Today’s episode comes to you live from the 22nd Institute for Advanced Financial (IAFP) Planning Conference in Gatineau, Quebec, recorded in front of an audience of professional financial planners. For this special episode, we cover key planning issues for incorporated business owners and walk through the lifecycle of a business owner or professional who eventually chooses to incorporate. We discuss crucial financial decisions they face along the way, particularly as corporate assets begin to grow, and wrap up with a Q&A covering topics like tax brackets, salary offsets, and more. Our conversation also tackles common misconceptions and explains strategies for income smoothing, tax deferral, and managing ‘corporate bloat.’ With today’s conference theme inspired by Star Wars, expect plenty of niche references along the way!
[0:00:03] BF: Welcome to the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital, and Dr. Mark Soth, AKA the Loonie Doctor.
[0:00:17] ANNOUNCER: We’re pleased to have Benjamin Felix here. His bio’s in the kit. Many of you know Benjamin and the podcast that he’s active on, Rational Reminder, with his colleague, Cameron. Benjamin lives in Wakefield, Quebec, and he enjoys hiking, mountain biking, kayaking and skiing. Dr. Mark Soth, Mark enjoys doing different things, unlike hiking, mountain biking, kayaking and skiing; from building projects in his workshop with his hands, or XL spreadsheets with his brain. Most of all, he loves to explore new natural areas of his family, including his dog, Beatrice. Black lab. We’re pleased to have them and we’ll turn it over to you guys.
[0:00:58] BF: Awesome. Thank you. This is actually a podcast episode that we’re going to release. This is episode 16 of the Money Scope Podcast. We’re going to do a podcast episode here in front of you and we’ll leave time for some questions at the end.
[0:01:09] MS: Yup.
[0:01:10] BF: All right.
[0:01:10] MS: Answer them live.
[0:01:11] BF: Yeah. Exactly. Welcome to episode 16 of the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We’re hosted by me, Benjamin Felix and Dr. Mark Soth, AKA the Loonie Doctor, or maybe today, Mark Solo.
[0:01:25] MS: Yup. For those of us that are listening just with audio only, you’re missing out seeing me in my Han Solo outfit.
[0:01:31] BF: Don’t forget about mine.
[0:01:32] MS: Yeah. Ben’s been growing his hair out to be my co-pilot. We’re going to get Benbacca, maybe. I don’t know.
[0:01:37] BF: Yeah, maybe.
[0:01:38] MS: We’re going to have fun. We’re here at the 22nd Institute for Advanced Financial Planning Conference in Gatineau, Quebec. We’ve got a Star Wars theme, which is why we’ve got this dress up. We’ll also dropped some Star Wars references here and there within the episode, so it’s my dream conference with Star Wars and finance together. With that, we’ll get going on some topics.
[0:01:58] BF: You’re a pretty big Star Wars nerd. I’m not.
[0:02:00] MS: Oh, yeah. Totally. I totally am. Yeah, I’ve had to explain a few things for him.
[0:02:04] BF: Yeah. I’m pretty clueless on this stuff. If you’ve been listening to Money Scope, as a few of you have, you’ll be acutely aware that we have not done an episode in quite a while, and we do want to say don’t worry, we haven’t gotten to the point in the show’s lifecycle where we start doing spoof episodes on –
[0:02:19] MS: Star Wars.
[0:02:19] BF: – time travel and Star Wars. Well, we’re doing that.
[0:02:22] MS: Now we’re here.
[0:02:23] BF: Here we are. We do have more highly invasive procedures. If you haven’t listened to the podcast, we’ve gone pretty deep, like uncomfortably deep on corporate financial planning topics, which is why we called it the Money Scope Podcast. We do have more procedures like that planned on insurance, pension plans for incorporated professionals, tax and estate planning, and also retirement planning. The problem with the episodes, the problem we created for ourselves is that we’re doing analysis that, as far as we know, in many cases, has not been done before, so we’ve got to build tools and models to create each episode. We pre-recorded a whole bunch of them, and then thought we gave ourselves enough runway, but we –
[0:02:58] MS: Not enough.
[0:02:58] BF: We ran out of runway. This conference was an opportunity for us to do an episode with a live audience, a professional financial planner, so we’ll hopefully get some good questions. What we’re going to do is cover key planning issues for incorporated business owners that we have already covered in past podcast episodes, so no new material necessarily. We’re going to walk through the lifecycle of a business owner, or a professional, who eventually chooses to incorporate, and how to approach the financial planning decisions that they face along the way, particularly with an emphasis on what to do as the assets in their corporations start to get large.
