insurance into your long term estate and tax planning.