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So you run your own business, things have been going well, but the more your business grows, the more complex your tax issues become. One often misunderstood tax concept is the Capital Dividend Account or CDA.

Capital dividends are simply a form of dividend, which can be paid out to Canadian shareholders tax-free. The caveat is that the amount of the capital dividend must not exceed the balance in the CDA.

What is the CDA?

What exactly is the CDA then you ask? Good question. The CDA is a notional account that is calculated by you and your accountant, and can be verified with the CRA. Notional meaning that it is not a literal account that you transfer funds in and out of, but rather a cumulative calculation that simply let’s you know the amount of capital dividends your corporation can pay out.

Capital Dividend Account =

(Non – Taxable portion of Net Capital Gains)

+ (Capital Dividends from other Corporations or Trusts)

+ (Proceeds of Corporate Owned Life Insurance less the Adjusted Cost Basis)

– (Capital Dividends paid)

The equation above shows the general calculation of the CDA, though the infographic below is likely an easier way to process the information. In words though, 50% of capital gains are added to the CDA, however it’s important to note that 50% of capital losses are subtracted from the CDA as well. Proceeds from life insurance received by the corporation as the named beneficiary are also added to the CDA less the adjusted cost basis (ACB) of the policy. Capital dividends received from other corporations or trusts are also added to the CDA. And of course, any capital dividends declared are subtracted from the balance.

Using the CDA to Your Advantage

Understanding the CDA can be very beneficial, especially when setting up a buy-sell agreement between you and your other shareholders, and when considering funding such agreements with corporate-owned life insurance policies. There are many advantages to having corporate versus personally owned life insurance, only one of which is to use the funds to purchase shares upon the death of a shareholder. The life insurance proceeds net of ACB are added to the CDA and can be paid out tax-free to the estate of the deceased shareholder in exchange for their shares of the corporation.

You can find out more about the benefits of corporate-owned insurance here.

Timing is Important

It’s also important to be aware of the potential pitfalls inherent in the CDA. Timing of the realization of capital losses and the payment of capital dividends is important. The overpayment of a capital dividend can result in steep tax penalties but can be avoided through careful tax planning. You should consult your tax advisors before deciding to pay a capital dividend.

Learning how to calculate and use your CDA can save your corporation a lot of money, and help you plan to ensure it will prosper long after you’re gone. A little careful planning today, can save a lot of heartache tomorrow.

You’ve built your business from the ground up and have worked hard to ensure its success. Now that your business is growing, isn’t it a good idea to protect it in case of a shareholder’s unexpected illness or death?

Watch this video to see how a shareholders’ agreement can help protect your business.

In previous articles, we’ve discussed corporate-owned insurance and how it can benefit your business. As a whole, life insurance, especially in the corporate sense, is a valuable asset and in the right circumstances, there are many benefits to owning it. However, like anything else in life, there are a few caveats to consider.

Beneficiary

Make sure to select the right beneficiary! Remember that you’re using corporate dollars to fund this corporate “asset” so if the corporation owns the policy (asset), pays for the policy (again, asset) but you designate you or your spouse as the beneficiary, then the Canada Revenue Agency (CRA) would assess a taxable shareholder benefit, which is not a good thing! So, what is a taxable shareholder benefit? Essentially, it is a fair market value benefit assessed from using a corporate owned asset for personal use without paying for the benefit. 

Creditor Protection

Corporate-owned insurance can achieve many objectives but can leave your policy vulnerable to the company’s creditors. To minimize this risk, additional planning is required and includes having another company own the policy and the operating company designated as the beneficiary. However, this more complicated structure might not be suitable for your circumstances. In this case, personally owned life insurance inherently provides the creditor protection that you may require.

Secure Planning

Purchasing corporate-owned life insurance can sometimes get complicated. Working with an experienced Advisor will provide you with the knowledge and expertise required to properly structure your plan. Your Advisor will be able to help you make informed decisions on questions such as: Does my shareholder agreement accurately reflect the insurance strategy implemented? How can I leverage the policy to create tax-free income in retirement? Will corporate owned insurance affect my ability to claim the qualified small business corporation exemption? Upon death, will the funds flow appropriately to achieve my estate planning objectives?

The Big Picture

It’s always good to know the big picture and when it comes to corporate life insurance, it’s important to know if there are plans to sell the corporation in the future. If so, keep in mind that when the policy is transferred to a shareholder from the corporation, a disposition will occur which can result in a tax liability to the corporation.

For more about this topic, please refer to this article: How Corporate Insurance Can Benefit your Business