Incorporated IT contractors who have been running their corporations for several years often arrive at a point where retained earnings have accumulated to a meaningful amount. The money is inside the corporation, active business income keeps coming in, and the question of what to do with it over the next decade starts to matter as much as the current-year tax bill.
Retained earnings are not a retirement account. They are an accounting figure representing the cumulative after-tax profits of the corporation that have not been paid out as dividends. They do not earn a return on their own. What happens to those profits after they are retained determines what they eventually become.
What Retained Earnings Actually Are
When the corporation earns income, pays corporate income tax, and does not distribute the remainder to shareholders, the after-tax amount increases retained earnings on the balance sheet. Retained earnings are a component of shareholders’ equity, not a cash balance.
If the corporation’s cash has been used for operating expenses, HST remittances, tax instalments, or reinvested in the business, retained earnings on paper may not correspond to available cash. A corporation can have $400,000 in retained earnings and less than $20,000 in its bank account. Understanding the distinction between the retained earnings figure and the actual cash position matters when planning how to eventually extract the accumulated value.
The Passive Income Trap
Retained earnings sitting inside a corporation are not earning investment returns unless the corporation actively invests them. When a CCPC earns investment income — interest, dividends from portfolio holdings, rental income, or capital gains from investments held inside the corporation — that income is taxed under rules that are different from active business income eligible for the small business deduction.
Interest, net rental or property income, foreign portfolio income, and the taxable portion of capital gains are generally subject to a high refundable-tax regime inside a CCPC. Canadian portfolio dividends are handled differently, usually through Part IV tax, but they can also generate refundable dividend tax. In broad terms, the tax on fully taxable passive investment income often lands near 50% before dividend refunds, depending on the province and the type of income. The refundable tax is tracked through eligible and non-eligible Refundable Dividend Tax on Hand (RDTOH) accounts and is recovered only when the corporation pays taxable dividends to shareholders. The mechanism is designed to approximate individual taxation of investment income, removing the deferral advantage that would otherwise exist on passive income inside a corporation.
The second consequence of passive income is its effect on the small business deduction limit. If a CCPC and any associated corporations earn more than $50,000 in adjusted aggregate investment income in a year, the $500,000 small business deduction limit begins to be clawed back. The reduction is $5 of SBD room for every $1 of passive income above the threshold. By the time adjusted aggregate investment income reaches $150,000, the SBD limit reaches zero and all active business income is taxed at the general corporate rate. For a contractor earning $300,000 per year in active income, losing the SBD represents a materially higher tax rate on the full amount.
Contractors with significant retained earnings who are considering holding investment portfolios inside their corporations need to understand this dynamic before passive income accumulates to a level where it affects active business taxation.
How Retained Earnings Eventually Come Out
There are three main mechanisms for extracting accumulated value from a CCPC: ongoing dividend distributions over time, a sale of shares, and a wind-down of the corporation. Each has a different tax profile.
Ongoing dividend distributions. The most common approach is to draw dividends from retained earnings over time, treating the corporation as the source of retirement income alongside RRSP withdrawals and any CPP entitlement. Dividends from a CCPC to a Canadian resident individual are typically non-eligible dividends if the underlying income was taxed at the small business rate. The gross-up and dividend tax credit mechanism partially accounts for the corporate tax already paid, but integration at the small business rate is imperfect — non-eligible dividends carry a higher effective personal tax cost than eligible dividends from a public corporation.
The RDTOH mechanism is relevant here. As taxable dividends are paid out, the corporation may receive a dividend refund from CRA. Non-eligible dividends can recover non-eligible RDTOH at 38 1/3% of the non-eligible dividends paid, limited by the corporation’s RDTOH balance, and may then recover eligible RDTOH in some cases. That refund reduces the net corporate tax cost on investment income that was originally subject to the high passive income rate. Tracking the RDTOH balance and ensuring dividends trigger the appropriate refund is part of ongoing corporate accounting and T2 preparation.
