Just as your ambitions are uniquely your own, so too is your tax situation: No single tax strategy will fit all scenarios. Instead, your tax obligations may require a personalized guiding plan with annual tinkering and consultations with tax advisors as your wealth accumulates or your business evolves.
“Tax management can be important, particularly if you have worked hard to build up a business or a career. You want to be able to enjoy what you have earned and protect it,” says Geoff Chen, a High Net Worth Planner with TD Wealth who works with wealthy families and business owners to help optimize their financial plans. He says tax planning is a subset of financial and business planning and not the other way around. “If you structure your life and corporation around tax issues, you may lose sight of your ultimate goals.”
The first area executives or business owners should look to maximize, is their contributions to registered accounts, says Chen. That would include Registered Retirement Savings Plans (RRSPs), Registered Educational Savings Plans (RESPs) and Tax-Free Savings Accounts (TFSAs), assuming you qualify. These plans are the starting point since contributing can help mitigate tax exposure in various ways.
As well, Chen says most high net worth individuals should also consider utilizing RRSPs another way: income splitting through the use of spousal RRSPs which can potentially lower the couple’s overall taxes. This is useful where one spouse is in a higher tax bracket and the situation is expected to continue at retirement.
“Everyone should consider making contributions to their favorite registered charities which can provide you with tax credits,” says Chen.
There may be other strategies that can bring about a tax benefit that high net worth Canadians can employ to preserve their financial well-being. “Once these primary tax considerations are implemented, individuals may still wish to manage the tax implications of their wealth.”
We talked to Chen who offered the following tax strategies for individuals who may have more complex situations and significant wealth. Read on to see if these may apply to you.
Who might consider this? A sole proprietor or someone starting a new business.
Owning an incorporated business can allow you to keep funds within the company structure where there is preferential tax treatment. The most obvious example is that the tax rate for small businesses is considerably less than the personal tax rate for individuals. This may provide certain tax deferral opportunities and, depending on the nature of the business, a significant lifetime capital gains exemption may be available when the business is eventually disposed of.
If you privately hold real estate in the U.S., here’s something to consider: If it’s valued at more than US$60,000 and your worldwide assets exceed US$11.7 million as of 2021, then you may be subject to U.S. estate tax.1 However, Chen says holding U.S. real estate through the corporation may be an effective strategy to mitigate U.S. estate tax concerns.
“With limited liability, incorporating your business also helps prevent the owner from risking their private wealth if the business is sued or fails,” Chen says.
Business people and entrepreneurs should be aware of the legal and accounting charges that are associated with setting up a corporation: Shareholder agreements, articles of incorporation, annual financial statements and reports and filing tax returns are just some of the costs involved.
Prescribed rate loans
Who might consider this? High income family members with surplus funds.
Similar to income splitting, this strategy may lower the overall tax obligation for a family and may be suitable for higher income families with liquid assets. Briefly, it involves a higher income family member loaning a lower income member funds at the government prescribed rate of interest. The recipient can invest the money and earn income after interest is paid. In this way, taxable income may be shifted from an individual in a higher tax bracket to a lower tax bracket so that the overall tax impact may be less. The rate of the prescribed loan fluctuates, which is why this strategy may make most sense when the rate is low and the investment returns can help justify the cost of the arrangement, says Chen. Unlike pension income splitting and spousal RRSPs, you can make a prescribed rate loan to a minor child as well as a spouse.
Chen points out some other things to consider: For instance, the loan must be documented, and interest must be paid annually on or before the following January 30 each year or attribution rules kick in. For the plan to be effective, investment gains should be sufficient to offset the interest paid plus any expenses involved in structuring the loan. And because this strategy involves investments in the market, it comes with a certain amount of risk and should be done with the assistance of a financial professional.
Who might consider this? Families who are sharing wealth and in need of tax and estate planning.
Chen says the tax benefits of a trust are the potential abilities to distribute wealth to family members and to lower the overall tax exposure of the family. A trust is a legal relationship between the person who sets up the trust (the settlor), the person who manages the assets in the trust (the trustee) and the individuals who benefit directly — the beneficiaries of the trust. For Canadian income tax purposes, it’s regarded as a separate taxpayer. It can also be used to mitigate taxes in connection with claiming multiple lifetime capital gains exemptions.
“The trustees have flexibility to make decisions based on business conditions, impending tax events or the needs of the family,” says Chen. “They have the discretion on when and how to make distributions to family members in a tax-efficient manner or whether to make any distributions at all in a given year. Due to business conditions, some years it may not be appropriate to make large payments at all.”
Chen says family trusts can offer other benefits: A trust may protect family wealth from spousal or creditor claims and minimize probate fees. One thing to keep in mind is that every 21 years from the date of the creation of the trust, it is deemed to have disposed of its assets at fair market value. Further tax planning may be necessary as that date approaches.
Who might consider this? Anyone who wants to make a sizable contribution or become more involved with their favourite charity.
The tax benefits of eligible charitable donations are available to all Canadians and you may earn tax credits which can lower the amount of tax you owe. Donations may be claimed in the year that they are made or carried forward for the next five years.
One charitable option available to high net worth individuals is a Donor Advised Fund. A Donor Advised Fund is a type of charitable giving vehicle that is created when a donor makes a contribution to a registered charitable foundation. The foundation in turn can gift all or part of the donation over to qualified donees (the receivers of the gifts), which can include any of the 86,000 registered charities in Canada. The donor is able to make recommendations to the fund concerning distributions of assets.
The individual making the donation — the donor-advisor — can set up their donor advised account and will receive the donation tax receipt up-front. The Private Giving Foundation, available through TD, has a minimum donation of $10,000 to get started (other foundations may vary), and a minimum subsequent donation of $1,000. The fund can provide flexibility if you are initially unsure which charity to donate to as there is no obligation to give immediately to a specific charity. In the meantime, you can continue to contribute to the fund and this money can continue to grow tax free.
As well as a tax credit, donating certain investments in-kind can potentially eliminate the capital gains tax on eligible securities. Eligible investments include investments trading on designated stock exchanges, segregated funds, mutual funds, and government bonds. Calculating the tax benefits is complex, says Chen, and depending on your situation, donating the investments, and receiving a tax credit may be more beneficial than selling the investments and facing capital gains.
Individual pension plans
Who might consider this? Executives with high incomes and small business owners.
High income earners may find at some point in their career that limiting their retirement plan to RRSPs may not be sufficient for their retirement objectives. An alternative solution, says Chen, is an Individual Pension Plan (IPP), a registered and defined benefit pension plan that a company can structure for its executives. A small business owner may also benefit from an IPP, although to qualify they must pay themselves a salary and meet certain other conditions.
An IPP can create more contribution room compared to an RRSP, and contribution room can rise significantly until age 65, says Chen, adding “the plans are based on the age and years of service of the recipient and usually become advantageous when the subscribers are in their middle 40s,” says Chen.
Whichever tax measure you embark on, Chen recommends not doing it alone and getting the best advice available from your advisor or tax professional before you make a move. That’s because tax legislation may be amended, business environments change, families grow, income sources evolve, and often unexpected problems occur. A plan that looks correct from a strictly financial point of view may not be what your personal situation needs.
“There are expenses involved with meeting experts in taxation, accountancy and finance. Working out a dedicated plan for your situation can be time-consuming,” Chen says. “But you may get the best result and have a much better outlook on your whole situation and not just your taxes.”
- Note that there are U.S. tax proposals to reduce this threshold to US$5.85 million. ↩