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Case Study: Mark the IT Contractor

Mark is an IT contractor residing in Alberta and needs some advice about what to do with excess capital and general tax optimization.

Here is the story:

We’ve got a rental property which we decided to try and sell. We located an investor who is interested. We’ve agreed on a price of $25,000 ‘cash to mortgage’. Once we pay legal fees, cancel the management company contract, and pay for title insurance, we’ll walk away with about $23,500. Here is our tentative plan for the cash (all numbers rounded for simplicity), but this is where I’d love some feedback.

  • Credit card debt repayment $4500
  • Line of Credit repayment $9500
  • Leftover $9500

Paying off these two debts will leave us with no debt except for our principal mortgage. So, the question is, what to do with the $9500 extra?  Here are some other relevant details:

  • I work as an IT contractor, earning approximately $80,000 per year in income through my corporation. I do not earn any “employment” income.
  • Wife does not work.
  • Most of the income is dividended from our corporation to my wife and I would like to have a nest egg in place to protect against job loss, as I am not protected by EI as a contractor.
  • I have lots of RRSP contribution room from previous years as an employee, but I’m thinking this might not be the best, as I would like to keep the money accessible as an emergency fund.
  • I’m in Alberta.
  • My mortgage is approx $260,000 with a 35 yr amortization at 3.89%, 5 year term started in August. Regular payment is $267 weekly, currently we’re paying $325 weekly, with plans to increase that amount to the $400 a week range once the other debt is repayed.
  • $11,000 in RRSP account.
  • We have 2 kids under 3 and are planning to have at least 1 more, maybe 2 more, in the next 5 years.

As far as goals, we want to have enough money to enjoy life, take the odd vacation, and be able to retire comfortably (not expecting to be wealthy, although of course that would be nice.

Right now of the approx $1,600 per week I earn, we save $300 for taxes, $75 for healthcare (since I have no benefits).  The rest of the expenses are; $150-$300 goes to debt repayment,  groceries, utilities, property taxes, and all the rest ($4,500/mo total).

So the question is, what to do with the $9,500 windfall?  Before we get to that, lets take a step back.

Lets start with the rental property.  Typically speaking, selling a rental property for a profit would result in capital gains tax.  That is, 50% of the profit would be added to income and taxed accordingly.  But Mark’s situation is a bit unique where they have no T4 income to report as Mark is a contractor with his own corp, and his wife is a stay at home mom with no other income.  If we were to assume that the profit was split evenly between spouses, it would result in about $6,000 in income for the year (each).  Depending on how much is “dividended” out from the corp to the wife, it will most likely result in very little tax to be paid.

If they were to pay out all of the corporate income in the form of dividends, they would report $6,000 income each, along with $33,800 each ($80k after tax and assumed split in two) in dividends from the Canadian Controlled Private Corporation (CCPC), which would result in $4,700 family income tax.  The $4,700 family income tax is about $2,300 more than if they never sold the rental property.  Having said that, the $9,500 windfall is now $7,200 after tax.  Alternatively, they could reduce the payout from the CCPC equal to the amount that they will receive from the sale of the rental, which will result in about $200 tax payable on the rental.

Another tax issue that Mark might want to consider is paying himself a salary instead of dividends only.  Why?  Paying himself a salary will enable him to make CPP contributions along with build his RRSP contribution room.  Even though he would pay more tax personally, the corporation would get a tax deduction which generally evens things out in the big picture.

I’d also like to say that it’s generally a very good move to pay off consumer debt first.  Not only does it release the burden of those monthly payments, it offers a psychological and financial confidence boost.

