Retiring With a Corporation

A corporation changes the retirement question. An employee approaching the end of a working life asks when the pension should start and how much can safely be withdrawn. An owner of an incorporated practice or business asks something different: what is inside the company, in which account is it sitting, and what does it cost to get it out. The money has already been earned and has already been taxed once, at the corporate level. Everything that follows is about the second layer of tax, the timing of it, and the sequence in which the company is emptied. Most of what is written for owners stops at the sale of the business. Far less is written for the owner who never sells, who winds the operations down and keeps a company holding investments and perhaps a policy, and who now needs an income from it for thirty years and an orderly exit for the estate after that. This article sets out the pieces in the order they arise.

What changes when the company is the payer

A corporation is a separate taxpayer. It files its own return, it pays tax on its own income, and the person who owns it is paid by it rather than being the same taxpayer as it. That single fact produces a choice an employee never has: the owner decides the form in which money moves from the company to the household, and the form carries consequences that outlast the year in which the decision is made.

The choice is not made once. It is made every year, for as long as the company exists, and the effects accumulate. A run of years paid entirely in dividends leaves a person at sixty five with no registered room built and no pension credits earned in those years. A run of years paid entirely in salary leaves the company with less retained and the household with more tax paid earlier. Neither is right in the abstract.

Nothing here is a rule of thumb, and any article offering one for this question should be read with suspicion. Corporate and personal rates differ by province, the integration of the two is imperfect, and the right answer depends on what a household actually needs to spend.

Salary, and what only salary creates

Salary is employment income. The company deducts it in computing its own income, the person includes it in theirs, and the company runs payroll: source deductions, remittances, a T4 and, in Quebec, the provincial equivalents. It is administratively heavier than a dividend and that is the reason it is often skipped.

Salary creates registered retirement savings plan room. The definition of earned income in subsection 146(1) of the Income Tax Act is built from income from an office or employment, net income from a business carried on by the taxpayer, net rental income from real or immovable property, and a short list of other amounts. Room accrues as a share of the prior year’s earned income up to an annual maximum. The share and the maximum are set out by the Canada Revenue Agency and the household’s own figure appears on the notice of assessment, which is where it should be read rather than from any article.

Salary also creates pension credits. Section 12 of the Canada Pension Plan defines contributory salary and wages as the person’s income for the year from pensionable employment, computed under the Income Tax Act. The Quebec Pension Plan, administered by Retraite Québec, applies the same principle to pensionable employment earnings in that province. Contributions are made by the employee and matched by the employer, and for an owner both halves come from the same source, so the cost is real and should be entered into the comparison honestly rather than treated as a free benefit.

A salary history is also what makes a registered pension arrangement for the owner possible at all. An owner who has taken dividends for twenty years has closed that door quietly, year by year, without ever deciding to.

Dividends, and what they do not create

A dividend is paid out of income the company has already been taxed on. The shareholder grosses it up and claims a credit meant to account for that tax. There is no payroll, no remittance schedule and no contribution, and in a single year the arithmetic often favours the dividend.

A dividend creates no earned income, so it creates no registered room. It is not income from pensionable employment, so it creates no pension credits. Those two absences are the entire long term case against a dividend only policy, and they are absences, which is why they are rarely noticed until the year the room or the credits are wanted and are not there.

Dividends come in two kinds. An eligible dividend is one the payer has designated as such, and subsection 89(14) requires that designation to be made by notifying each recipient in writing at the time the dividend is paid. The capacity to designate is limited by the general rate income pool defined in subsection 89(1), which tracks income that has borne the general corporate rate. Everything else is a non eligible dividend, taxed at a higher personal rate because less corporate tax stood behind it. Getting the designation wrong is expensive, and the mechanics belong to the accountant who prepares the return.

The notional accounts and what each one releases

The most useful thing an owner can learn before retirement is that a corporation does not have one pot of money. It has one operating account at a financial institution and several notional accounts, and the notional accounts hold nothing at all. They are running records maintained for tax purposes, and their only function is to decide the character of a dollar as it leaves.

