What to Do With Retained Earnings in Your Corporation

As discussed in our companion article on incorporation, one of the core benefits of incorporating is the ability to leave income in the corporation, taxed at corporate rates, rather than withdrawing everything personally each year. But "leaving income in the corporation" raises a follow-up question: what happens to that money while it stays there? For many incorporated business owners, the answer is "it sits in a corporate bank account" — which, beyond a reasonable operating reserve, often represents an underused opportunity.

Active Business Income vs. Investment (Passive) Income

Income a corporation earns from actively operating its business (selling products, providing services) is "active business income," eligible for the small business deduction (a reduced corporate tax rate) up to the small business limit. Income earned from investments held by the corporation — interest, dividends from other corporations, capital gains — is "investment income" or "passive income," taxed differently, generally at a higher corporate rate than active business income within the small business limit, though with a portion potentially refundable when paid out as dividends to shareholders (through the refundable dividend tax on hand mechanism).

The Passive Income Rules and the Small Business Deduction

A provision introduced some years ago reduces a corporation’s access to the small business deduction (the preferential tax rate on active business income) if the corporation’s passive investment income exceeds a certain threshold in the prior year — the small business limit is reduced gradually as passive income rises above this threshold, and is eliminated entirely once passive income reaches a higher threshold.

This means that a corporation accumulating significant retained earnings, invested in a way that generates substantial passive income, could see its active business income taxed at a higher rate as a result — an effect that is separate from, but related to, the tax treatment of the investment income itself. For corporations with retained earnings approaching levels where this becomes relevant, this is an important factor in deciding how much to retain versus distribute, and how retained funds are invested (since different types of investment income are treated differently for purposes of this calculation).

What Corporations Commonly Invest In

Investment Type	Considerations
GICs, high-interest savings accounts	Lower risk, generates interest income (fully taxable passive income); useful for funds needed in the shorter term or as an operating reserve beyond immediate needs
Publicly traded stocks and ETFs	Capital gains and dividend income, each taxed differently within the corporation; longer time horizon generally more appropriate given market volatility
Corporate-owned life insurance	Covered in our companion article — a distinct strategy with its own tax treatment, often considered alongside (not instead of) traditional investments
Real estate	Can be held within a corporation, though this introduces its own considerations (potential loss of small business deduction if real estate becomes a primary activity, and other structural questions) — often warrants a separate holding company structure

Should Retained Earnings Be Invested Inside the Corporation, or Withdrawn and Invested Personally?

This is, in many ways, the central question. Investing within the corporation continues to defer personal tax on the original business income (the amount has not yet been paid out personally), but the investment income itself is taxed at corporate rates (generally less favourable for passive income than personal rates in some cases, though the refundable tax mechanisms are designed to mitigate double taxation over time). Withdrawing the funds personally (as salary or dividends, as discussed in our companion article) to invest personally means paying personal tax on the withdrawal now, but then benefiting from personal tax rates and preferential treatment (like the dividend tax credit on Canadian dividend income, or the capital gains inclusion rate) on the investment income going forward.

The "right" answer depends on factors including the individual’s current and expected future personal tax rates, how long the funds are likely to remain invested, the type of investment income expected, and the passive income rules discussed above. This is a calculation that benefits from being run for a specific situation — there is a meaningful body of analysis on this question (often referred to in terms of the corporate versus personal "investment tax" comparison), and the answer is not the same for every business owner or every dollar.

A Holding Company Structure

For corporations with significant retained earnings, particularly where there is some concern about the operating corporation’s liability exposure, a common structure involves a holding company — the operating corporation pays dividends (which can generally be paid between connected corporations without triggering tax, under certain conditions) up to a holding company, which then holds the investments. This separates the investment assets from the operating business’s liability exposure (creditors of the operating business generally cannot reach assets held in a separate holding company) and can provide additional flexibility for estate planning and eventual succession, discussed further in our companion article on succession planning.

Setting up and maintaining a holding company structure involves its own costs (additional corporate filings, potentially additional accounting complexity) and is generally most relevant once retained earnings reach a level where the liability protection and planning flexibility benefits are meaningful relative to these costs — this is not typically a "from day one" structure for a small corporation with modest retained earnings.

The Capital Dividend Account Connection

Certain types of income earned within a corporation — notably the non-taxable portion of capital gains, and life insurance proceeds in certain circumstances — can be added to the corporation’s Capital Dividend Account (CDA), which allows that amount to eventually be paid out to shareholders as a tax-free capital dividend. This is covered in detail in our companion article, but is relevant here because it means the type of investment income generated by retained earnings — not just the amount — affects how that money can eventually be extracted from the corporation.

A Starting Framework

Question	Why It Matters
How much does the business need to retain as an operating reserve?	This portion should generally prioritize accessibility and capital preservation over growth
Beyond the operating reserve, is the corporation approaching the passive income thresholds that affect the small business deduction?	If so, the amount and type of retained earnings may need to be considered alongside the corporation’s active business income
What is the time horizon for funds beyond the operating reserve?	Longer time horizons may support a different investment approach than funds that might be needed for the business in the near term
Has the corporate-versus-personal investment comparison been run for your specific tax situation?	This determines whether continuing to retain and invest within the corporation, versus withdrawing and investing personally, is more advantageous for the funds in question