Options

So lets go through some options on the windfall amount assuming all consumer debt has been paid off with the old payments going towards the mortgage:

  1. RRSP – An RRSP contribution is an option, but in this situation, it’s perhaps not the most efficient choice.  I would avoid RRSP contributions as both Mark and his wife are in low tax brackets due to their corporate structure.  In addition, it’s not as liquid as other options should they need the cash.
  2. Emergeny Fund TFSA – With 2010 here, people 18 and older now are permitted to contribute $10,000 to their TFSA.  With very little savings, a single income and 2 young children, I would highly recommend an emergency fund that can cover expenses should the need arise.  $7,200 is definitely a good start.  With the TFSA providing a tax shelter, it’s the first place that comes to mind.  Even though rates are low right now, he would want to have the cash easily accessible, like in a cashable GIC or a high interest rate account.
  3. Corporate Account – As I mentioned above, instead of withdrawing everything out of the corporation, they could withdraw less and use the capital gains from the rental sale to cover regular expenses, thus get taxed less in the current tax year.  This would result in keeping the cash amount within the corporation until it is needed or withdrawn in a more tax efficient manner.  Note though that interest earned within a CCPC is taxed at the highest possible corporate rate which is close to 50% in most provinces.
  4. Mortgage Paydown – To continue paying off debt, Mark could put the $7200 towards his $260,000 mortgage balance.  Although this option provides a guaranteed return higher than a savings account, it doesn’t provide his family with any liquidity.  The liquidity problem could be solved by obtaining a HELOC (providing he has enough equity) and using that if an emergency arises.

Conclusion

Personally, because of the financial scenario, I would use the rental sale windfall as an emergency fund.   There are a couple options for the emergency fund.  He could simply open a TFSA and deposit the money in there while withdrawing from his corporation as they normally do to cover expenses.  However, this causes additional personal income tax to be paid.

The alternative would be to withdraw a little less from the corporation for the year equivalant to the amount of the windfall to reduce overall taxation.  This would keep the emergency fund within the corporation temporarily until withdrawn during more tax efficient years.  At which point, a TFSA should be used.

What do you think?  What would you do with the extra money?

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 20 comments… add one }
  • saveING.ca This is why I signed up with ING Direct December 30, 2009, 11:17 am

    Nice analysis, I love these case studies!

  • 2 Cents December 30, 2009, 11:50 am

    I agree with your analysis. Liquidity is important because of the income structure. We are in a similar situation with one variable income (sales commission) and it can be stressful to plan financially under those circumstances. Having a solid emergency fund and low debt really helps us sleep at night.

  • Tim Landry December 30, 2009, 1:20 pm

    ONE thing he does not mention is having adequate disability insurance. His most important asset is his ability to earn an income. An emergency fund is a great idea – but why do we have more concern for protecting our home and car than with protecting what pays for them. An emergency fund allows a long elimination eriod – although there is very little benefit to going longer than 90 days. If he is insurable that is one HUGE gap

  • cannon_fodder December 30, 2009, 1:27 pm

    I agree with paying of the high interest, non deductible debt first. With only 1 income and possible additions to the family, I would put the remainder of the money in a TFSA.

    I’d invest in dividend producing ETFs (like XFN, XRE and XTR). In 2-3 years you might earn enough in dividends (assuming nothing unforeseen happened causing you to liquidate your position) to pay for a 1 week cottage rental for your family vacation. Also look to use an Aeroplan or Airmiles based credit card for all your expenses if your vacation plans might include flying. If you want the utmost in flexibility you can go for cash back credit cards (https://www.milliondollarjourney.com/top-cash-back-credit-cards-in-canada.htm). Of course, never carry a balance unless you can get a 0% interest credit card (http://www.canadianmoneyforum.com/showthread.php?t=1414).

    Your corporation probably doesn’t have much in the way of expenses. Thus, I don’t know if it would make sense to look at cash flow damming (https://www.milliondollarjourney.com/the-cash-flow-dam-explained-cash-damming.htm).

    I like the fact that you are paying down your mortgage at a rate closer to a 20 year amortization rather than the safe 35 year amortization you initially took.

    Try tracking all of your expenses for 3 months – you may find easy ways to divert $100/month from unwise spending to something you need (emergency fund) or want (vacation).

    Try to determine what would happen if something with significant negative impact occurred. How could you cope financially? If you get scared enough, you might find the motivation to activate a plan to minimize the risk to your livelihood.

