Corporate Life Insurance

What Are Retained Earnings and Why Are They a Corporate Tax Problem?

If your corporation earns more than you take out each year, the surplus stays inside the company as retained earnings. That's a good problem to have — but it comes with a tax structure that quietly works against you. Here's how it works and why more Alberta business owners are looking for a better place to park that capital.

What Are Retained Earnings?

Retained earnings are the accumulated profits that have stayed inside your corporation after you've paid corporate taxes and after you've taken out whatever you wanted personally as salary or dividends. They sit on the corporate balance sheet as an asset — cash, investments, or both.

For successful incorporated professionals and business owners in Alberta, retained earnings can build up quickly. A physician, dentist, or consultant running a professional corporation often takes out only what they need personally, leaving the rest inside the company to compound over time. That's the plan — and it's a sound one at the corporate tax level.

The problem starts when you decide what to do with those earnings once they're sitting inside the corporation.

How Retained Earnings Are Taxed in Alberta

When your corporation earns income from its core business activities — billings, client fees, consulting revenue — that income is taxed at the small business tax rate. In Alberta, the combined federal and provincial corporate tax rate on active business income for a CCPC (Canadian Controlled Private Corporation) under the small business limit is roughly 11%.

That's the good news. The bad news is what happens when you invest those retained earnings inside the corporation.

Passive investment income — interest, dividends, and rental income earned on corporate investments — is taxed at a much higher rate. In Alberta, the combined passive income tax rate for a CCPC is approximately 50%. That means every dollar your corporate GIC earns is reduced to roughly 50 cents after tax.

Note: these are approximate rates and your specific situation will vary. The point is the comparison — active income is taxed lightly; passive income is taxed aggressively.

The Compounding Tax Drag Problem

The 50% passive income rate sounds bad on its own. The larger problem is compounding. If your corporate GIC earns 4.5% and half of that is taken in tax every year, you're actually compounding at roughly 2.25% after tax inside the corporation. Over 15 or 20 years, the gap between 4.5% compounding and 2.25% compounding is enormous.

Here's a simplified illustration: $500,000 in a corporate GIC at 4.5% gross, with 50% passive income tax applied annually, grows to approximately $730,000 over 15 years on an after-tax basis. The same $500,000 growing at 4.5% with no annual tax drag grows to approximately $1,000,000. That's a $270,000 difference — purely from the annual tax bite on passive income inside the corporation.

This is why corporate-owned life insurance strategies are increasingly relevant for business owners with meaningful retained earnings. Tax-sheltered growth inside a corporate-owned permanent life insurance policy is not subject to the same passive income tax treatment. The inside build-up of a participating whole life or universal life policy grows without being taxed each year — changing the compounding math materially.

The RDTOH Refund Mechanism

There is a partial offset called the Refundable Dividend Tax on Hand (RDTOH). When a corporation pays dividends to shareholders out of passive income, it can recover a portion of the tax it paid. This partially reduces the effective rate — but it requires distributing the income personally, which triggers personal dividend tax, and it doesn't eliminate the problem. It's a deferral and partial mitigation, not a solution.

The Second Layer: Getting Money Out of the Corporation

The passive income tax drag is the first problem. The second problem is getting the retained earnings out of the corporation eventually.

When you want to move corporate retained earnings to your personal estate — or to your heirs — you have limited options. You can pay yourself a salary (deductible to the corporation, fully taxed to you personally). You can pay dividends (taxed personally, depending on the type of dividend). Or you can wind up or sell the corporation, triggering capital gains and possibly dividend treatment on excess corporate value.

In all of these scenarios, the retained earnings face a second layer of tax on the way out. The only mechanism that fully sidesteps this is the Capital Dividend Account — which is funded primarily by life insurance death benefits inside the corporation.

This is the core of why corporate-owned life insurance strategies make financial sense for the right business owner. See what is the Capital Dividend Account for a detailed explanation of how that mechanism works.

What Can You Do About It?

There are several strategies that Alberta business owners use to address the retained earnings tax problem. Here are the main ones, briefly:

• Corporate Insured Retirement Plan (CIRP): Redirect retained earnings from GICs into a corporate-owned permanent life insurance policy. The policy grows tax-sheltered inside the corporation. At retirement, the cash value can be pledged as collateral for a bank loan — creating a tax-efficient income stream without triggering passive income tax each year.
• Corporate Estate Bond: Replace low-yielding, fully-taxed fixed income on the corporate balance sheet with a corporate-owned life insurance policy. The death benefit flows through the Capital Dividend Account to heirs tax-free. See corporate estate bond vs. GICs for the full comparison.
• Immediate Financing Arrangement (IFA): Make a large single-premium deposit into corporate life insurance, then immediately borrow against the policy from a bank. The corporation keeps its working capital, holds a growing tax-sheltered asset, and may deduct the loan interest. Complex — requires specialist advice.
• Income splitting: Pay family members salary or dividends from the corporation where appropriate and legitimate under the tax on split income (TOSI) rules. Reduces corporate retained earnings but requires meeting specific CRA conditions.
• Hold company structures: Some business owners use a holding company to hold passive assets at arm's length from the operating company. This doesn't eliminate the passive income tax, but it can provide asset protection and estate planning benefits in combination with insurance strategies.

When Should You Start Thinking About This?

Most accountants will flag the retained earnings issue when your corporate balance sheet reaches a certain level — often $500,000 to $1,000,000 in passive assets. But the right time to plan is earlier, not after the passive income tax has already dragged down compounding for several years.

Corporate life insurance strategies are age-sensitive — the cost of insurance is lower at younger ages, and permanent life insurance is most effective when set up with time to compound. A 45-year-old business owner who starts a CIRP today gets significantly better math than a 58-year-old starting the same strategy.

If you're incorporated, have retained earnings, and haven't had this conversation with both your accountant and an insurance broker, it's worth scheduling both. See why you should talk to your broker before your accountant on this topic for context on how the conversation typically works.

Frequently Asked Questions