What Should You Do With Retained Earnings in a Professional Corporation?

As a professional corporation becomes more established, there may come a point when the business is generating more capital than is required for current expenses, taxes and near-term operating needs. That can create a good problem to have — and a new set of financial planning decisions.

Should excess capital remain inside the corporation? Should some be invested? Should funds be withdrawn personally through salary or dividends? Should personal registered accounts, debt reduction, insurance or longer-term retirement planning enter the conversation?

There is no single answer. The right strategy depends on what the corporation needs today, what you may need personally, how long the money can remain invested and what role those assets are ultimately expected to play.

Retained Earnings Are Not the Same as Cash in the Bank

Retained earnings are an accounting measure representing profits that have remained in the corporation over time. They do not necessarily equal the amount of cash that is immediately available to invest.

Before making long-term investment or planning decisions, it is important to understand the corporation’s actual liquidity — including upcoming taxes, operating expenses, debt obligations, business investments and an appropriate cash reserve.

Once those shorter-term requirements are accounted for, the remaining capital can be considered within a broader corporate and personal wealth strategy.

Start With the Needs of the Business

Before excess corporate capital is invested or committed to a longer-term strategy, the corporation should have enough liquidity to support its ongoing obligations.

That may include income taxes, payroll, professional expenses, debt payments, equipment purchases, future business investments and an appropriate operating reserve. The right amount will vary depending on the stability of the business, upcoming commitments and how predictable future cash flow is.

Capital that may be required in the near term generally has a different job than money that can remain invested for many years. Separating those two pools is an important first step.

Decide What the Corporation Needs — and What You Need Personally

One of the central planning considerations is timing. Leaving funds inside a corporation may defer personal tax because the money has not yet been withdrawn personally. RRSP contributions may also defer tax because a deduction is available today and tax is generally paid when funds are withdrawn later.

In both cases, the question is not simply, “Which option saves more tax today?” The more useful question is whether the structure provides the right combination of tax efficiency, flexibility and long-term usefulness for your goals.

Corporate Investing Can Put Excess Capital to Work

When capital is not required for business operations or near-term personal needs, investing inside the corporation may become part of the strategy.

A corporate investment portfolio can provide long-term growth potential and allow capital to remain within the corporate structure rather than being withdrawn immediately. The portfolio should still be designed around its purpose, time horizon, liquidity requirements and overall risk tolerance.

Corporate investments should also be coordinated with personal investments rather than treated as an entirely separate financial world. Asset allocation, diversification and future retirement income needs can often be considered more effectively across the entire financial picture.

Passive Investment Income Can Affect the Small Business Deduction

This is where accumulating corporate investments can introduce another planning consideration.

Under the current federal rules, the business limit of a Canadian-controlled private corporation can begin to be reduced when the combined adjusted aggregate investment income of the corporation and associated corporations exceeds $50,000. The federal business limit is fully eliminated once that amount exceeds $150,000.

That does not mean a corporation should avoid investing simply because passive income may eventually affect its small-business limit. It means the impact should be understood before a growing investment portfolio becomes large enough to influence the corporation’s tax position.

The calculation can be more complicated when associated corporations are involved, and provincial tax treatment may differ, so this is an area where financial planning and accounting advice should work together.  CRA — Passive income business limit reduction

Personal Registered Accounts Still Matter

Having substantial retained earnings does not make personal registered accounts irrelevant.

RRSPs and TFSAs can still play important roles in a broader wealth strategy. RRSP contributions may provide a personal tax deduction and allow investments to grow tax-deferred, while TFSAs can provide tax-free growth and flexible access to capital.

The question is not necessarily whether corporate investing is better than registered investing. Different accounts offer different advantages, and the most effective strategy may use several of them simultaneously.

This is why decisions about salary, dividends, RRSP contributions, TFSAs and corporate investing are often best considered together rather than one account at a time. CRA — How contributions affect your RRSP deduction limit

Debt Reduction and Near-Term Goals Deserve a Place in the Conversation

Investing is not automatically the best use of every available dollar.

Depending on interest rates, personal borrowing, corporate debt and upcoming financial goals, paying down debt or creating additional liquidity may provide more value than immediately adding to an investment portfolio.

Major personal goals can also influence the decision. A home purchase, education funding, family commitments or a future business transition may require capital outside the corporation.

Good planning considers the next several years as well as the next several decades.

Insurance Can Become Part of Long-Term Corporate Planning

As retained earnings and corporate wealth grow, insurance may also become relevant to the planning conversation.

Corporate-owned life insurance can sometimes be used to address estate liquidity, business obligations, succession planning and longer-term wealth-transfer objectives. Where a private corporation receives qualifying life-insurance proceeds following death, the net proceeds may contribute to the corporation’s capital dividend account, which can potentially support the payment of capital dividends to Canadian-resident shareholders.

That does not mean insurance should replace a diversified investment portfolio or ordinary business liquidity. Its role should be determined by the risk being addressed and the long-term objectives of the corporation and its shareholders.

This is a topic we’ll explore separately because permanent insurance, corporate ownership and more advanced strategies deserve their own discussion. CRA — Capital dividend accounts

Think About the Retirement Endgame Before You Get There

For many incorporated professionals, the corporation eventually becomes an important part of the retirement plan.

By that point, wealth may be spread across corporate investments, RRSPs, TFSAs, personal non-registered accounts and potentially insurance assets. Each source can have different tax characteristics and different roles in producing retirement income.

The accumulation decisions being made today can therefore affect future withdrawal flexibility.

Thinking ahead does not require knowing exactly what retirement will look like twenty years from now. It simply means recognizing that corporate capital being accumulated today will eventually need a purpose.

Questions Worth Asking

Before deciding what to do with growing retained earnings, it may help to consider:

• How much liquidity does the corporation need for taxes, expenses and unexpected opportunities?
• How much capital can realistically remain invested for five, ten or more years?
• How much income do you need personally?
• Would additional salary create useful RRSP contribution room?
• Are RRSP and TFSA opportunities already being used?
• How large is the corporate investment portfolio becoming?
• Is passive investment income beginning to affect the corporation’s small-business limit?
• Are there personal or corporate debts that should be addressed first?
• What role could corporate assets eventually play in retirement?
• Are estate, succession or insurance needs becoming more important as wealth grows?

The Bottom Line

Accumulating retained earnings is a sign that a professional corporation has reached an important stage of financial development.

The challenge is no longer simply generating income. It is deciding how that capital should be deployed.

Some funds may need to remain liquid. Some may be withdrawn personally. Some may belong in registered accounts. Some may be invested corporately. And as wealth grows, retirement, insurance and estate considerations may become increasingly important.

The objective is not to find one perfect destination for every dollar.

It is to build a coordinated strategy in which corporate capital and personal wealth work toward the same long-term goals.

Ready to Put Your Corporate Capital to Work?

If retained earnings are accumulating inside your corporation and you are beginning to wonder what should happen next, Delta Creek can help you coordinate corporate investments, personal savings, retirement planning and insurance around one broader financial strategy.

This article is provided for general information only and should not be considered tax, legal or accounting advice. Individual circumstances vary. Tax and corporate planning decisions should be reviewed with the appropriate professional advisors.