    Finally, discuss with your wife the possibility for her to earn some income to assist with your family’s goals. Perhaps it is working from home when she is not caring for the kids, or on weekends, or evenings. You can only cut expenses so far but earning more is almost limitless.

  • DavidV December 30, 2009, 1:27 pm

    I was thinking of an RESP, but Mark said he wants the money to be available. So I’d vote for TFSA, but I agree with Tim Landry that since he is the only breadwinner in the family with small kids, disability insurance is key.

  • Tim Landry December 30, 2009, 1:49 pm

    PS – even if he were NOT the only breadwinner in the family, disability insurance is still important. When one spouse is disabled, the disability chances for the other spouse SKYROCKET – stress of supporting two (or more) with one income PLUS desire to “be there” for the disabled partner

  • Mark December 30, 2009, 2:28 pm

    Hi there, Mark here. I appreciate the comments. Regarding the disability insurance, I have explored it and gotten some quotes from my insurance provider, I just haven’t acted on them yet. This is a good reminder to do that ASAP, which I will in the early new year.

  • Robert December 30, 2009, 2:34 pm

    Love the case study – this is almost identical to my situation (IT Contractor in Alberta, wife doesn’t work much, but I only have 1 kid…). Earning $80K gross per year in the corporation and paying dividends means he should be paying very little personal income tax. Very little, assuming he is not withdrawing 100% of his income through dividends. You can withdraw about $25K+ per person in dividends before paying tax.

    Mark should pay himself at least $3,500 salary per year (as well as to his wife) since the first 3.5K is CPP exempt. And he should be splitting the dividends equally between himself and his wife, to maximize income splitting and to minimize taxes.

    Another consideration is to setup a PHSP (Personal Health Spending Account) so that his corporation effectively pays any medical costs. You can setup a PHSP for around $150 plus 5-7% of any claimed amount. Google PHSP for details on how these work.

    Totally agree with the advice re: Emergency fund and TFSA. I have 3+ months of dividends in my corporation (at ING), plus a personal fund, but then I earn more and seem to have been doing contracting longer. The emergency fund is ultra-important as contractors are at the whim of the economy and employers. However, about $40 per hour seems really on the low side for IT contracting (though it depends on what exactly Mark does).

    Love all the other advice; reminds me I need to look at disability insurance for myself. My wife teaches piano 3 nights a week for a few hours, which helps too. Also, gets her some ‘adult brain time’ away from the kid (who is a teenager now), which is MORE important than the income.

    Personally, I find CPP to be not worth it. By the time you pay personal share, and you pay the corporations share (it’s all you money really) you are paying 10%+ of the insured amount. I ran the math and figured at the max CPP was returning around a 1% return. I would rather save that 10% personally and invest it – which is why TFSA’s are so awesome. But even in a non-registered investment you can do better than CPP. My thoughts.

    Good luck Mark!

  • Tim Landry December 30, 2009, 2:40 pm

    Be sure of a few things – one (given the emergency fund – you MAY be best served by a 90 day elimination period – but do NOT go longer The price differential simply is not worth the lost benefit; two – be sure you are protected in your “regular” occupation for the entire benefit period. You do NOT want to give the insurer the right to come in and say “You can do something else – we no longer need to pay you; three – make ABSOLUTELY SURE you are protected against partial/residual disabilities. Someone whose job is largell knowledge/communication based (as I expect yours is) is more likely to be partially disabled than totally PLUS as the owner of a business the motivation to try to work – even if at a redeuced capacity is usually very strong. Also – things like cancer, MS, etc START with partial disabilities – heart problems end with them. Finally look at a Guaranteed Insurability feature. The cost is almost NOTHING and it guarantees your ability to increaase your coverage later on as your budget permits – with no proof of health or occupation

  • ldk December 30, 2009, 2:49 pm

    We have a similar tax situation, and I would agree completely that the gains should be held in a TFSA (something liquid) for emergencies or for a higher-than-expected tax bill come April.

