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 2010, 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 2010 returns which are due April 30, 2011.
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 2009, the corporation must prepare and file T5 slips to report the dividends on or before March 1, 2010 (as February 28, 2010 falls on a Sunday).
If your corporation had business income after 2000 in excess of the federal small business limit or received public company dividends after 2005, the corporation 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 complex 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 the 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 ($500,000 effective January 1, 2009, prorated for non-calendar year-ends), 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 $500,000 will be taxed at the small business tax rate. Note that the small business limit is lower in British Columbia, Manitoba, Nova Scotia and the Yukon, but it is set to increase in British Columbia.
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 tax 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 have made this rule of thumb more difficult to apply. Also, the changes to the taxation of dividend rules for dividends paid after 2005 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.
In our current tax environment, owner-manager remuneration strategies are being further complicated by changing tax rates. In particular, there will be significant reductions in the federal corporate tax rate (until 2012) while the personal tax rate on eligible dividends will be increased. As a result of this, over the next few years, integration will work best for business income taxed at the top corporate rate and paid out as an eligible dividend, only where the dividend is paid in the same year. In cases where the dividend is being deferred to a subsequent year, integration will not work as well and there will be an integration cost, as the tax rate on eligible dividends is increasing. Therefore, consideration should be given to paying out an eligible dividend this year while the tax rate on eligible dividends is lower. For a more detailed discussion on integration, see the article “The Impact of Integration on Owner-Manager Remuneration Strategies” in our Tax Factor 2009-03 publication.
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 scientific research and experimental development, as beneficial tax rules are phased out where a corporation’s (or associated group’s) taxable income for the prior year exceeds the federal small business limit. Finally, where a corporation begins to retain high-rate income, its tax instalment 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 numerous factors to consider in establishing the optimal salary/dividend mix, 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 $500,000 of active business income, you could 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 reduced, and in some cases eliminated, 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 certain limits (on an associated group basis) will begin to lose access to the small business deduction and the enhanced 35% investment tax credit for scientific research and experimental development. Taxable capital for the prior year is generally used in determining how much of these benefits are lost. Access to the small business deduction is eliminated when taxable capital reaches $15 million and access to the enhanced 35% investment tax credit is eliminated when taxable capital reaches $50 million. The $50 million amount is applicable for taxation years ending on or after February 26, 2008 and is subject to proration for taxation years that include this date (previously the amount was $15 million). 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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