The Cash Cushion That Raised His Tax Rate

A business owner, a pile of savings inside his company, and the year-end review that showed what it was costing. 

AT A GLANCE 

The clients: Raymond, 57, and Cheryl, 55, who built a food distribution company with 41 employees over 26 years 

The gap: $2.7M of savings invested inside the company, which pushed passive income to $112,000 and cut next year's low tax rate to $190,000 of profit 

The fix: year-end loss harvesting, a $900,000 working reserve, and the $1.8M surplus moved into corporate-owned insurance over about six years, subject to insurability, policy costs, and a long-term funding commitment. A holding company would not have worked 

The illustrated result: passive income fell below the $50,000 threshold and the low tax rate applied to the full $500,000 of profit the following year, an estimated $37,000 less corporate tax for that year in this hypothetical scenario. Future results depend on passive income levels, tax rules, and the owners' circumstances, and savings may vary 

The team: their accounting team and a wealth team, working from one plan 

A lot of business owners keep extra cash inside the company because it is taxed at a lower rate there. That is usually sensible, right up until the investments start raising the tax on everything else. The people and numbers below are illustrative, but the situation is one we see often. 

The figures show how the rules could apply in one hypothetical case. They are not a prediction of results for any other company. 

Raymond, 57, and Cheryl, 55, have run a food distribution company for 26 years. It supplies restaurants and care homes across Alberta, has 41 employees, and brings in about $12.4 million a year. For most of those years Raymond left the profits in the company and called it the safety net. Over time the safety net grew into a $2.7 million investment portfolio held inside the operating company. They joined their accounting firm in the spring, after their previous accountant retired. 

THE GAP 

At their November year-end review, their new accounting firm brought them together with a wealth team it works with directly. The two teams found the problem together and showed Raymond and Cheryl what it was: $112,000 of investment income for the year. Alberta companies pay about 11 percent tax on their first $500,000 of profit.

That low rate starts to shrink once investment income passes $50,000, and the amount is based on the year before. At $112,000, next year's low rate would apply to only $190,000 of profit. The rest would be taxed at 23 percent, an estimated $37,000 more for that year in this illustration. Raymond's first question was whether a holding company would solve it. It would not.

Companies owned by the same people share one limit and their investment income is added together, so money in a holding company counts too. 

“I thought those investments were helping the company. Nobody had told me they were raising its tax rate.”  — Raymond (illustrative) 

WHAT CHANGED 

• Their new accounting firm brought them together with a wealth team it works with directly, so both teams looked at the same numbers at the same meeting 
• They tested the holding company idea and set it aside, because companies owned by the same people share one limit 
• The wealth team worked out that the company needed about $900,000 of the $2.7 million it was holding, which left $1.8 million of surplus 
• Before December 31, they sold some positions already at a loss to offset part of the year's gains, which cut the estimated extra tax for the next year from about $37,000 to about $22,000 
• The $1.8 million surplus is planned to move into a corporate-owned permanent life insurance policy over about six years, subject to Raymond and Cheryl being insurable. Growth inside a policy that meets the exempt test generally does not count toward the $50,000 line, but the policy comes with premiums, costs, and a long-term funding commitment 
• The rest of the portfolio was repositioned to produce less taxable income, with the changes staged so selling did not push the number back up 

WHAT TO WEIGH BEFORE USING INSURANCE 

Corporate-owned permanent life insurance is not the right fit for every company, and it was one part of a broader plan here. Before choosing it, owners should weigh: 

• Cost: premiums and policy charges reduce the amount that would otherwise stay invested in the company. 
• Long-term commitment: this plan relies on deposits of about $300,000 a year for about six years. Reducing or stopping deposits can change the outcome. 
• Insurability: coverage depends on medical and financial underwriting. A policy may cost more than expected or may not be available. 
• Surrender charges and access: surrender charges may apply, and access to the policy's cash value is limited in the early years. 
• Policy performance: cash value growth depends on how the policy performs and on its terms, and may be lower than illustrated. 
• Exempt-test limits: tax rules cap how much can be deposited while the policy keeps its exempt status, which limits how much surplus can move into it and how quickly. 

A licensed insurance advisor should review whether a policy fits the company and the family before any decision is made. 

THE OUTCOME 

The reduced limit still applied for the first year, because it is set by the prior year's passive income, but in this scenario the year-end moves were estimated to cut that year's extra tax from about $37,000 to about $22,000. 

By the end of that first year, passive income was about $46,000, below the $50,000 threshold, so the full $500,000 small business deduction applied the year after. In this illustration, that is an estimated $37,000 less corporate tax for that year on the profits the company keeps. The figure is specific to this hypothetical scenario; actual savings may be higher or lower and can change from year to year. 

Staying under the threshold is not automatic. It depends on future investment returns, how the company grows, changes to tax rules, and the owners' circumstances, so the plan is reviewed every year. 

Cheryl, who had wondered for years whether they were doing this right, now gets a one-page summary every quarter. 

Life insurance proceeds received by a corporation are generally not taxed, and part of them may be paid to the family as capital dividends through the company's capital dividend account. How much can be paid that way depends on the policy's adjusted cost basis at the time and on the tax rules then in effect, so the treatment should be confirmed with a licensed advisor and the family's CPA. 

THE TAKEAWAY 

Money kept inside a company usually does a good job for its owner. It is worth checking once a year that the investments have not started working against the company that holds them, and the obvious fix is not always the one that works. Every option also has costs and trade-offs worth understanding before deciding. It helps when your accountant and your wealth team are looking at the same page. 

Get your accountant and your advisor at the same table 

If your company holds investments, this is a good time to see what they are doing to your tax rate, while there is no deadline.

Important information: This case study is an illustrative scenario prepared for educational purposes only. It does not depict a real client or engagement, and all names, figures, and outcomes shown are hypothetical. Nothing in this piece is tax, legal, accounting, insurance, or investment advice. Tax rules change and outcomes depend on individual circumstances. Please speak with your own qualified advisors. 

Tax savings shown are estimates for this hypothetical scenario only and are not guaranteed; actual results depend on future passive income, tax rules, and individual circumstances. Life insurance involves premiums and costs, underwriting, and a long-term funding commitment, and the tax treatment of policy proceeds depends on factors such as the policy's adjusted cost basis and the tax rules in effect at the time.