What to Do With Retained Earnings: 3 Choices

In this article, "company" and "corporation" mean the same thing. Retained earnings are the profits your company has kept instead of paying them out. Surplus is extra money in your company. It is what is left after you take what you need to live on.

Most owners with a company do one of two things with surplus. They leave it in the company, or they pay it out to themselves. Both choices make sense. But both can cost more tax than people expect.

There is also a third path. You can use a planning structure beside your company. This means a plan that works alongside the company. A pension and an insurance policy are two examples. It is often worth a look once your surplus gets large.

So there are three paths:

1. Leave the money invested in the company.
2. Take the money out for yourself.
3. Use a planning structure beside the company.

1. Leave it invested in the company

Keeping money in the company defers personal tax. That means you do not pay personal tax on it until you take it out. The money also stays ready for the business to use. The catch is what happens once the money is invested:

• Investment income is money the company earns from its investments. In Ontario, it is taxed at roughly 50% inside a Canadian-controlled private corporation. That is the tax name for a private company in Canada. Generally, it cannot be controlled by people who live outside Canada. It also cannot be controlled by public companies.
• Part of this tax is paid back to the company later. But that only happens when the company pays taxable dividends. A dividend is a share of company profit paid to its owners.
• Passive income is another name for this investment income. Active business income is money the company earns from running the business. The federal small business deduction is a tax break. It gives a lower tax rate on active business income, up to a limit. Once passive income passes $50,000 a year, it can start to shrink this tax break. We explain this in the $50,000 passive income rule.

2. Take it out for yourself

You can pay yourself more salary or more dividends. This moves money into your own hands. Then you can use RRSPs, TFSAs and personal investments. An RRSP is a Registered Retirement Savings Plan. A TFSA is a Tax-Free Savings Account.

But taking money out adds a layer of personal tax now. It is often taxed at top marginal rates, which are above 50% in Ontario. A marginal rate is the tax rate on your next dollar of income. You pay this tax before the money is ever invested.

Salary and dividends work in different ways. Salary creates RRSP room. That is the amount you are allowed to put into an RRSP. Salary also builds your Canada Pension Plan (CPP) benefits. And salary is deductible to the company. That means the company can subtract it from the income it pays tax on.

Dividends do not create RRSP room. Your mix of salary and dividends is a key topic. It is one of the most important talks to have with your accountant each year.

3. Use a planning structure

Some plans can sit beside your company and use its surplus. Here are three to know about. Two of them can lower the tax drag on long-term surplus. They are the pension plan and the insured retirement program. Tax drag is the tax that cuts into savings each year as they grow. But each plan needs to be set up properly and reviewed with your accountant.

• Individual Pension Plan (IPP): a pension paid for by your company. Are you over 40 and paid a salary? Then it can allow bigger contributions than an RRSP. A contribution is money put into the plan. The company can deduct its contributions from its income. The money grows inside the plan without being taxed. You pay tax on the pension when it is paid out to you.
• Corporate Insured Retirement Program: this is life insurance first. Your company owns a participating whole life policy on you. This is permanent coverage, meant to last your whole life. It is a kind of corporate-owned life insurance. Cash value is money that builds up inside the policy. The cash value grows with no yearly tax. That growth is not counted as passive income.
• Shared ownership critical illness insurance: this insurance pays a benefit if you get a serious illness the policy covers. You and your company share the policy. The company owns and pays for the illness benefit. If there is a claim, the company gets that benefit tax-free. You own and pay for a return-of-premium rider. A rider is an add-on to the policy. If there is no claim, you can generally get all the premiums back tax-free.

With the insured retirement program, you can borrow against the policy in retirement. The loans are not taxed as income. But borrowing has real risks, including borrowing costs and lender terms. Lender terms are the rules a lender sets for a loan.

The insured retirement program also matters at death. When you die, the policy pays a death benefit to the company tax-free. Most of it can then reach your estate as tax-free capital dividends. Your estate is what you leave behind when you die. This works through the Capital Dividend Account. It is a special tax account. It lets the company pay out these dividends tax-free.

Which mix is right?

Most owners end up with a mix of choices. It may include some salary, some dividends and a reserve inside the company. It may also include one or two plans for long-term surplus.

The right mix depends on your age, your income and your family. It also depends on when you expect to sell your business or retire.

Not sure where you stand? That is what a 15-minute call is for. We work alongside your accountant, not instead of them. Nothing is recommended until your accountant has reviewed the numbers.