[0:03:30] MS: This is really a great venue to do that, because a lot of the issues that come up with corporations and really, financial planning is actually probably the best answer to most of those dilemmas. It combines taxes, it combines how you’re invested, it combines how you’re spending and earning. Then not just in one year at a time, but actually, how you do that over your entire lifespan. Without planning and projecting that out, you really can’t come up with good solutions to a lot of the issues that might arise.
[0:03:57] BF: Yeah, and the optimal plan. I mean, there’s no ex-anti-optimal plan. We can’t predict the future is basically what I’m saying. The optimal plan requires this constant reassessment and adjustment, because the optimal will change over time, or at least the expectation of optimal. I think, it’s also an area where a focus on certain aspects, or outdated analysis leads to some pretty commonly applied and I think we would say, bad rules of thumb. We’re going to talk through some of those as we go along here.
One of the first questions to grapple with for a professional who can incorporate, or who may incorporate is when to actually do that. There are times when a small business owner has to, or probably should for liability reasons in corporate. For different types of businesses, it’s also really important to consider different details of corporate structure when you’re setting that up.
Real quick, actually, if people don’t know, Mark Soth is a practicing physician. He comes to this from someone who is a physician with a professional corporation. He got very interested in personal finance to the point where he became, I mean, I would say an expert, or at least approaching that level on these topics. A lot of the stuff that we talk about in our podcast does focus on professional corporations. Anyway, quick digression there for some context.
For professional corporations, the main benefits of incorporating are really smoothing personal income and managing taxes over time. Something that both of us often see is people who get advised to incorporate earlier than they probably should, and the main downside of that, of course, being unnecessary costs and complexity.
[0:05:28] MS: Yeah. That, I think, as one of the issues as just a practical end user, one of the biggest advantages of a corporation, everybody thinks about investing, but really, about smoothing your income is probably one of the biggest benefits for someone who has a wildly fluctuating income. We could have a wildly fluctuating income just based on the nature of your business. Say, for example, if you’re a smuggler and you’re smuggling glitters them out of the castle system, there’ll be years where you make the castle run another 12 parsecs and you make lots of money and there’ll be other years where you get boarded by some Imperial Stormtroopers and Jabba the Hut comes knocking.
If you’re just taking that money as income as a sole proprietor, you’re going to have years where you have high marginal tax rates and years where you have low income, but you don’t make it up doing that. By smoothing out that income over time, you can stay in lower overall tax brackets as you try to manage your income. I’m a physician and people say, well, physicians have a pretty bomb-proof business. But even if you have a stable business, you’re going to have fluctuations in your income. It’s very common early in the career. You may take parental leaves. You may have sick leaves for you, or a family member. Those types of things can happen unexpectedly, and having a corporation where you’ve saved some of the money from the big years to help smooth out some of the lower income years can be really, really helpful.
[0:06:49] BF: Yeah. I don’t get the jokes on the castle run. I mean, I’m laughing, because I don’t understand what you’re talking about. Beyond smoothing lumpy compensation early in a career, I think a corporation’s main benefit is income smoothing over the full lifespan, not just early on in a career. As many of you likely know, net income earned in a corporation is taxed at the 10% to 27% range, depending on the province and whether the corporation has access to a small business limit. That’s typically going to be lower than the personal tax rate of a high-income earner. I mean, it will always be lower.
Taking money out of the corporation, of course, still results in personal tax. When you combine that with a corporate tax is already paid. You think about taxing the corporation combined with personal tax and a dividend that gets distributed out, the overall tax bill is going to be close and even sometimes higher than having earned that income personally as income in the first place. That’s tax integration at work. The benefit of the corporation. You’re not saving tax, but the benefit of the corporation is that it provides an option on the timing of paying personal taxes, the personal portion of taxes.
Then in the interim, investing the after-tax corporate, but personal tax dollars in the corporation, and then taking out its dividends later on in life, that often lower personal tax rates provides pretty meaningful tax deferral and tax bracket smoothing benefits. An added benefit is the flexibility to split income with the shareholder spouse after age 65, which further supports the likelihood of a lower tax bracket later on. Being able to dividend split before age 65 would be another possible reason to incorporate, but of course, that became much more difficult with the 2018 TOSI changes.
If a client’s not able to dividend split with the spouse, or if they’re not retaining significant earnings in their corporation to invest, a corporation’s much less beneficial, a professional corporation. They’re still the liability cases we mentioned earlier. In that case, there’s usually no rush to incorporate until you can do one of those two things. Again, especially for professional corporations.
