October may mean postseason baseball in Canada for the first time in more than two decades, but it also means small business month has arrived. If you have small business owner clients who have incorporated their operations or have professionals who operate through a professional corporation, you know that their No. 1 tax-related question this time of year is whether to invest surplus funds within their corporation or to withdraw these funds and invest them personally.
Often, it may be beneficial to leave funds in a corporation for investment rather than withdrawing the funds and investing them personally thanks to a significant tax-deferral advantage in that your clients don't have to pay personal taxes on the after-tax corporate income until it's withdrawn from the corporation. This tax-deferral advantage is significant and, on active business income subject to the small business deduction, ranges from 26% in Alberta up to 40% in New Brunswick.
The amount that was deferred can then be used either to reinvest in the business or as investment capital, which can generate investment income. Of course, the downside of this is that taxes must then be paid at high corporate tax rates annually on any investment income earned in the corporation.
The increase of the tax-free savings account's (TFSA) annual contribution limit to $10,000 from $5,500 in this past spring's federal budget has business owner clients wondering if leaving funds in the corporation to enjoy the signfinicant tax-deferral advantage still makes sense. After all, if a business owner client's surplus cash can be invested tax-free in a TFSA, would it make sense to leave it in the corporation, only to pay taxes on the investment earnings?
The answer is complicated by the fact TFSA contributions can only be made personally and not by a client's corporation. As a result, to make a TFSA contribution, your clients must first withdraw the funds from their corporation, meaning that taxes must be paid by their corporarations and/or the clients personally before they have the after-tax cash necessary to contribute the funds to their TFSAs.
Modelling using various rates of return shows that in almost every scenario, leaving funds in your clients' corporation to take advtange of the tax-deferral advantage will likely leave them with less money in their pocket than a TFSA over long periods of time as corporate investment income is taxable while TFSA income is completely tax-free.
The only exception to this rule-of-thumb would be if you could find an investment that only resulted in a deferred capital gain at the end of the investment period. In such a case, corporate investing could yield more after-tax funds than a TFSA. But, it would be rare to find such an investment that doesn't trigger any taxes during its holding period. This means that the TFSA is the way to go for most business owner clients who have surplus funds.
You can see the full results and conclusions in Canadian Imperial Bank of Commerce's latest report, TFSAs for Small Business Owners: A Smart Choice.