The capital dividend account, defined in subsection 89(1), releases a dollar that is not included in the shareholder’s income at all. The general rate income pool releases the ability to designate a dividend as eligible, which changes the rate the shareholder pays rather than the fact of paying. Refundable dividend tax on hand, in its eligible and non eligible forms under subsection 129(4), releases a refund of tax the company has already paid on investment income, but only when the company actually pays a taxable dividend, under subsection 129(1). Paid up capital releases a return of capital rather than income. A genuine shareholder loan releases a repayment, which is not income either.

Read that list again as a retirement plan and the problem takes shape. Two owners with identical balance sheets can face materially different tax over a retirement because of what sits in those records and the order in which they draw on them.

Passive income and the small business deduction

An owner who retains earnings inside the company and invests them is doing something the Act watches. Subsection 125(5.1) reduces the business limit, the amount of active business income eligible for the small business deduction, by the greater of two calculations. One is driven by taxable capital employed in Canada. The other is driven by adjusted aggregate investment income, a term defined in subsection 125(7) that captures interest, most rents, portfolio dividends and the taxable portion of capital gains, while carving out gains on the disposition of active business assets.

The thresholds are dollar amounts written into the subsection. They are not reproduced here on purpose, both because thresholds move and because the figure that matters is the company’s own adjusted aggregate investment income for the preceding year, which only the accountant who prepares the return can state. What the reader needs to carry away is the direction: above a floor the business limit is ground down, and at a higher level it is gone.

The practical consequence for a retiring owner is uncomfortable. The portfolio accumulated to fund retirement can raise the tax paid on the operating income of the same company, or of an associated one, in the year before the owner stops working, which is a reason the shape of what a company holds deserves as much attention as the amount. For the treatment of the income itself, see how investment income is taxed.

The capital dividend account

The capital dividend account is the tax free route out of a private corporation, and no other account does the same job. Subsection 89(1) credits it with the non taxable portion of capital gains realized by the company, with life insurance proceeds received in excess of the adjusted cost basis of the policy immediately before death, and with capital dividends received from other corporations. It is reduced by capital dividends that have become payable.

Access is by election. Under subsection 83(2) a private corporation resident in Canada may elect, in prescribed manner and form, at or before the time the dividend becomes payable, with the result that no part of the dividend is included in computing the income of any shareholder. The election is a filing with a deadline, not an attribute of the money, and an election made for more than the balance available attracts a penalty tax on the excess. The balance is confirmed with the Canada Revenue Agency before the election is filed, every time, without exception.

The balance is not permanent. A later capital loss reduces it, so an account that looked substantial at the end of one year can be smaller at the end of the next without a dollar having been paid out. For the mechanics as they apply to an insurance credit, see the capital dividend account and life insurance, and for the gain side, how the inclusion rate works.

Where a corporately owned policy sits in this

A policy owned by the corporation is an asset of the corporation. The company is the owner, the payer and the beneficiary, and the premium is generally not deductible. At death the company receives the proceeds, and the amount by which those proceeds exceed the adjusted cost basis of the policy immediately before death is credited to the capital dividend account, which is what allows that value to be paid out to the estate or to surviving shareholders without inclusion in income.

Two things must be said plainly. A premium is not a deposit and a policy is not a deposit account: deposit insurance does not apply to it, and the protection that does apply is provided by Assuris within its own published limits. And where value is taken from a policy during life by way of a policy loan, that loan is made by the insurer against the value of the contract. It is not a person borrowing from themselves.

This is also where a shareholders agreement meets a retirement plan, because the same policy is frequently doing funding work under a buy sell agreement. Read corporate owned life insurance for the ownership question and policy loans for a business for how value is accessed before death.

Winding the company up

Winding up a corporation is not a transaction. It is a sequence, usually spread across more than one taxation year, and the order of the steps changes the tax. Assets are sold or distributed, the notional accounts are used while they are still available, final returns are filed, a clearance certificate is obtained from the Canada Revenue Agency before property is distributed, and the company is then dissolved under its governing corporate statute.

The tax rule at the centre is subsection 84(2). Where funds or property of a corporation resident in Canada are distributed or otherwise appropriated to shareholders on the winding up, discontinuance or reorganization of its business, the corporation is deemed to have paid a dividend equal to the excess of what was distributed over the reduction in paid up capital of those shares. Subsection 88(2) then separates that winding up dividend: the portion covered by the capital dividend account can be elected as a capital dividend, pre 1972 capital surplus is deemed not to be a dividend, and the balance is a taxable dividend in the shareholder’s hands.