Share sale and the Lifetime Capital Gains Exemption. If the corporation qualifies as a Qualified Small Business Corporation (QSBC), each shareholder may be eligible to shelter a capital gain on the sale of shares from personal tax using the Lifetime Capital Gains Exemption. The LCGE limit for QSBC shares is indexed annually; the current limit is available from CRA. If the corporation’s shares are sold at a gain within the available exemption limit, the capital gains deduction can shelter the gain from regular personal tax, subject to the shareholder-specific limits and issues described below.
QSBC share qualification requires that the corporation be a Canadian-controlled private corporation at the time of sale, that substantially all (90% or more) of the fair market value of its assets be used in an active business carried on primarily in Canada or in certain connected shares or debt at the time of the sale, and that throughout the 24 months immediately preceding the sale, more than 50% of the fair market value of the corporation’s assets were used in an active business in Canada or in certain connected shares or debt. The shares also need to satisfy the 24-month ownership condition, generally requiring ownership by the taxpayer or a related person or partnership during that period. IT consulting corporations that hold significant cash or investment portfolios inside the corporation can fail the asset test if passive assets exceed the permitted threshold at the time of a contemplated sale. Planning around QSBC qualification begins years before any transaction.
The LCGE is a per-shareholder exemption. In a corporation with two shareholders, each shareholder may be eligible for their own exemption on the gain attributable to their shares, subject to each shareholder’s qualifying conditions, individual LCGE limit, cumulative net investment loss position, and alternative minimum tax exposure.
Wind-down and dissolution. If the corporation is to be wound down rather than sold, the process involves settling liabilities, distributing remaining assets to shareholders, filing the final T2, considering or obtaining a clearance certificate from CRA before final distributions where appropriate, and completing the corporate dissolution or registration steps. The assets distributed are characterized differently depending on their nature — amounts from the Capital Dividend Account can be paid out tax-free, remaining amounts are distributed as deemed dividends or return of paid-up capital, and capital gains realized during the wind-down are subject to the applicable inclusion rate. The winding down a CCPC guide covers the mechanics of each path.
The Capital Dividend Account
The Capital Dividend Account is a notional account that tracks amounts a private corporation can distribute to Canadian-resident shareholders as tax-free capital dividends. The CDA is credited with the non-taxable portion of capital gains realized by the corporation — generally one-half under the current general inclusion rate, subject to special rules and future law changes. It is also credited with certain life insurance proceeds and capital dividends received from other corporations, and reduced when capital dividends are paid or capital losses are realized.
A corporation that has realized capital gains over its operating life — from the sale of investments, goodwill, or other capital property — may have a meaningful CDA balance available when planning a wind-down or a large distribution. Dividends paid from the CDA are received by Canadian-resident shareholders free of personal income tax when the required capital dividend election is properly filed. Sequencing the distribution — CDA dividends first, then other taxable amounts — matters for the overall tax cost of the wind-down.
Unlike RDTOH, the CDA does not disappear if dividends are not paid. The balance carries forward until it is used, subject to the detailed CDA rules. It does not appear as a line on the standard financial statements; it is tracked from the corporate tax records and supported when filing the capital dividend election, often using Form T2054 and Schedule 89.
The RRSP-Corporation Comparison
Retained earnings inside the corporation represent a tax deferral: corporate income was taxed at the small business rate rather than the personal marginal rate, and the difference remains invested until withdrawn. How that deferral compares with the RRSP as an alternative retirement vehicle depends on a set of inputs that are specific to each contractor’s situation.
The RRSP offers a deduction at the marginal personal rate, tax-sheltered compounding, and full inclusion in income at withdrawal. The RRIF conversion at age 71 imposes minimum annual withdrawals. Contribution room is generated only by salary and certain other earned income — not by dividends. A contractor who drew only dividends in a given year accumulated no new RRSP room from those dividends; the opportunity to create salary-based room for that year is gone, although previously unused RRSP room continues to carry forward.
