Owner-manager considerations
If you carry on your business through a corporation, there are even more planning points available to you.
Pay dividends from your corporation
In certain situations, a corporation can be used to split income with family members. For instance, if your spouse or children, who are 18 years of age and older, subscribe for shares of your corporation at fair market value using their own funds, they can receive dividends from the corporation out of its after-tax profits and you can split income. Dividends paid by the corporation before its year-end could generate a tax refund on its corporate tax return, if it has previously earned investment income on which it paid tax. If your corporation has a year-end early in 2008, say January 31st, you could declare a dividend in January, which would generate a tax refund for the corporation on its current return. The recipients of the dividend would then be taxable on their 2008 returns which are due April 30, 2009.
There could be a problem with this type of planning if you’ve loaned or transferred property to the corporation. In this case, you must ensure that the company maintains its status as a Small Business Corporation (SBC). Otherwise, you could be subject to an imputed interest penalty if your spouse or children are shareholders.
Income splitting with minor children is more difficult because of the income splitting tax. Under these rules, minor children are taxed at top personal rates on dividends received from your corporation, as well as certain types of business income. Make sure you ask your BDO advisor for a copy of our Income Splitting bulletin for further information on this tax.
You should review your corporation’s status throughout the year, and again at year-end in conjunction with tax planning for you and your family. If dividends are required, they should be properly documented and recorded in the company’s minute book. Also, for any dividends paid in 2007, the corporation must prepare and file T5 slips to report the dividends on or before February 29, 2008.
If your corporation has had business income after 2000 in excess of the federal small business limit or received public company dividends after 2005, you may be able to pay an eligible dividend. These dividends are subject to a lower tax rate and must be designated as eligible. As these rules are fairly new and strict documentation rules apply, you should consult with your BDO advisor before declaring dividends to take advantage of the eligible dividend rules.
Establish your salary/dividend mix from the corporation
If you draw funds from your corporation throughout the year for personal expenses, you should determine whether these amounts will be characterized as salary or dividends before year-end. Otherwise, the funds withdrawn could be treated as a shareholder loan, unless certain conditions are met. A shareholder loan would be included in your income without benefit of the dividend tax credit, and without being deductible to the corporation as salary. Also, it would not be considered earned income to you for RRSP purposes.
In general terms, if your company earns active income that is less than the small business limit ($400,000 for taxation years beginning after 2006), it’s usually better to declare dividends, the payment of which can offset the shareholder loan. For federal tax purposes (and for certain provinces and territories), active business income up to $400,000 will be taxed at the small business tax rate. Note that the small business limit is higher in Alberta and Saskatchewan and is set to increase further in both provinces.
In the past, where active income exceeded the small business limit, the general rule of thumb was to have the corporation pay you a salary or bonus to reduce its income to the small business limit as the total corporate and personal tax associated with retaining excess income and paying it out as a dividend to you exceeded the tax cost of a bonus (referred to as a “tax integration cost”). At the same time, not paying a bonus resulted in a tax deferral, as general corporate income tax rates on income retained by the corporation are lower than the top personal rate. Despite the deferral, paying a bonus was often the rule of thumb as the integration cost was just too high.
However, in recent years, beneficial tax reductions, such as reductions in corporate tax rates and increases in the provincial small business limits (beyond the federal limit), have made the rule of thumb more difficult to apply. Also, the changes to the taxation of dividend rules for dividends paid after 2005 will either partially or fully remove the integration cost where corporate business income in excess of the small business limit can be paid out as an eligible dividend. So, depending on what province or territory your corporation operates in, there may not be a need to declare a bonus when looking solely at income tax rates.
Of course, there are other considerations to make in the salary versus dividend decision. Drawing dividends alone will not provide you with earned income for RRSP purposes. Also, if you have no other sources of earned income and your spouse works and earns more than you, neither one of you will be eligible to claim child care expenses. Child care expense deductions are generally limited to 2/3rds of the earned income of the lower income spouse. Therefore, you should ensure that you receive enough salary to allow a maximum RRSP contribution and a claim for child care expenses. Another important consideration is whether your corporation is engaged in research and development, as beneficial tax rules are phased out where a corporation’s (or associated group’s) income for the prior year exceeds the federal small business limit. Finally, where a corporation begins to retain high-rate income, its tax installment base will increase at the same time additional income tax for the prior year becomes payable, which could create a short-term cash flow issue.
Given the changes in the taxation of dividend rules are fairly recent, specific advice will be important—speak to your BDO advisor.
Consider paying interest on shareholder loans
If you’ve paid yourself sufficient salary to maximize your RRSP and family’s child care deduction claim and your corporation still has more than $400,000 of active business income, you should consider charging interest on any loans you’ve made to the company. The interest would be deductible to the corporation and would not be subject to provincial payroll taxes (the decision on whether to pay interest or an eligible dividend would be similar to the decision above for bonuses).
To be deductible to the corporation, the interest must be charged at a reasonable rate. Also, there must be a legal obligation to pay interest established in advance. Therefore, if you intend to charge interest on your loans to the corporation, you should establish the terms at the beginning of the year. It should be noted that where a minor child or a trust for a minor child makes a loan in support of a business carried on by a relative, the interest will be subject to the income splitting tax (or kiddie tax).
Consider planning to reduce your corporation’s taxable capital before year-end
Depending on their size, corporations can be subject to provincial capital taxes. The jurisdictions vary in how they calculate taxable capital and the rate at which the tax is charged. Note that some jurisdictions have begun to reduce, and in some cases eliminate, capital tax. For those jurisdictions which continue to levy capital tax, taxable capital usually includes share capital and debt and may require some tax-based adjustments. All jurisdictions that impose capital tax provide an allowance which reduces taxable capital for certain specified investments.
There are a number of very simple steps that can be taken prior to year-end to reduce capital tax. For instance, using excess cash to pay off some debts may reduce your taxable capital. Consult your BDO tax advisor for further information on planning points that may be applicable to your situation.
You should note that Canadian-Controlled Private Corporations (CCPCs) with taxable capital in excess of $10,000,000 (on an associated group basis) will begin to lose access to the small business deduction and the enhanced 35% investment tax credit for research and development. Taxable capital for the prior year is generally used in determining how much of these benefits are lost, with the incentives being eliminated when taxable capital reaches $15,000,000. The “clawback” of these benefits represents another reason why capital tax planning should become an important part of your year-end tax review.
Purchase older automobiles from your corporation
If you use an older corporate-owned automobile for personal use, you may want to purchase it at fair market value. As discussed in our Automobile Expenses and Recordkeeping bulletin, the standby charge benefit included in your income is based on the original cost of the automobile, no matter how old it is. Buying the older automobile now will ensure that you won’t be taxed on a large automobile benefit next year.
Your BDO advisor can help you determine whether this strategy makes sense for you.
Next section: Investment Income
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