[0:08:42] MS: Yeah. That’s one of the common things that I see come to my office is premature incorporation. There’s lots of causes of that that can happen, but the most common cause is people underestimate how long it takes for them to be able to take advantage of the tax deferred investing within a corporation. People think corporation’s actually automatically more tax efficient, but it’s actually not, if you’re just flowing money through it. You have to be able to save money in there to take advantage of that tax deferral. That can take people longer than they think to actually be able to do that, because when you start up a business, by the time you start making money and getting it off the ground really well, or if you’re training as a professional, there’s usually going to be debt that’s there. Probably personal debt that needs to be paid back. You’re going to have a lot of pent-up delayed gratification that’s going to need to be fed with some spending.
It’s very common also to have a lot of room left over in your tax-sheltered accounts, like your RRSP, or your TFSA that you could take advantage of probably before being able to really benefit from being incorporated. That can take commonly three to five years before you do it. Whereas, if you do it right away, you’re going to be paying extra costs and having extra complexity that you didn’t necessarily need to have.
[0:09:53] BF: Yeah. I think that’s another pretty common misconception. I know I still see it with clients. I did a paper on this, geez, probably eight years ago now, just showing that, hey, investing in a TFSA, or an RRSP is actually pretty good, even if you have money in a corporation. I don’t know if that’s common knowledge, maybe in this room it is, but more generally, I don’t know that it is.
Of course, we also have the FHSA now that people can take advantage of. A corporation allows partial tax deferral. You’re deferring the personal portion of tax. But an RRSP is giving you 100% tax deferral, because you can bonus out, or salary out the amount, which is a deduction to the corporation, and then you’ve got, obviously, the personal deduction on the RRSP contribution, and the RRSP gives you tax-sheltered growth, which is incredible. Corporate investment income is taxed at a, well, we’ll talk about what tax rates, tax debt in a little bit, but it’s taxed annually, and it can sometimes be taxed at a very high rate if the corporation has too much in there. Mark’s got a funny term for that. We’ll come back to the later, though.
An FHSA has the same features, but it also gives the potential for tax elimination if it’s used to buy a qualifying home. All that to say that maxing out those registered accounts typically, even the TFSA, this one is interesting, because with the TFSA you do actually have to pay the personal tax. For someone with a high income, that can look pretty painful, but when you model it out over a long enough horizon, the TFSA will surpass the corporation, because it has a higher after-tax rate of growth.
Our view on this is that maxing out those registered accounts before starting to maintain money in a corporation is typically going to make sense, particularly for a younger professional, or business owner.
[0:11:25] MS: Yeah. I think one of the issues with the upfront tax hit on the TFSA, and then it takes time for that tax-free growth to then outpace it, is people often think of their time horizons until they retire. Whereas, the reality is, especially if you have a higher income person, their TFSA time horizon may be their entire lifespan. It’s commonly much longer than what you think, so most of the time it would make sense to be using that TFSA, except under some really extraneous circumstances, where your timeline you know is going to be really, really short.
The dilemma of a corporation really, it comes up after you’ve filled all the registered accounts, taken care of some personal debt, and you’ve got extra money to invest after that, and you’ve got to put it somewhere. Really, it’s a debate between a personal non-registered account versus a corporate non-registered account. When you can do that comparison, in general, that’s where a corporation really will usually shine. There’s a few reasons for that. The biggest one, of course, as you mentioned, is tax deferrals. Because you’re paying a small amount of tax, 12% to 27% roughly on the active business income, it leaves you a lot more capital to invest. That capital than grows over a longer period of time.
Even though you eventually take the money out and pay taxes, it’s quite forgiving in the fact that you actually grow such a larger pot of money in the meantime, that it ends up still coming out well ahead of that. Now, there’s also some less obvious advantages that come along, which w’’ll unpack, because they hinge on how you pay yourself. One of them would be using an IPP, for example, so you can have an individual pension plan if you’re incorporated. You can’t have that just as an individual. You have to have been paying yourself salary to be able to use something like that. It allows you to put more money in a tax shelter than a regular RRSP does under the right circumstances, but it depends on salary.
Then, the other part of the equation which Ben alluded to already is how efficiently your corporation’s investments grow depends on how badly they’re taxed along the way. The tax on corporate investing can be extremely low. It could be roughly close to the lowest personal tax bracket if you’re paying out enough dividends to live on, that also keeps all of the refundable taxes flowing back to the corporation.
If you’re not paying attention to that and not paying enough dividends, then it gets taxed at roughly the highest tax rate to start off with. You have this tension there between salary and dividends, and this really leads into the big debate about how to pay yourself from a corporation, and that’s one of the planning areas that can make a big difference to how well it turns out over time.
