As an owner-manager, how do you determine if you are holding surplus cash in your Canadian private corporation? And what should you do with it if you are?
How much after-tax cash should your company keep in reserve?
This is a question posed by many business owners. Odds are if you’re thinking about it, you are probably sitting on too much and wondering if it could be put to better use.
Some business owners may have a specific fixed number in mind. Some may hold an amount equivalent to the next three or six months of projected expenses. We recommend looking at your working capital, consider whether that number is growing or shrinking, and then consider your monthly operating expenses.
Working capital represents the difference between a company’s current assets and current liabilities—with “current” usually referring to within the next calendar year. Working capital reflects the net assets available to run a business and also provides an excellent snapshot of your company’s liquidity and short-term financial health.
If your annual working capital is growing, and exceeds your operating expenses over a three-month period, you are likely sitting on too much cash.
What should you do with surplus cash in your corporation?
There are several issues to consider if your company is fortunate enough to have surplus cash beyond its forecasted needs. Where is there the most need for the money? What options are available? And what are the tax implications of those options? Is there a business or personal need for the cash in the short to medium-term? If not, is there a longer-term use for the cash to help you retire debt, save for retirement, or achieve a savings goal?
Here are some options to consider if you are an owner-manager and have surplus cash accumulating in your Canadian-controlled private corporation (CCPC):
Is there is a business need for the funds in the short to medium-term?
Will your company require the surplus cash in the short-term to pay corporate tax or HST instalments or make a major purchase? Do you anticipate a low cash-flow period? Are you building inventories heading into your peak season? If there is no immediate business need, you may want to consider investing the excess funds within your corporation. The investment income generated from the surplus cash may be considered incidental to your business and taxed as active business income (ABI), since the cash is required for a business purpose. A more disciplined approach to saving and investing in a corporation will have different corporate tax rates apply.
Because there is a significant tax deferral associated with leaving after-tax corporate income inside your corporation, this may be an attractive option.
On the other hand, when funds invested in the business represent after-tax profits beyond what is required to operate the business, the resulting investment income will usually be considered passive income. Not only is passive income taxed at a higher rate, too much passive income can reduce—or eliminate—the small business deduction (SBD) that your CCPC may otherwise be entitled to.
Note: a portion of the tax paid on passive income is refundable to the corporation when taxable dividends are paid out to the shareholders.
Either way, if you think you may need the cash for the business in the medium-term, ensure that any investments can be easily liquidated when the time comes.
If there is no immediate business need for the surplus cash within your corporation, do you have a short to medium-term personal need for the funds? If so, the next step is to determine the best way to withdraw the money, taking the tax implications of the various options into account. Some methods of withdrawing cash from your company are taxable, but some could be tax-free.
A salary or bonus paid to you by your corporation
Salary or bonus income is generally taxed as income at your marginal tax rate. It is typically considered a deductible expense and will lower your corporation’s taxable income.
Your level of corporate income will often influence whether your company should pay you a salary or bonus. It may make more sense for your company to pay you a salary or bonus if it is paying tax at the high general corporate tax rate as opposed to the small business rate. This allows your company to get a deduction from its income at a higher corporate rate.
Note: If you are considering paying yourself a salary or bonus from your holding company, we recommend that you consult with a professional tax advisor to determine if doing so makes sense in your situation.
Paying a taxable dividend
A dividend payment is not a deductible expense for your corporation, since dividends are paid out of after-tax retained earnings. However, when your company pays you a taxable dividend, it may receive a dividend refund for a portion of the taxable dividends it pays if the corporation has earned passive investment income.
Eligible dividends are dividends paid out from high-rate active business income (ABI) and ineligible dividends are paid out from passive investment income that was earned in the corporation. Although you pay tax on a taxable dividend at your marginal tax rate, eligible dividends are taxed at a lower rate than non-eligible dividends at the personal tax level.
Paying a capital dividend
A tax-free capital dividend can be paid to your company’s shareholders when there is a positive balance in the Capital Dividend Account (CDA). A company can generate a CDA by reporting capital gains in the corporation.
Reducing paid-up capital (PUC)
In some situation, your company may be able to return PUC to you tax-free as a return of capital.
Repaying loans to shareholders
When your corporation repays a loan to you, the repayment is not taxable.
Retirement and estate planning needs
If there is no short to medium-term business or personal need for the cash, you should consider your long-term retirement and estate planning objectives.
Once you have defined your long-term goals and objectives, there are several options for how you can use the surplus cash in your company to boost your retirement income, enhance the value of your estate, or both. Here are a few:
Consider deferring the payment of dividends until your retirement, when you may be taxed at a lower personal rate.
Individual pension plan (IPP)
Your corporation can set up an IPP for you. Contributions made to an IPP are deductible from your corporation’s income and grow tax-sheltered until you withdraw them in retirement when they are taxed at a lower marginal tax rate. We look at the IPP as a super-charged RRSP.
Retirement Compensation Arrangement (RCA)
Your corporation may deposit funds into an RCA, which is a trust arrangement that will provide you with supplemental pension benefits and distribute the funds to you on your retirement.
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There is no ‘one size fits all’ answer to the question of what to do with surplus cash in your Canadian private corporation. The answer will depend on your specific situation and your personal and business needs. Our dedicated team is here to support you. Please call us at 905-821-9215 or email us at firstname.lastname@example.org if you have any questions or require any assistance.