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In certain situations, a corporation can be used to split income with family members |
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 2012, say January 31, 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 2012 returns which are due April 30, 2013.
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 is a shareholder.
Income splitting with minor children is more difficult because of the income splitting tax, or “kiddie 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. Refer to 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 2011, the corporation must prepare and file T5 slips to report the dividends on or before February 29, 2012.
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 federal small business limit of $500,000, 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 $400,000 in Manitoba and Nova Scotia.
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, the corporate tax system was substantially changed in 2006, with the introduction of the eligible dividend rules. At the same time, the federal government and some provincial governments started a gradual process of lowering general corporate tax rates. Soon, it became clear that as the general tax rate changes were phased in, the tax cost of keeping “high-taxed” general corporate income in Canadian-controlled Private Corporations (CCPCs) was going to decline dramatically, particularly in those provinces which also undertook to reduce provincial corporate tax rates.
A complicating factor to this analysis is the fact that the personal tax rate on dividends will increase between 2011 and 2012, and then is projected to remain at the 2012 rate. This means that income earned in 2011, and paid out as a dividend in 2012 or future years, will have a higher integration cost than if it is paid out as a dividend in 2011. Because the personal tax rates on dividends are not scheduled to change after 2012, this is an issue for 2011 only. 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 “Owner-Manager Remuneration Strategies - Integration Revisited” in our Tax Factor 2011-02 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 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 consider paying yourself 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 the most 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 your family’s child care deduction claim and your corporation still has more than $500,000 of active business income, and you have decided that it is preferable to pay taxable income other than dividends to yourself, 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
An additional consideration for CCPCs is monitoring taxable capital. CCPCs with taxable capital for federal tax purposes 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 includes share capital and debt and usually requires some tax-based adjustments, as well as providing for an allowance which reduces taxable capital for certain specified investments.
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 “clawback” of these benefits represents a good reason as to why capital tax planning should become an important part of your year-end tax review. At one time, most provinces levied a tax on capital. However, all jurisdictions, with the exception of Nova Scotia, have generally eliminated capital tax on non-financial institutions.
There are a number of very simple steps that can be taken prior to year-end to reduce taxable capital. 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.
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.
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