[0:13:53] BF: Yeah. I just want to emphasize the benefit of the tax deferral in the corporation. Mark and I modeled out the effects of the capital gains inclusion rate increase on corporations to see how impactful is this for retirement plans of people with corporations. What we found in our modeling was that it had an impact, but it was not nearly as impactful as we maybe expected when we saw that.
[0:14:13] MS: Yeah. You can tolerate a little bit of a tax bump for the fact that you have so much tax deferral, as long as your time frame is good.
[0:14:18] BF: Yeah. On a state’s different story, but throughout the course of retirement, not such a big deal, is what we found.
[0:14:24] MS: Yeah.
[0:14:25] BF: I mentioned tax integration earlier. I want to come back to that. It’s a really important concept to understand as we continue talking about this. The way that it is achieved with corporations is with the corporate notional accounts. We have the RDTOH, the general rate income pool, RDTOH being refundable dividend tax on hand, the GRIP general rate income pool, capital dividend, CDA, and they all exist to achieve tax integration. When a corporation has taxable investment income, it pays tax at a rate closest to the highest personal tax rate, but a big portion of that is refundable. Mark mentioned, when that is flowing properly, the net tax rate is actually pretty low. That happens when a dividend is paid to a shareholder. That’s non-eligible refundable tax on hand.
When a corporation receives an eligible dividend, it creates eligible RDTOH and GRIP. When a corporation pays tax at the general business rate, it creates GRIP. Then when a corporation realizes the capital gain, it creates CDA, capital dividend account. When the flow of dividends is functioning well, and you’re consistently releasing that RDTOH, a corporation’s annual tax drag gets really low. That’s great, but maintaining that state requires pretty careful attention, both to what the corporation is investing, but also, how the owner of the corporation is paying themselves.
If there are insufficient dividends being paid, which can happen if someone has low consumption needs, or if they have very large amount of passive assets in their corporation, then that tax drag starts to become pretty penalizing. It gets close –
[0:15:56] MS: Uncomfortable.
[0:15:56] BF: Yeah, it’s uncomfortable. Mark does have a funny name for that. I’m not going to give it away yet, but it always makes me laugh. I think this is where errors can really occur. If advisors are honing in on one aspect of corporate investing, for example, trying to optimize just for minimizing tax drag in the corporation, or compensation. If they’re focusing on one type of income, like, let’s just pay salary, or let’s just pay dividends, I think that can cause real issues.
[0:16:24] MS: Yeah, especially if things unfold over time. We’ve talked a bit about tax integration in other venues and a bit about it today as well. Tax integration doesn’t generally favor corporations when you take the passive income and you flow it through, but there are aspects of it that are a bit more efficient. That can lead to one of the common errors that you might see, which is over concentration in Canadian dividend payers. Because one of the things about tax integration is that eligible dividends within a corporation can be very tax efficient.
Now, I’m a little bit apprehensive bringing up the topic of dividends, because it’s unwise to anger the Wookie. This goes way beyond the idea that dividends are nice and great and people have a psychological attachment to them, because they can see the income coming in. It’s tangible to them, rather than focusing on the underlying positive characteristics, or factors that are associated with dividends. Sometimes, but not always. It’s beyond that. It has more to do with the taxation itself.
There’s two ways that people get drawn into this. It’s a real issue. I’ve seen people have their entire corporate portfolio just as Canadian dividend paying stocks, period. You get a big concentration risk there, because you’re focused on this. One of the advantages of having eligible dividends is that when you get a dollar of eligible dividend income into your corporation, that also gives you the ability to pay out a dollar of eligible dividends to the shareholder. Most shareholders have to take money out of their corporations to live on. So, if they’re able to pay out eligible dividends, instead of non-eligible dividends, they get a personal tax savings somewhere in the 8% to 10% range, depending on the province and the tax bracket.
That means they have to pay themselves less out of the corporation each year to get the same amount of spending money, which keeps more money in the corporation. That is an efficiency that is there and it’s real. The other part of it is that you don’t get penalized for eligible dividends. When an eligible dividend is collected by a corporation, it pays 38% tax roughly. Then it gets that 38% refunded completely when the eligible dividends is passed out to the shareholders. The net corporate tax is zero. The personal savings are in the 8% to 10% range, so that can be very attractive to people if they’re focused on just the taxes. This is where the error occurs, because then you’re just taking on a bunch of specific risk instead, which you don’t have to look far to see that come home to roost.