Because the balance is a taxable dividend, the year in which it lands matters. Splitting a wind up across two calendar years, or across a change in the household’s other income, is ordinary planning, and it is decided before the first distribution rather than discovered afterwards. Old age security recovery tax frequently turns a good year into a bad one, which is covered in the old age security clawback.

The shares at death

Paragraph 70(5)(a) of the Income Tax Act provides that a taxpayer is deemed to have, immediately before death, disposed of each capital property and to have received proceeds of disposition equal to the fair market value of the property immediately before the death. Shares of a private corporation are capital property. There is no exemption for the fact that they are not listed, not liquid and not saleable to anybody outside the family.

The value of those shares is the value of what is inside the company: the portfolio, the real property, the cash, and the policy proceeds if death is what triggered them. A gain accrued over a working lifetime is realized in a single return, and the tax is payable in cash on the ordinary deadline, whether or not anything has been sold.

Subsection 70(6) provides the exception. Where the property passes to a surviving spouse or common law partner, or to a qualifying spousal trust, and the conditions are met, the transfer occurs on a rollover basis rather than at fair market value. That is a deferral to the second death and nothing more. The general rule is set out in the deemed disposition at death and the filing side in the final tax return.

The double tax problem

Here is the difficulty that makes this a planning subject rather than a reporting one. The deemed disposition taxes a gain on the shares in the deceased’s final return. It does nothing at all to the company, which still holds the same assets with the same cost base it always had. When the estate or the heirs eventually take the money out, that extraction is a dividend and is taxed again in their hands.

One economic value, two taxpayers, two taxing events, and no automatic relief connecting them. Left alone, the combined result can exceed what either event would have produced on its own. The Act does not fix this by itself. Relief exists, but every route to it is elective, conditional and subject to a deadline that begins running at death.

That is the whole argument for deciding the exit before it is needed. An executor or liquidator learning about this in the eighth month after a death, with a terminal return due and a company nobody has valued, is poorly placed to make an election that had to be planned. Estate liquidity is usually the first constraint and is discussed at estate liquidity.

Post mortem planning, named in outline only

Three routes are commonly used to reduce the double count, and they are named here in outline so that a reader knows what to ask for. None of them is set out in enough detail to act on, and none of them should be.

The first is the loss carryback under subsection 164(6). The graduated rate estate has the shares redeemed, which produces a deemed dividend and a capital loss on the shares, and the legal representative may elect for a taxation year within the first three taxation years of the estate that capital losses of the estate be deemed capital losses of the deceased in the last taxation year. The second is the pipeline, in which the estate transfers the shares to a new corporation and value is extracted over a period as a return of capital rather than as a dividend, an approach constrained by section 84.1, which is an anti surplus stripping rule, and by the administrative positions the Canada Revenue Agency has taken about timing and continuity of the business. The third, in the right corporate structure, is the cost bump available under paragraph 88(1)(d) on the winding up of a subsidiary.

Each route has conditions and a deadline, each interacts with the others, and the choice among them depends on what the company owns and who is inheriting. This is specialist tax work, coordinated with the lawyer or notary handling the estate. Related structures are covered at the estate freeze and business succession planning.

Why the order is a projection, not a rule

By this point the pieces are all on the table: what salary buys, what dividends cost, what each notional account releases, what the portfolio does to the business limit, what the wind up triggers and what death does to the shares. The question that remains is the order, and the order cannot be written down as a maxim because it is the output of a calculation.

The inputs are specific to one household. What does it need to spend, in which years. What other income arrives and when. Which province, at which rates. What is the current balance of each notional account, and the adjusted aggregate investment income for the preceding year. Is there a spouse to roll to. Change any one of those and the sequence changes.

So the deliverable is a projection, built with the accountant who prepares the corporate return, revisited annually because the balances move, and rebuilt when the legislation moves. Our role beside that work is the insurance and capital side of it, described at how this applies to incorporated professionals. The projection is the accountant’s.

Frequently Asked Questions

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For the accounts and structures named above, read corporate owned life insurance for how a policy is held by a company, the capital dividend account for the route value takes out of one, and the deemed disposition at death for what happens to the shares. The estate freeze is the structure most often used to cap the growth this article taxes, and business succession planning covers the case where the company is passing to somebody rather than being wound up.