It's officially tax season. My good friend, Mark, has already filed his tax return. He owes quite a bit of tax this year – which he hasn't paid yet. "Tim, I'm not going to pay the amount to the government," he said.
"That's not a good idea, Mark. They could throw you in jail for not paying your taxes," I reminded him.
"No, I'll use the Jimmy Kimmel line of reasoning with them," Mark continued. "I'll remind them that prisons cost a lot of money. I'll tell them to keep what it would cost to incarcerate me, and we'll call it even."
Mark and I spoke for an hour about ways to pay less tax. Today, I want to look at types of income that can be tax-free. Build these into your life, and you could reduce your tax burden big-time.
- Take a non-taxable car allowance. If you use your own car for work purposes, your employer can pay you an allowance that can be tax-free if the allowance is reasonable and based on kilometres driven for work. Also, employer-provided vehicles will generally leave you worse off after taxes, owing to taxable benefits, than a tax-free allowance for using your own car.
- Borrow from your employer, not a bank. If your employer is willing to lend you money at low interest, you won't face a taxable benefit provided your employer charges the prescribed rate of interest, which is currently just 1 per cent (the rate can be revised quarterly). Loans to purchase a home are given even more flexible treatment.
- Negotiate non-taxable benefits at work. There are other benefits your employer can provide that can be tax-free. These can include the payment of certain education costs on your behalf, certain club memberships, certain employer-paid premiums to health plans, counselling, some discounts on merchandise, professional membership fees, and more. See CRA’s Income Tax Folio S2-F3-C2 online at cra.gc.ca.
- Take shareholder loan repayments. If your company owes you money, take a repayment of some or all of those dollars and you won’t face tax on the amounts. Consider creating a balance owing to you by transferring certain assets to your company in exchange for a promissory note. This could be done as part of an estate freeze, for example.
- Extract your paid-up capital. If you paid, or subscribed, for shares in your company, the amount you paid often represents your “paid-up capital” (PUC). Your PUC is sort of a cousin to your adjusted cost base (ACB). You can receive a repayment of your PUC without tax. There are certain ways to accomplish this, and the rules are complex, so visit a tax pro to talk it over.
- Pay yourself capital dividends. Your company will have something called a “capital dividend account” (CDA). If there’s a positive balance in the CDA, your company can elect to pay you tax-free dividends out of this CDA. The CDA is increased by, for example, the tax-free portion of any capital gains realized by your company, life insurance death benefits received by the company, and capital dividends received by the company.
- Focus on returns of capital for cash flow. There is no cash flow more tax-efficient than a tax-free return of your original capital that you invested. If you’ve invested outside a registered plan and are investing for capital growth, then drawing down on your investments over time will provide you with dollars that are partly a return of your original capital (your adjusted cost base – ACB), and partly capital gains.
- Make RRSP withdrawals when income is low. I don’t want to encourage tapping into your retirement savings today, but if you have a very low income in a particular year, and need some cash, you may be able to make withdrawals from your registered retirement savings plan at a low or no tax cost.
- Deduct home-office costs. If you’re self-employed (full- or part-time) and you carry on business principally from your home, you’ll be able to deduct a portion of costs such as mortgage interest, rent, property taxes, insurance, repairs, maintenance, landscaping and utilities, among other things. These costs can go a long way to offsetting income from your business, making the income very tax-efficient.
- Claim the principal-residence exemption. Investing money in your home can increase its value over time. If the value of your home continues to appreciate, these gains can be tax-free if you can claim the principal residence exemption on a sale of the home later. Keep in mind that, like other equity investments, there’s risk, and no guarantee your home will be worth more in five years than it is today.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.