[0:18:43] BF: Yeah, that’s exactly the issue. We did some modeling around this for an earlier Money Scope episode. What Mark just described is real. I mean, Canadian eligible dividends do look pretty good in a corporation. What we found in our modeling is that it’s, and maybe this is just obvious, but it’s very, very sensitive to the performance of Canadian stocks. You can have really tax efficient performance, but if Canadian stocks underperform as they have done, at least relative to US stocks in recent history, the tax savings goes away. You’re taking all this specific risk by owning Canadian stocks, which may pay off, but it may not. It’s an uncompensated country specific risk that you’re taking in order to get some tax savings. We don’t generally think that makes a lot of sense.
You could try to just locate the equity allocation of the portfolio in a corporation, depending on the balances and the different account types, but then you get the added risks and complexity of trying to manage an asset location strategy, combined with an asset allocation strategy across multiple accounts with different tax treatments, and that can get very complicated and it can add some risks as well. I think the other potential challenge with focusing on high eligible dividend pairs in a corporation is the amount of passive income that that’s going to create.
Canadian equities tend to have pretty high yields, and even more so if it’s a dividend focused portfolio. When a corporation has a large amount of passive income relative to what it pays out to shareholders, it becomes inefficient, as we’ve been talking about. That’s by design. It makes sense to discourage too much tax-deferred investing. There are two main mechanisms that the government uses to accomplish that.
[0:20:07] MS: Yeah. We’ve talked about how a corporation is great for tax deferral, and the more you can keep it and grow, the better it is. The obvious tendency will be, well, I’m just going to keep as much as I possibly can within the corporation. Grow it as big as I possibly can with this big tax-deferred pot of money. But it’s like having gas collect in a bag. There’s mechanisms in the tax system that make you have to pass that gas out. That’s why I’ve called this corporate bloat, because if you have all this money in the corporation, and it gets bigger and bigger, it eventually gets bloated, and it starts to get uncomfortable. There is a relatively simple solution to that, which is to pass some gas out.
You can either choose to pass that out in a planned way, or if you keep it in, it’s going to happen in an unplanned way, probably in an unplanned location, and it may be even worse than what you thought it was going to be. It’s a good concept to know about, because it’s really like, how to plan to pass the gas out of your corporation is what optimal compensation is actually really all about, because that keeps your corporation growing, but efficient at the same time, so you don’t get unintended consequences later on. There’s two big mechanisms where this bloat can develop. One is with the refundable dividend tax on hand mechanisms. To discourage us from keeping a bunch of money in our corporation, when passive income comes in, it’s taxed at roughly the highest personal rate, so around 50% for interest, 38% for eligible dividends, and then foreign dividends is actually a little bit worse than that, even just because of an interaction that happens there with some of the credits and the refundable taxes.
That’s not the end of the story. You do get some of that money refunded back to the corporation when you pay out dividends and then pay personal taxes on it. That’s why flowing some of that money out of the corporation helps to keep it efficient. Now, the problem that arises is let’s say, I don’t need much money to live on, or maybe I don’t need much from my corporation. There are people who are incorporated. They have a high-income spouse who pays for all their costs of living, essentially, and how much they take out of their corporation each year is basically an elective decision. Then you have to face this dilemma, do I take more money out of the corporation and pay personal taxes on the dividends in order to get that refunded tax back to the corporation, and becomes this balance between which is going to be more efficient overall.
When we look at optimal compensation, we’re trying to minimize the personal and the corporate taxes when you put it together and do that over time. It can be complicated, because if you have a long time delay between when you have that tax collected and you get it refunded, then the value of that refund becomes less over time, because it’s all priced in nominal dollars. When it gets refunded to the corporation later on, $3,000 of a refund may not be the same then as it was when you originally had it. There is pressure to release the gas out in a timely fashion, before the value of that refundable tax becomes less. You face dilemmas with having to pay out enough dividends to release that.
The other way that people’s corporations can become a bit more bloated is if it’s getting into the wrong side of the passive income limits. Again, this is another mechanism brought in more recently that if you have over $50,000 a year of passive income within your corporation, once you start to go above that, then it starts to shrink the threshold at which your corporation can get the small business deductions. With the small business deduction, the corporate tax rate is roughly in the 12% range. If it gets bumped up to the general corporate tax rate, it’s a big jump. It’s up to around 27%. It’s a big tax increase to the corporation’s active income that’s caused by that passive income. It happens at a 5 to 1 clip, which is the other thing. For $1 over the passive income limit, that reduces the threshold for the active income by $5. You’re effectively having that 15% bump times 5, which would be 75%.
