Should business owners and professionals contribute to an RRSP?

Registered Retirement Savings Plans were initially deisgned for people who did not belong to a pension plan, including self-employed business owners. But some financial advisors and accountants encourage incorporated business owners and professional clients to avoid RRSPs because:

  • B.C.’s small business income threshold increased from $400,000 to $500,000 as of January 1, 2010. 
  • Effective March 19, 2007 the Lifetime Capital Gains Exemption increased from $500,000 to $750,000 for small business corporation shares. 
  • Effective January 1, 2010, B.C.’s small business corporate tax rate on active business income (up to $500,000) is 13.5 per cent.

Let’s take a step back in time when B.C. corporate tax rates were higher and the small business income threshold was lower. Most owner managed businesses would have regular payroll set up to pay themselves. This was an added administrative cost. It also meant remitting income tax and CPP (both employee portion and employer portion for owner managed businesses). An owner of a business would effectively be paying twice the amount into CPP, with only one half of this amount being tax deductible for the corporation. At year end, it was common to give the owner an additional management fee or a bonus to reduce taxable income in the corporation, and increase income personally.

The regular payroll/wages, plus any management fees or bonuses were all considered “earned” income. This is significant in how it relates to RRSP accounts. Your annual RRSP deduction limit is increased by multiplying your previous years earned income by 18 per cent (up to a yearly maximum). Annually it made sense for business owners to contribute to an RRSP. This effectively reduced current year income personally, and allowed business owners to tax shelter funds for retirement.

Let’s fast forward to today. With corporate tax rates so low, many accountants are advising to have the income taxed fully in the corporation and avoid paying any wages or bonuses (or at least a reduced amount). The one main exception to this would be professionals who pay an annual fee into an association that provides a matching RRSP program. As an example, doctors who pay British Columbia Medical Association dues have an RRSP matching program. In these cases we recommend that doctors take advantage of this program to make paying the dues worthwhile. This results in some wages which need to be paid in order to generate the RRSP deduction limit.

Assuming no wages, management fees, or bonuses are paid then the total net income would be taxed within the corporation. The net income after tax is added to retained earnings. If the owner/shareholder required cash then a dividend would be paid from retained earnings. Dividends are taxed at a considerably lower rate then wages.

The downside to dividends is that they are not considered “earned income” and as a result no RRSP deduction is created. The other component to factor in is that you are not paying into CPP (both employee and employer) annually when dividends are paid. The maximum employer portion of CPP is $2,163.15, and maximum employee portion of CPP is $2,163.15. Self employed business owners effectively pay a combined maximum of $4,326.30 for 2010 if earnings are $47,200 or greater.

By paying dividends, this comes with CPP saving today, but a sacrifice in the future. Unlike OAS which is based on residency, CPP is based on your reported earned income and CPP contributions. If you do not pay into CPP, then you should not expect to receive CPP at retirement. If you pay only a little into CPP, then you should expect to receive a little CPP at retirement.

Every time legislation changes people should take a pause to determine if what they have always done still makes sense. Is there a better strategy to provide for flexibility or to reduce taxes longer term?

An example of this is the introduction of the Tax Free Savings Account and Registered Education Savings Plan. Business owners can use both of these types of accounts to tax shelter income and to obtain the deferral benefit that an RRSP provides.

One of the benefits of corporate investment accounts is that investment counsel fees and interest expense, relating to the investments, may be tax deductible. These are not tax deductible within an RRSP.

Margin account agreements are not possible within an RRSP. With RRSP accounts, you are forced to begin pulling funds out at age 72. In some of these cases, this results in OAS being clawed back. With a corporate account there is no requirement to pull funds out. After going through some periods of volatility, investors should appreciate the ability to claim a loss if they have them.

Net capital losses in a corporation may be carried back up to three years or to offset taxable capital gains in the future. Losses within an RRSP cannot be claimed.

When we are talking to business owners, the number one misconception we come across is the belief that when the active business is done, the corporation is wound up at the same time. This is generally not the recommended strategy. In some cases where shares are sold, then the financial assets would typically have been moved to a holding company and only the active company is sold.

There are other reasons to have a holding company in addition to an operating company – cleansing for the lifetime capital gains exemption, income splitting, creditor protection and ease of selling. In many cases we are assisting people with the investments within the holding company as they get built up and through retirement.

Building up equity within a corporation provides flexibility and it makes sense today. There are some tax efficient ways, utilizing insurance products, to move retained earnings out during your lifetime and at death that are certainly more appealing then paying 44 per cent (or more) of your RRIF to the government on death.