If you own a Canadian corporation and have accumulated $100,000, $250,000, $500,000 or even $1 million in retained earnings, you have an important financial planning opportunity.
But here is the question:
Are you simply allowing your corporation to accumulate profits year after year, or do you have a strategy to put that money to work while managing your overall corporate and personal tax exposure?
Many incorporated professionals, consultants, doctors, dentists, real estate investors and small business owners focus on reducing their annual corporate tax bill. However, an equally important consideration is what happens to the money after corporate tax has been paid.
Leaving profits inside a corporation can provide flexibility, but it also creates planning considerations:
How should accumulated corporate funds be invested?
How can you build retirement income without withdrawing all the money personally?
Can you transfer wealth to your family in a tax-efficient manner?
How can you reduce the tax consequences of passing your corporation to the next generation?
Can you create a tax-efficient legacy for your beneficiaries?
The good news is that Canadian tax legislation provides several legitimate planning tools that can help address these questions.
Before Choosing a Strategy: Understand What Retained Earnings Actually Mean
Retained earnings are the accumulated profits of a corporation that have not been distributed to shareholders as dividends.
For example:
The $500,000 is not necessarily sitting in a bank account. Some of it may be invested in GICs, mutual funds, stocks, real estate or other business assets.
It is also important to understand that retained earnings are an accounting balance, not a separate tax-free investment account.
The objective is not simply to eliminate corporate tax. It is to manage the combined corporate and personal tax burden while using the corporation’s available funds efficiently.
There are three different planning objectives:
Tax deferral: Keep money invested inside the corporate structure instead of immediately withdrawing it personally.
Tax-efficient retirement planning: Move corporate funds into an approved retirement arrangement or create future retirement income.
Tax-efficient wealth transfer: Structure assets so that more wealth can eventually reach shareholders and beneficiaries with appropriate tax planning.
Let’s look at the four tools and when each makes sense.
1. Capital Dividend Account (CDA): Start by Checking Whether You Already Have Tax-Free Money Available
First step: Lowest setup complexity
What is a Capital Dividend Account?
The Capital Dividend Account (CDA) is one of the most useful tax-planning mechanisms available to eligible Canadian private corporations.
It is a notional tax account maintained for tax purposes. It is not a bank account, and you do not need to establish a separate corporation or purchase an insurance policy to check whether a CDA balance already exists.
The CDA tracks certain tax-free amounts accumulated by a private corporation.
Some common sources include:
The non-taxable portion of eligible capital gains.
Net proceeds from qualifying corporate-owned life insurance policies received on death.
Capital dividends received from other corporations.
Certain other amounts specifically permitted under the Income Tax Act.
How does it help reduce personal tax?
Normally, when a corporation distributes its retained earnings to an individual shareholder as a taxable dividend, the shareholder must report that dividend on their personal tax return.
However, an eligible private corporation can elect to distribute an available CDA balance as a capital dividend.
A properly elected capital dividend is generally received tax-free by Canadian-resident individual shareholders.
Example:
Suppose your corporation receives $300,000 from a qualifying life insurance death benefit.
Assume the policy’s adjusted cost basis (ACB) at death is $40,000.
Assumes the corporation is the beneficiary, receives the proceeds and there are no other CDA adjustments or restrictions.
The corporation may then distribute the available CDA amount to its eligible shareholders through a properly declared capital dividend.
The shareholder does not pay personal income tax on the qualifying capital dividend.
When is the best time to use CDA?
CDA should be reviewed before implementing more complicated tax-planning strategies.
Consider reviewing your CDA:
When your corporation sells an investment property or another capital asset at a gain.
When your corporation receives proceeds from corporate-owned life insurance.
When your corporation receives a capital dividend from another corporation.
Before declaring dividends to shareholders.
During year-end corporate tax planning.
Limitations you should know
There are some important restrictions.
You cannot simply transfer ordinary retained earnings into the CDA.
CDA is not a general-purpose tax-free withdrawal account.
The balance must be calculated under the Income Tax Act.
The corporation must make the required election using CRA Form T2054.
An excessive capital dividend election can result in significant Part III tax exposure, generally 60% of the excess unless an applicable corrective election is available.