Now, you can see that would make passive income would make corporations overall tax bill jump quite substantially, unless you do something to address it. Again, the best way to address it is to try to move some money out of the corporation, either by reducing the active income by paying more salary, or by paying out more dividends, and using some of that extra GRIP that was generated to pay eligible dividends, because some of your corporate money got taxed at that higher tax rate.
Now, it sounds like a big deal, but it often isn’t a big deal for people, because the amount, again, comes back partly how you’re investing. If you have a portfolio that’s targeting dividends and it’s paying 5% a year, well, a million dollars, you’re going to have $50,000 a year, start to get into potentially the passive income limits. If you have a globally diversified portfolio that has a yield of maybe 2% per year, you could have a portfolio of two and a half million dollars. It can become much larger. The passive income is only part of the equation, too. Let’s say, you pay yourself salary from your corporation, well, you can pay yourself salary, and let’s say, your net corporate income after paying salaries $250,000 after you paid out the salaries, well, you can have a 5-million-portfolio. This may not become an issue for people until their portfolios are relatively large, depending on how you invest and how you pay yourself.
[0:25:08] BF: Yeah. We’re going to talk through a couple of other ways that you can treat corporate bloat, or at least prevent it. One of the things that we’ve seen, I still see this today, is clients being advised to pay only dividends and also, to retain as much as possible in the corporation. I don’t know if other people still see that today. I know we do. Then, there are lots of reasons for this. One of the big ones that I find really interesting is the perception that dividends are more tax efficient, which typically, they’re not when you account for both the corporate and personal sides of the tax equation. The other one being that paying dividends avoids the need to pay into CPP. In many cases seen, CPP framed as a tax that you want to avoid by paying yourself dividends.
Now, like I mentioned, dividends are typically less tax efficient than salary when both sides of the tax equation are considered. Paying into CPP is probably a good idea for most people. It’s the only inflation index annuity that’s available to self-employed people in Canada. If you want to hear more about that topic, I do want to recommend checking out Aravind and Jason’s talk, which is tomorrow at 10.45, right? They’ve got a very, very good talk on CPP, including the after-tax cost of making CPP contributions for some of the corporation. Look forward to that.
One of the benefits of paying some salary, especially early on in a career, is that it can help delay the onset of corporate bloat. Paying enough salary to generate RSP room and also to make RSP contributions can often make a lot of sense, and it gets money out of the corporation and into the RRSP. Then you mentioned the IPP earlier, this also opens the door to that. The IPP after age 40 has an even larger tax-deferred amount that can go into it than an RRSP.
We looked at this when the recent capital gains inclusion rate increase happened. The IPP looked pretty good in our modeling before that happened. After that changed, the IPP looks really compelling. You only get that by paying salary. Step one in treating, or preventing corporate bloat is paying some salary.
[0:27:03] MS: Yeah. I mean, we’ve talked a lot of ways about treating it. Really, the prevention is to over time, if you can shift money from your corporation into personal accounts in a tax-efficient way, and your tax shelter is the obvious solution. There can be some unusual circumstances, which are a little bit less unusual now, where it does sometimes make sense to pay some extra money out of your corporation and invest it personally. A good example would be is, let’s say, the corporation owner has a low-income spouse, well, they may take out more income to live on and preserve their spouse’s income and let their spouse start to build up a non-registered investment account, because it can be taxed at a relatively low rate.
I would also say, and this is something that’s a little bit different. I think psychologically, there’s a bit of an advantage of having some non-registered money available. If you’re able to do that efficiently and that people have a hard time spending money, if it means taking money out of their corporation and then paying taxes on it and then doing something that they wanted to do. It may prevent people from doing things that they may want to do. Whereas, if they have some non-registered money, that has a relatively light tax burden to access it, and that helps them to actually smooth out their consumption over their lifespan and spend some of the money now rather than later. There’s an advantage, too, with that.
This is really where I think planning becomes very, very valuable with corporations. It’s hard for people to know how to spend money now, versus the future if they have no idea what that future is going to look like. A lot of people are afraid of running out of money, but you also don’t want to die and have all this money that you could have used while you were alive. Not only is that utility that’s lost from just a personal lifestyle standpoint, I mean, it’s also going to be potentially less tax efficient if you’ve missed some opportunities along the way.
[0:28:47] BF: Yeah. I want to talk more about optimal compensation, which is, I don’t think we invented it, but that’s what we called it.
[0:28:53] MS: Yeah.
[0:28:54] BF: We worked on this over the last couple of years, also with help from Braden Warwick at PWL. It’s just the idea that rather than paying salary, or dividends, there’s theoretically some optimal combination of salary and dividends in every year, and it’s going to change over time, that maximizes lifetime wealth, decreases lifetime taxes, and increases lifetime consumption. It’s a really hard math problem to solve, but it’s a math problem that can be solved. It changes, I mean, the salary versus dividends debate is something that everyone here will be familiar with, and it flips that on the head, or at least makes it no longer a debate.