The corporation offers a lower initial tax rate on active business income, no prescribed withdrawal schedule, the ability to time dividend payments across years based on other income, and the potential LCGE on share sale. It does not compound passively — retained earnings must be invested to generate a return, and investment income inside the corporation is subject to the passive income rules described above.
Neither vehicle is universally superior. The comparison depends on the contractor’s marginal personal rate, the expected return on investment, the time horizon, whether QSBC qualification is a realistic planning target, and what other retirement assets exist. A CPA preparing the T2 and T1 together can model both tracks with actual numbers.
For contractors who have accumulated retained earnings without salary payments in the same years, the RRSP balance may be lower than expected relative to the corporate balance. Assessing whether partial salary payments over the coming years should generate additional RRSP room is part of an integrated retirement review.
Spousal Shareholding and Income Splitting
Dividends paid to a spouse who holds shares in the corporation may allow income splitting in retirement, subject to the Tax on Split Income rules. TOSI applies a top marginal rate on certain income received by family members from connected corporations where the recipient was not meaningfully involved in the business. Where TOSI does not apply — for example, because the spouse meets an excluded business or reasonable-return exclusion — dividend splitting between spouses can reduce the combined household tax burden on retained earnings extracted over time. The excluded shares exception is narrower for pure service corporations, because one condition is that less than 90% of the corporation’s business income is from services.
Whether TOSI applies depends on the facts specific to each shareholder’s involvement and the year of assessment. The analysis should be done before dividends are paid to a family-member shareholder, not afterward. Spousal share ownership established later in a corporate lifecycle, without accompanying involvement or qualifying contributions, carries more TOSI risk than ownership established early with appropriate documentation.
What to Review Before Winding Down
A contractor who anticipates reducing their active practice or winding down the corporation within the next five to ten years should begin reviewing the following before the timeline is close:
QSBC qualification. Does the corporation qualify, or could it be restructured to qualify, for LCGE purposes? The review includes the 90% asset test, the CCPC requirement, the 24-month share ownership condition, and the 24-month asset-use test. If the corporation holds significant cash or investments relative to its active business assets, the asset test may fail without planning. Remediation takes time.
RDTOH balance. Does the corporation have an RDTOH balance that should be recovered through dividend payments before the corporation ceases operations? RDTOH is not recovered merely because the corporation dissolves. The refund is triggered by taxable dividends, including deemed dividends in some wind-up situations, and the corporation has to claim the dividend refund on time. Coordinating those dividends during the wind-down or in the years before it is part of the tax cost analysis.
CDA balance. Has the corporation realized capital gains that have created a CDA balance? Tax-free CDA dividends should generally be extracted before taxable dividends in a wind-down sequence.
RRSP and TFSA. Are the registered plan balances appropriate given the corporation’s retained earnings? The corporation and the registered plans are both part of the retirement picture, and the withdrawal strategy across both affects the personal tax rate in each year of retirement.
Corporate investment structure. Is the corporation holding a passive investment portfolio that is triggering the SBD clawback? If so, does the SBD clawback affect the active income from consulting work, and is the passive income being managed in a way that minimizes that effect?
These are planning questions that are most usefully addressed while there is still time to act on the answers, not in the year a wind-down is being executed.
The Long View
Retirement planning for incorporated IT contractors is built incrementally through compensation decisions made each year, the way investment income inside the corporation is managed, and the structure of the corporation relative to the conditions for QSBC qualification.
A decade of dividend-only draws with no salary means no RRSP contribution room from those corporate draws, no CPP entitlement built from that corporation in that period, and a corporation with accumulated retained earnings but no corresponding registered retirement asset. Whether that trade was worthwhile depends on what the corporation’s funds earned while deferred, how the eventual extraction is structured, and what other assets are available.
The planning window for the best outcomes is wider than most contractors expect. The decisions that matter for retirement tax cost are made years before retirement is imminent. For contractors earlier in their practice, the salary-versus-dividend review each year, reviewed before fiscal year-end while there is still time to act, is where the retirement picture is actually built. For contractors closer to a transition, the QSBC, RDTOH, and CDA questions belong on the table with the CPA now, not later.