Corporate investing still wins despite new capital gains changes

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If you operate your business through a corporation, including a professional corporation, you can choose to either invest your after-tax business income within your corporation or withdraw the after-tax income, pay personal tax and then invest the remaining funds personally.

With the changes to the capital gains inclusion rate effective June 25, 2024, two-thirds of capital gains are now taxed in a corporation, whereas only one-half of the first $250,000 of annual capital gains are taxed for individuals.

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This has led many business owners and incorporated professionals to question whether it’s still worth incorporating a business or professional practice. And, for those with money in existing corporations, some have wondered whether it makes sense to pay all the money out now as dividends and begin investing personally rather than corporately, so as to take advantage of the 50 per cent inclusion rate on the first $250,000 of annual capital gains.

A new Canadian Imperial Bank of Commerce report out this week, explores whether you should consider withdrawing after-tax business income from your corporation so you can personally benefit from the lower, one-half inclusion rate on the first $250,000 of annual capital gains personally, or just leave it in the corporation and invest corporately.

To better understand this dilemma, let’s go back to the basics of corporate tax integration. After your corporation pays tax on its business income, the remaining amount can be used as starting capital for corporate investments. We’ll call that “corporate capital.”

Alternatively, your corporation could choose to distribute the after-tax amount to you as dividends and, after you pay personal tax, the remaining amount can be used as starting capital for personal investments. We’ll refer to this as “personal capital.”

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For example, let’s say Eli is a medical specialist and an Ontario resident who earns $10,000 of professional income in his professional corporation. This income is eligible for the small-business deduction, so his corporation would only pay $1,220 of combined federal and Ontario corporate tax, leaving $8,780 of corporate capital for him to invest inside his corporation.

If Eli left the $8,780 of funds in his corporation, invested in a stock that appreciated by five per cent and sold that stock after one year, there would be a capital gain of $439 before tax. This gain is taxable at the new two-thirds capital gains inclusion rate.

Once the corporation pays tax on the gain and distributes both the taxable dividend (two-thirds of the gain) and the non-taxable capital dividend (the one-third non-taxable portion of the gain) to Eli, his net cash from the capital gain, after paying personal tax, is $269.

Alternatively, Eli’s corporation could distribute the $8,780 of after-tax business income to him as non-eligible dividends. If he is in the top Ontario tax bracket, he would pay $4,190 of personal tax on those dividends and be left with $4,590 of starting capital for personal investments, which is his personal capital. Note that this personal capital ($4,590) is about half the corporate capital ($8,780) above.

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If his investment also appreciated by five per cent, after one year, Eli would have a capital gain of $230 personally, before tax. Assuming one-half of capital gains are included in his income (because his total annual capital gains personally are less than $250,000), after paying tax of $62, his net after-tax cash from the gain would only be $168.

Curiously, after one year, Eli’s $269 net after-tax cash with corporate investing is substantially higher than his net after-tax cash of $168 with personal investing. This seems counterintuitive, since two-thirds of capital gains are taxed in a corporation, but only one-half of capital gains are taxed personally.

So, how can corporate investing give Eli more after-tax cash than investing personally, when the fully integrated corporate tax rate on capital gains (38.62 per cent in Ontario) that are earned through a corporation is much higher than the personal tax rate on capital gains with one-half inclusion rate (26.77 per cent in Ontario)?

The answer lies with the starting capital. When $10,000 in small-business income is used for investment, the corporate capital of $8,780 is about 90 per cent higher than the personal capital of $4,590. This creates a huge advantage for corporate investments over personal investments because 90 per cent more investment income can be earned. Even though the tax on corporate capital gains is quite a bit higher than for personal capital gains, the extra capital gains with corporate investment outweigh the higher capital gains tax.

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If we extend the above example to 30 years, with a capital gain realized at the end of the period, Eli would have net after tax cash of $17,900 with corporate investing. That’s about 60 per cent more than the $11,200 of after-tax cash he’d end up with if he had instead been investing outside his professional corporation in a non-registered account, even with the lower capital gains inclusion rate.

Note that the calculations above assume that you always pay tax at the top marginal rate. If you don’t pay tax at the top rate or you think your tax rates may change in the future, perhaps upon retirement, the outcome may be quite different.

Similarly, the outcome may also differ if you are able to split income with family members, perhaps by paying dividends to a spouse or common-law partner once you reach age 65 (to avoid the tax on split-income rules for private corporations).

There are other factors to consider, too. For example, leaving after-tax income in your corporation may expose the funds to creditors of the business. Also, having too many investment assets could mean your corporation may not be considered to be a qualifying small-business corporation for the purpose of claiming the lifetime capital gains exemption (LCGE). That means the investments may affect your ability to claim the LCGE to eliminate tax on up to $1.25 million of capital gains when you sell shares of your corporation.

The rules and associated math are complex, so be sure to get your own tailored advice by speaking with your own financial, tax and legal advisers.

Jamie Golombek, FCPA, FCA, CFP, CLU, TEP, is the managing director, Tax & Estate Planning with CIBC Private Wealth in Toronto. [email protected].

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