Optimize after-tax income

Private business owners need cash flow to support their lifestyles. The challenge is how to minimize personal taxes, while optimizing desired income. Removing money from a company for the owner’s benefit requires careful tax analysis. Here are some options for business owner clients when it comes to extracting cash. Each has unique considerations and income tax consequences.

Salary and/or bonus

These options are deductible by the company and taxable to the shareholder. Generally, to be a tax deductible expense, the payment must be considered reasonable for business purposes. For example, it may not be reasonable to pay the shareholder’s 14-year-old child $50 an hour to stuff envelopes. Payments to active owner-managers for salary and bonuses are not subject to the same rule. They are, however, subject to withholding at source, which means income taxes together with the employer and employee portions of CPP/QPP contributions. Significant shareholders who own 40% or more of a corporation, and non-arm’s- length individuals aren’t eligible for employment insurance, so there are no employee or employer contributions required.

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Withholding of CPP/QPP applies to income levels up to $52,500 in 2014, and is not applicable to the first $3,500 of income. Employer contributions are deductible to the company, while employee amounts create a tax credit and provide longer-term future value. Effectively, CPP/QPP is not considered an expense. Income tax on employment income is a more significant concern, as top marginal tax rates are between 39% and 50%, depending on the province of residence.

Dividends

Dividends are derived from the company’s after-tax profits. There are two types: eligible and ineligible. The distinction is based on the tax treatment applied at the corporate level. For instance, a corporation that pays a low tax rate because of its eligibility for the small business deduction can pay ineligible dividends. Meanwhile, eligible dividends flow from income taxed at regular corporate rates.

The top effective tax rate on eligible dividends ranges between 19% and 36.06%. Rates for ineligible dividends hover in the 27% to 39.15% range. The differences arise from the provincial tax rates that vary across the country. There is no withholding mechanism on dividend income, so the shareholder nets a higher amount at the time of payment. However, taxes are still payable, although they would be delayed until the income tax deadline in April. A regular flow of annual dividends mean the shareholder will have to pay tax in quarterly installments.

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Analysis

Here’s the classic framework for analyzing salary and dividend options.

	Salary	Ineligible dividends	Salary	Eligible dividends
Corporate profits pre-tax	$500,000	$500,000	$500,000	$500,000
Salary paid to shareholder	$500,000	n/a	$500,000	n/a
Corporate taxes (16% / 27%)	zero	$80,000	zero	$135,000
After-tax corporate profits	zero	$420,000	zero	$365,000
Shareholder income	$500,000	$420,000	$500,000	$365,000
Shareholder tax rate	45%	33%	45%	28%
Shareholder taxes payable	$225,000	$140,000	$225,000	$102,200
Shareholder cash flow	$275,000	$280,000	$275,000	$262,800

Based on this analysis, there’s a slight advantage ($5,000) for dividends when the company is eligible for the small business deduction. However, when the company is not eligible and pays tax at the top corporate rate, salary is preferred ($12,200) over dividends. (This example uses average tax rates from several provinces.) Be sure to include provincial tax rates and customize the analysis to your clients’ tax rates.

Capital dividend election

The Capital Dividend Account (CDA), available to private companies, offers a source of tax-free dividends if the account holds a positive balance. Credits to the CDA arise from the disposition of capital property, eligible capital property, the receipt of capital dividends from other companies, and the receipt of life insurance proceeds. Be sure to review dispositions or receipts from these sources in order to evaluate the opportunity for payment.

Paid-up capital reduction

A company can return the shareholders’ original investment if it reduces the paid-up capital in its shares. Depending upon original financing and past transactions, this can provide a lump-sum source of non-taxable income.

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But there’s a possibility of inadvertently creating a capital gain, and you can calculate that by looking at when a reduction exceeds the shareholder’s adjusted cost base. This strategy is best used in consultation with professional tax advisors, who can evaluate past transactions that impact the outcome.

Repay shareholder loans

If a company owes money to shareholders and has available resources, it can repay outstanding loans at no tax cost. For example, a company may bonus-down to the small business limit by paying a bonus to the shareholder. The shareholder often lends back the after-tax bonus to finance business operations. Over several years, the outstanding amount of the loan owed to the shareholder could be substantial. This strategy provides another source to access lump-sum amounts of cash.

Transfer an asset

Shareholders can sell a personally owned asset to the company. This tactic is best employed when the asset is currently used or could have value to the company. For instance, if the shareholder personally owns a piece of land used by the business as a parking lot, the land could be transferred to the corporation. An outright sale at fair market value would generate cash for the shareholder and, although tax consequences may arise, the low-tax nature of capital gains can be more efficient than other options.

Alternatively, if a shareholder’s asset has a high adjusted cost base, a section 85 transfer could minimize any immediate tax consequences on the transfer, and provide cash, tax-free, equal to the tax cost of the asset. Section 85 allows for a tax-free transfer of an asset to a corporation in exchange for consideration that includes debt and company shares.

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Evaluating each option to scrutinize the tax costs helps ensure shareholders extract cash for lifestyle needs in the most efficient manner.

by James and Deborah Kraft. James Kraft, CPA, CA, MTax, CFP, TEP, is vice-president, Head of Business Advisory & Succession at BMO Nesbitt Burns. Deborah Kraft, MTax, TEP, CFP, is director, Master of Taxation Program, at the University of Waterloo.