A year-end review showed an owner-manager's investments were shrinking the company's low tax rate, and the obvious fix would not have worked.
AT A GLANCE
The clients: Raymond, 57, and Cheryl, 55, owners of a food distribution company with 41 employees, who joined the firm in the spring
The gap: $2.7M of investments inside the operating company, producing $112,000 of passive income and cutting next year's small business limit to $190,000
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 full $500,000 small business limit applied 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 client's circumstances, and savings may vary
The team: the firm's tax team and WealthCo's planning, investment, and risk specialists, working from one plan
If you have owner-managed clients, you probably watch the $50,000 passive income line. The harder question is what to do when a client is already over it, because the fix most people reach for does not work. The people and figures here 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 client.
Raymond, 57, and Cheryl, 55, own a food distribution company in Alberta that supplies restaurants and care homes. After 26 years it has 41 employees and about $12.4 million in revenue. Raymond always left profits in the company as a cushion, and over time the cushion grew into a $2.7 million investment portfolio held inside the operating company. They joined the firm in the spring, after their previous accountant retired.
THE GAP
At the November year-end review, the firm's managing partner brought Raymond and Cheryl together with the team at WealthCo. Between them, the two teams found the problem and could show Raymond and Cheryl exactly what it was.
The firm's tax team had run the company's adjusted aggregate investment income, or AAII, for the first time since taking on the file. It came to $112,000.
Once passive income passes $50,000, a company's small business limit shrinks by $5 for every $1 over, and the amount is based on the prior year. At $112,000, next year's limit would fall from $500,000 to $190,000. The other $310,000 of profit would be taxed at 23 percent instead of 11 percent, an estimated $37,000 in extra corporate tax for that year on money the company keeps, in this illustration.
Raymond's first question was whether a holding company would fix it. It would not. Companies under common control are associated, so they share one small business limit and their passive income is added together. Investment income in a holding company would reduce the operating company's limit just the same.
“I thought those investments were helping the company. Nobody had told me they were raising its tax rate.”
— Raymond (illustrative)
WHAT CHANGED
Introduced Raymond and Cheryl to WealthCo for the year-end review, so the tax team and the wealth team looked at the same numbers together
Tested the holding company idea and set it aside: associated companies share the limit, so moving the portfolio would not change the number
WealthCo's planning 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, WealthCo's investment team realized about $50,000 of losses on positions already under water to offset part of the year's gains, trimming passive income to $87,000 and the estimated extra tax for the next year from about $37,000 to about $22,000
WealthCo's risk team designed a corporate-owned permanent life insurance policy on Raymond and Cheryl, to be funded with the $1.8 million surplus over about six years, subject to both being insurable. Growth inside a policy that meets the exempt test generally does not count as passive income, so the policy is designed to keep that money out of the number for as long as the policy keeps its exempt status. It also brings premiums, costs, and a long-term funding commitment
WealthCo's investment team repositioned the taxable portfolio to produce less current income, funded each year's deposit from maturing holdings and low-gain positions, and staged the changes so the sales 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, you and your client 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 client's circumstances, which is why the firm now reviews the company's passive income every year at the year-end meeting. Cheryl, who had wondered for years whether they were doing this right, 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
The first fix most people reach for, a holding company, would not have worked, because associated companies share the limit and their passive income. What worked in this scenario needed a tax team that knew the rule, a risk team that could weigh what insurance would cost and how much surplus it could hold, and an investment team that could manage the timing. Any one of them alone would have left the problem in place.
If you take on an owner-manager with a portfolio inside the operating company, the calculation belongs on day one. The plan around it can belong to all of us.
Bring your owner-manager clients to the table
If you have clients with a portfolio inside the operating company, we would like to run the numbers with you. Book a call and we will walk through what a joint review with your tax team and ours could look like.
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. 