    I would also definitely second the motion that Mark and his wife consider paying themselves salaries out of the corp so they can contribute to CPP and establish RRSP room. With their debts repaid they will be in position to begin a long term savings plan…something the self-employed especially need to be diligent about.

    Good luck~

  • Sarlock December 30, 2009, 3:41 pm

    TFSA is the way to go, I think. $80k/year in split dividend income is nice but it’s not huge in a single income family with kids, so having a good sized emergency fund would really help.

  • FT FrugalTrader December 30, 2009, 3:57 pm

    That’s a few times now I’ve heard that CPP isn’t worth it for the self employed. I think I may run some numbers to see the results for myself. Has anyone already run the numbers in a spreadsheet?

  • ldk December 30, 2009, 4:38 pm

    I would definitely be interested in seeing a CPP spreadsheet as it would be instructive in our personal situation. (We pay ourselves salaries such that we maximize the CPP contribution and then either dividend out the excess revenue or retain it/invest it within the corporation.)

    In Mark’s situation however, it appears that they are doing no other retirement/long term savings, so having both CPP and the RRSP contribution room might be hugely important in the future.( Though we don’t know Mark’s age…it might make a difference if he’s 25 or 40!)

    My parents are also self-employed and only claimed dividend income…they are now 63 and 65 and eligible for very little in CPP….and-you guessed it…they have no significant savings aside from their home equity.

  • Mark December 30, 2009, 4:46 pm

    Hi, to answer some more of the points raised in the comments I thought I’d chime in again.

    I’m 34, not doing much retirement saving at the moment, but am entirely focused on that (along with the emergency fund) once the debt is paid off.

    As far as CPP and RRSP limits, we discussed that with our accountant and given that I have over $70,000 in eligible RRSP contribution room from years as an employee, I’m not too concerned with creating more space.

    With regards to the dividends, the way I wrote my initial e-mail is somewhat confusing. We dividend out to either/both myself and my wife in whatever manner is most tax efficient. Once you subtract eligible write-off’s in the corp (paying ourselves mileage, PHSP, office supplies, etc) we figure to end up with about $60k in corporate income. at $30k each in dividends, there is minimal personal taxes to worry about.

    We already have a PHSP setup and have used it a bit. We have a number of eligible expenses which we have not yet funneled through the corp, as I am expecting to earn more next year, so this will help to reduce the corporate tax burden.

    Thanks again to everyone for the suggestions and to FT for posting this. Keep ’em coming!

  • Robert December 30, 2009, 6:27 pm

    To FT and Idk:

    When I looked at CPP, I approached it from the standpoint of “how much money do I need to accumulate to buy an annuity that pays the same as CPP?” Looking for an annuity calculator and some crunching, and assuming 30 years to go, the total lump sum required was basically the same as the contributions (thus, the 1% return). I didn’t keep the spreadsheet.

    When you are self-employed, you pay a maximum of $4,300 in CPP between your corp. payment and personal. Your maximum benefit is $935 per month ($11,200 per year). I just looked at a quick calc at:
    http://www.seclonlogic.com/demo/comparator.asp

    And at age 35, no assets currently, contributing $4300 per year for 30 years, 0 inflation and a 2%, your annuity is $11,600 for a lifetime pension.

    I am NOT a financial expert, would love to see an article on this and some other readers thoughts. Would need to investigate how much CPP benefits have increased relative to premium increases (both employee and employer). I suspect rates are increasing faster than benefits. I looked at the HRDC website and currently I qualify for about $350 a month in CPP based on my years as an employee.

    Mark – FWIW I expense about 20-25% of my income through my corporation each year. This covers PHSP, our nominal salaries of $3500, and then use of house, internet, meals, travel, acctg fees etc. Just a guideline, my first couple of years it was closer to 10%. Get over 30% and you will probably attract unwanted CRA attention! Last year my total taxes paid (corporate and personal) as a percentage of my corporations revenue was 8.5%. Trying to get it lower though!

