Corporate Asset Transfer - Unlocking Your Capital Surplus
Having a successful business in Canada can sometimes be a double-edged sword. On one hand, revenues, incomes and retained capital are high or significant, but on the other hand, being able to access that capital can be challenging, especially from a tax perspective. While many business owners my decide to invest some of that excess capital into investments such as stocks, bonds, mutual funds or real estate, any growth or distributions are taxed fairly heavily and can even erode the small business deduction. The situation becomes even more complex when looking for a tax-efficient way to get the excess capital that’s retained in the corporation, into the hands of your heirs. Upon death, there is also taxation of these investments, either in the form of capital gains or taxable dividends upon the distribution of these assets, which would erode the amount that would be left for the estate/shareholders. on top of that, the business may have to pay capital gains, based off the Fair Market Value (FMV) of the business.
The challenge most business owners face is, how to move the surplus capital in the corporation from a ‘taxable’ to a ‘low’ or ‘non-taxable’ basis. So, what’s the solution?
The Corporate Asset Transfer Strategy
The Corporate Asset Transfer Strategy uses corporately-owned life insurance to create a tax-free inheritance. The Corporation redirects a portion of its after-tax surplus into a permanent life insurance policy, thereby moving the excess surplus out of the corporation in a very tax-efficient manner. The Corporation becomes the owner, payor and beneficiary of the policy, which allows this strategy to work.
In essence, the Corporate Asset Transfer strategy is a tax-efficient strategy that allows business owners to transfer excess capital to their heirs with paying little or no taxes. This strategy focuses on leveraging tax laws to transfer the assets ‘trapped’ in the business in a way that reduces the overall tax burden, while maximizing the benefit for the estate. The strategy has multiple benefits, such as:
Reducing the fair market value (FMV) of the corporation’s assets: this would reduce the capital gains/future taxable income that would be payable upon sale of the business or death of the owner.
Increasing the Value of the Estate: The estate would get an immediate boost (by 6 or 7 figures, or more), with the potential of growing year over year.
Tax-Free Payout: Upon death of the business owner, the proceeds are paid tax-free to the corporation. Any amounts in excess of the Adjusted Cost Basis (ACB) are paid from the corporation to the beneficiary (whether shareholders or the estate) tax-free through the Capital Dividend Account of the corporation.
Tax-Efficient use of Capital: As business income is taxed at a lower rate than personal income, using the surplus ‘trapped’ capital from the business to pay the premiums is a much more efficient way to fund the policy. This also allows for personal income to be used for other things, such as paying down debt.
No Effect on Small Business Deduction: In Canada, the Small Business Deduction (SBD) gets reduced by any passive income you have from the corporation. Investing through the corporation can create passive income for the corporation, thus potentially reducing the SBD. The SBD will be reduced by $5 for every $1 of investment income above a $50,000 threshold. Under this formula, the SBD will be eliminated when investment income reaches $150,000 in a given taxation year.
What is a Capital Dividend Account?
The capital dividend account (CDA) is a notional account that keeps track of the tax-free amounts accumulated by a private corporation. The CDA appears on a company’s financial statement. Business owners can use the CDA to pay out tax-free income to its shareholders as a capital dividend.
Let’s look at an example of a client scenario and how the numbers work.
Client Scenario:
Client is 55 year-old male and owns a successful and profitable business
Has significant surplus capital built year over year and wants to create an inheritance for his family
He is looking for a tax-efficient strategy to get the excess capital out of his business and into the hands of his heirs
Can allocate $50,000 of the surplus over the next 10 years, for a total of $500,000
He is debating whether to invest that $50,000 through his corporation, or use the funds to pay the premium on a corporately-owned permanent life insurance policy
Tax Sheltered Cash Accumulation: Permanent Life Insurance policies have a built-in Cash Value component, that grows tax sheltered and that can be accessed later in life, if needed
Creditor Protection: If structured properly, the Permanent Life Insurance policy is protected from creditors. This is a big bonus for business owners and reduces exposure in case debtors come after your business.
*From a Canadian Life Insurance Company, based on*
Investments based on a 5% Rate of Return
Not only did the size of the Client’s estate immediately increase, there was also a reduction in their corporation’s future taxable income, since assets are transferred to the tax-exempt insurance plan. The benefit payment in excess of the adjusted cost base of the policy goes to their company’s capital dividend account, which then pays out tax-free to a shareholder or to the Jones’ estate. There would be some taxes paid on the ACB amount, but the overall tax rate based on the Net Amount to Shareholders/Estate is low. For example, if the client were to pass away at age 75, the Net Amount to Shareholders would be $1,180,073, out of a $1,318,022 death benefit. This results in a Net Tax Rate on the total death benefit being a very low 10.46%, which is significantly lower than what would be paid if the funds were withdrawn from the corporation as income.
This is on TOP of the benefit of not eroding the Small Business Deduction (SBD). If the value of the Investments within the corporation gets too high, this could cause the SBD to reduce or even be eliminated, which would raise the taxes in the entire corporation.
Having a business is stressful in itself. When you have to manage taxes, investments and surplus cashflow, it can become a little overwhelming . The Corporate Asset Transfer Strategy is a powerful tool for business owners looking to transition surplus capital out of their business in a tax-efficient way.
As with any complex business decision, careful planning and professional guidance are essential to ensure that the strategy is executed properly. Consulting with tax advisors, accountants, and legal professionals can help you navigate the intricacies of the Corporate Asset Transfer Strategy and make the most of the opportunities it offers.
Whether you’re looking to simplify your business’s future, minimize tax exposure, or maximize your estate, understanding and implementing a corporate asset transfer plan can help secure the long-term success and growth of your business.
If you’re interested in learning more about this strategy, or maybe even implementing it, reach out to us for a detailed review.