[0:29:26] MS: Maybe we should call it mostly optimal to the compensation, because you’re only going to get close, because you’re making assumptions about the future. It’s always going to be changing, but it’s pretty much always comes out better than being just dividends, or just salary, but actually, having some thought process of the mix that you’re going to have with it.
[0:29:42] BF: Yeah. It is a complex problem to solve, and Mark and I have beat our heads against –
[0:29:46] MS: In a long time. Yeah.
[0:29:48] BF: The way that we both did it separately, but we check each other’s work is by developing optimal compensation algorithms. We just built a program that tells you what type of income to take out in each year. Then we tested those algorithms and adjusted them as we tested them. Right now, PWL has three different algorithms. We have three, because they work well under different circumstances and in different provinces, and it’s really hard to predict which one of them is going to work. We run all three of them in tandem. Then for a given client situation, we just take the one that works the best. We’re measuring whether it works by how much it’s affecting net worth and lifetime consumption in a positive way.
As we mentioned, salary has the best corporate and personal combined tax rate, and it’s got the advantage of creating RRSP room. That’s big points for taking out salary. I’m just going to talk through some of the logic in our algorithm. Then as the investments account grow, like we’ve been talking about, you start to care about dividends, because you want to release the RDTOH that’s building up, and you’ve also got realized capital gains, and some capital dividend account building up, which lets you pay out tax-free dividends.
When that starts to happen, despite dividends being a little bit less tax efficient, when you release RDTOH, dividends can actually look better than salary, sometimes. Combined with salary, if you end up having more income, so if you’re taking some amount of salary and then you start taking out dividends to release RDTOH, then you end up with way more personal income than you actually need to fund your consumption. That’s not tax efficient either. The way that our algorithms tend to work is that salary gets decreased as the need for taking out dividends increases. Typically, what we see over the lifecycle of someone with a corporation is they start out taking a high salary to fund their lifestyle and their RRSP contributions, and then salary decreases over time, and different types of dividends start to become a more prominent part of the income plan.
[0:31:30] MS: Yeah, that’s the general gist of it. It can get complicated when you start to get all sorts of little niche situations. The tools that we built actually do deal with a lot of those niche situations. I’ve got a calculator on my site that’s like a salary and dividend optimizer calculator, where you put in the goal consumption, because that’s the thing that drives everything else, and then what the income of the different sources of corporate income are like, passive and active income, and then it’ll go through the algorithm to give the mix. If you just want to think about it in very simple terms, it comes down to paying enough dividends to empty out those notional accounts, and then adding enough salary in to make up the difference. That’s really what it comes down to at a high level.
[0:32:08] BF: We do want to make sure we leave time for questions. But I will just mention, one of the problems that Mark and I both see, me at PWL, and Mark with all the DIY investors that he talks to, is that a lot of times, these problems will be attempted to be solved using products, as opposed to planning. That could be using permanent life insurance, which I’m not saying it’s a bad thing in all cases. Jason Pereira disagrees. But it’s often used, I think, inappropriately, and that’s particularly true with young physicians. That’s something that I know both of us see frequently.
Another one is the Global X, previously Horizon’s total return ETFs, which have a pretty unique structure that Mark’s written some stuff about that we worked on together. They introduce different tax risks. I think people try to say, “I have this problem with my notional accounts, my passive income, and I want to do something about it.” Rather than saying, maybe there’s an optimal way to take income out of the corporation, they’ll try and solve that problem with products. I think, generally, that’s a mistake. Not to say those are bad products that don’t have uses, but trying to solve that problem with product, as opposed to planning, I think is a mistake.
[0:33:13] MS: Yeah. When I look at it, the advantage that planning has over products is flexibility. If you are planning, what you end up doing is using multiple pots of money in different accounts. Whereas, if you use products, you sometimes get locked into those products. I mean, it’s obvious with permanent life insurance. But even with corporate class funds, how do you extract yourself from that? That could become an issue as well, because the rules can change. I mean, we’ve seen legislative changes to corporations. If you have everything concentrated in one strategy without having a bunch of pots, then you’re more vulnerable to that.
It wasn’t too long ago that corporations seemed like the Death Star, this big, invincible space station, but it’s all fun and games, until Red Leader drops down in your trench and starts going down there and then fires some photon torpedoes up the exhaust port and blow up the whole thing. You’ve got to be careful about spreading out your risk amongst all the different accounts that you can have access to. I think gives you more options to draw down. It leaves you less exposed if there’s a problem.
