Three Tax Efficient Strategies for Managing Retained Profits
By Lyman Gardiner, CPA, CA, LPA, CBV
While most businesses have suffered a difficult or terrible 2020, there are small pockets of the economy that have enjoyed unprecedented demand and revenue. Many of the business owners who benefited from this unexpected boom in business may now find themselves in new financial territory – what to do with higher than expected profits.
There are a few different strategies a business owner can pursue if retained profits are higher than expected at the end of the fiscal year. In many instances, keeping the funds in the business makes sense.
For businesses that qualify for the Small Business Deduction, the 12.2% corporate tax rate on the first $500,000 of income in Ontario is very favourable when compared to personal tax rates. Other businesses paying the 26.5% corporate tax rate are still paying a lower tax rate compared to most personal tax rates.
Option #1 – Build Up the Balance Sheet
Business owners should consider using the extra profits in the company to build up the balance sheet and strengthen the business. Reducing the long-term risks to the company by reducing debt may prove beneficial, especially in a situation where the business is now facing an uncertain economic future. Alternatively, now might be an ideal time to build assets and inventory, especially if a strong cash position can provide advantageous purchasing power.
The end of the fiscal year may also be an ideal time to review accounts receivable to write-off any doubtful accounts and receive a tax deduction. The same approach to reducing your overall corporate tax can be taken by reviewing and moving out obsolete inventory for a tax deduction.
Option # 2 – Restructure to Creditor Proof the Profits
If the excess profits are not expected to be needed in the short-term, it may be wise to creditor proof the business by removing surplus funds from the operating company and placing it in an investment holding company. The holding company can use the funds for investment purposes. Investment income is taxed in different ways. For example, Canadian dividends are taxed more favourably than interest income. It is important to understand the tax implications of each option as part of your corporate restructuring exercise. The use of family trusts with personal and corporate beneficiaries and a variety of share classes are all tools used to optimize your corporate structure to achieve your goals. A review of the various structuring options will determine the best approach to take.
Option #3 – Withdraw Profits in a Tax Efficient Manner
There are several tax efficient strategies to consider if the shareholders would prefer to increase their annual withdrawal from the business. Using the surplus profits to maximize RRSP contributions can help owners and shareholders avoid paying higher level tax on the income. If the unexpectedly busy year resulted in family members playing a more active role in the business, there may be an opportunity to direct retained profits to them by way of salary or dividends. Both wage and dividend payments require documentation of the shareholder’s working hours and arrangements. When paying a family member using dividends, it is important to review the Tax on Split Income (TOSI) rules.
Before diving into one of these options, it is important to take some time to reflect on the drivers of the strong financial performance and to try and anticipate how the business will perform in the coming years. For example, if profits seem high, but inventory levels have been decreased significantly, it may provide an inaccurate picture of overall financial performance. If the coming months or years look rocky, then strengthening the balance sheet and retaining funds directly in the operating company may be the best long-term use of this year’s bumper proceeds. You should also consider the uncertainties in the near future that can impact your business and what the effects of another potential shut-down or major slow-down might be before allocating this excess cash towards debt or inventory.
The accounting and tax advisors at GGFL help business owners identify their opportunities and manage their business and personal finances in a tax efficient manner. Please contact us to discuss how you can most effectively make use of your retained profits.