  • steve December 30, 2009, 8:20 pm

    Just a quick clarification on the TFSA point (2. Emergency Fund TFSA) – I believe the contribution limit for 2010 is still set at $5000 – please correct me if it is $10k.

    I *think* what the author meant was that if a TFSA is opened in 2010 then you get the previous year’s contribution plus the current year.

    Oh ya and I agree with the article – another winner from MDJ! Thanks.

  • PittyPat December 31, 2009, 9:03 am

    Mark, sorry to throw cold water on some of the suggestions but it would be terrible to find out years from now that you have to pay back taxes and penalties on income and gains you’ve innocently allocated to your spouse because of the way it was done. You mention you have an accountant, please get him/her to explain Attribution Rules – in fact FT how about this topic for a future column?

    It is a complex topic but basically if you are planning to split income with your spouse and you want to avoid future tax troubles you’d better be able to “attribute” to her the initial source of investment funds that generated that income. E.g. a properly set up interest-bearing investment loan from you that she used to invest; her own inheritance; previous savings from her job, etc… Having her name on the title to the rental property does not in itself enable you to split the capital gains or rental income with her in the eyes of the Taxman. Check out Interpretation Bulletin IT 511R available on the CRA website (www.cra.gc.ca). Probably the same thing goes for the allocation of dividend income between you two from your corporation though there isn’t enough info in your postings to be sure.

    It isn’t too difficult to do the paperwork to make things right from a tax perspective (but doubt it can be retroactive). One way is to set up a formal investment loan to your spouse so she can “invest” in the property and corporation; but again there are rules to be followed and she has to actually write you a cheque for loan interest each year (another FT column perhaps?) which can be deducted by her on her return. May seem a bit of a hassle and who wants more paperwork, but taking the time to do it right it could save you and your spouse all kinds of grief later.

    As far as paying her a salary, make sure you can show the Taxman she is paid a market rate (can be high end of scale) and actually doing something to earn it like filing, keeping records, answering business phone/email and setting up appointments. When the kids are older, you can get them to do the something for the company too and in effect split the income even further.

  • FT FrugalTrader December 31, 2009, 9:37 am

    PittyPat, thanks for the comment, and some very good points. Regarding the corporation though, since the wife is receiving dividends, I assume that she is a shareholder. My understanding is that she can receive dividends from the corp regardless of her income or savings. I’ve written about dividend sprinkling before which explains it a bit more.

  • FT FrugalTrader December 31, 2009, 10:39 am

    Steve, yes, I should have been more clear. It’s $10k contribution room including 2009. So $5k for 2009 and $5k for 2010.

  • Gates VP January 1, 2010, 9:27 pm

    Hey @Mark, the emergency fund is the easy winner here and the TFSA fits the bill very well.

    But I’m going to really emphasize the disability insurance. You should have both short-term and long-term as the sole bread-winner.

    To put this into perspective, the average job search here in the US is taking 3 to 6 months. I know that Alberta is doing better, but as a contractor you have to carry at least 3 months living expenses in an account (I’ve heard contractors argue 6-12 months).

    In the same vein, you are currently carrying the risk of being a contractor. You’re balancing those risks against the increased income that comes from paying less tax through your corp. But you’re still carrying a lot of risk. So you have to mitigate with insurance and cash buffers and professional development and advertisement.

    That said, you probably want to look at your rates. $40 / hour (80k / year) is not a rate that gives you very much room to buffer against big problems.

    Before moving to the US two years ago, I worked for a private consulting firm in Edmonton. We started at $75 / hour for basic software development / website work. Previously, I worked a government of Manitoba gig at $65 / hour or so. Big firms (IBM, Accenture, Thoughtworks, etc.) charge in the $100++ range for their development and sys admin services.

    I want to be clear this isn’t a personal slight, I’m not disparaging the value of the work you do. But if things feel tight in terms of covering “employee” disability and life and cash reserves, then I would personally point at the $40 / hour as being “not enough”.

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