[0:34:12] BF: Yeah. I think bringing products to a planning fight is a mistake. I think neglecting notional accounts, that’s another one that we often talk about this. We’ll see people with a massive CDA balance, or a massive RDTOH balance, and they’re just paying themselves a salary, because they don’t realize the impact of –
[0:34:26] MS: No. When they could take that money out tax-free, use it in some other way, or even pay themselves less salary and keep more in the corporation, if that’s what they wanted.
[0:34:34] BF: They might have those notional accounts and have bought a permanent insurance policy to deal with their passive income. Our view on this is that approaching that problem with financial planning is – not to say that products are not part of financial planning, but approaching it with planning first is generally superior to using products. It’s low-hanging fruit. I mean, this is an area that our modeling has shown can add a ton of value to clients’ wealth over their lifetimes, and it’s not rocket science.
[0:35:00] MS: There’s not a lot of downside to it. That’s the thing. There’s not a lot of risk to that. Great. Well, I think with that, I think we’ll wrap up there from what we want to talk about and open the floor to some questions.
[0:35:10] MALE1: Hey, Mark, man. Quick question. With a lot of my physician clients, their compensation structure is modeled in a way where they’ll have a salary of maybe $80,000 to a $100,000 from the university, and then the remaining of their billings will go into the corporation. Assuming that they don’t have any passive threshold income, because they’re making too much in dividends, we’ve already utilized dividends to clear out notional accounts. Would just love to get your thought on, if you in your modeling, have looked at basing on the salary being, with most integration, a little more efficient, RRSP room generated, and so forth, versus giving up that employer contribution to CPP if you were to take additional salary out of your corporation as a compensation model.
If you guys have looked at that and I know it’s all situational dependent on tax, but assuming highest tax bracket, Ontario, what your thoughts on would be if it’s worth getting that additional salary to offset that cost of the employer contribution being given up to the government.
[0:36:06] MS: Yeah. There’s a couple issues buried in there. Yeah. When I go through the algorithm, outside sources of income are counted in it. It starts with your consumption and how do you fund that? Spousal income’s in there. If you have income outside of your corporation, like from a university job, that gets accounted in for. Then after that, it becomes optional about what you take. Then you get into the dividend versus salary algorithm. I do account for the fact that you do end up overpaying into CPP a little bit when you have income coming from two different companies, because your over contribution back when you do your personal tax return, but the university will have paid some CPP and your corporation will have paid some CPP and that won’t get brought back into it.
The impact of that is so small, compared to the impact of keeping those notional accounts flowing and developing the RRSP room. I mean, one thing we found when we did our modeling with the capital gains taxes and how to handle that from a compensation standpoint is losing that RRSP room is actually really valuable. Now, it depends on your province. In Ontario and New Brunswick, there’s some nuances to the corporate taxation with the passive income, so you can take advantage of that. If you take advantage of that with a big capital gain, then that overpowers the RRSP power a little bit.
Generally, having that RRSP room, which you’re going to have that beyond the point where you’re past the maximum CPP threshold. That just comes in at a little bit as a wafer at the bottom, but the benefits of using salary on top of that over the long run, far outweigh it. To both for the RRSP, and eventually, if you wanted to do an IPP, you would have had those years of salary service that you can then roll much more money into the IPP potentially.
[0:37:42] BF: I think you found that we could be pretty loose with the CPP benefit to show that salary still makes sense, because the RRSP room is so valuable.
[0:37:49] MS: Yeah. You get other benefits, too. Remember, when you pay into salary and CPP, when you pay salary, you get the employment credits and you get credits for paying into CPP and things like that, too. It offsets the cost of it quite substantially.
[0:38:01] BF: It’s a good question though. We have built into our model, too. We model outside income. So, the algorithm starts after that. I mentioned earlier that CPP is not really a tax. It’s an asset, but this is one case where it actually is a tax. It’s just something that gets factored into the equation.
[0:38:14] MS: But it’s just an incrementally small thing.
[0:38:16] BF: Right.
[0:38:17] MS: Yeah. Exactly. It becomes a bit of a moot point almost. Yeah. It’s not a big impact.
[0:38:21] MALE2: Hi. This question is for Mark Solo. When you were frozen in carbonites, did you have a power of attorney written before? Was that for your friend, Chewbacca Ben Felix? Or was that for Princess Leia?
[0:38:35] MS: Yeah. It’s all very foggy.
[0:38:44] ANNOUNCER: With that, good question. We’ll close up here.
