Corporations – How They Are Taxed & Getting Your Money Out
The following is a brief and general overview of the following three popular questions most business owners ask:
- How are corporations taxed?
- How should I be paying myself through my corporation?
- How can I take money out of my business in the most tax-efficient manner?
How they are taxed:
Tax rates on Canadian Private Corporations are applicable only on profit, after deducting from the revenue all the current expenses, the interest, the amortization and the depreciation.
The basic federal rate is 38%, however there is a deduction of 11.5% in 2011 and 13% from 2012 to 2015 for private corporations earning profit from manufacturing and processing activities.
Additional deductions of 10% is applied on the federal rate if a business has to pay provincial or territorial tax. This is known as the provincial tax abatement. The federal or provincial abatement is created to leave room for the provincial taxes. This adjustment brings the federal rate to 16.5% for the year 2011 and 15% from the year 2012 to 2015.
Businesses profiting from activities outside the country will also have access to a federal rate reduction but not to the provincial abatement. Their total rate is then limited to the federal one, which is 26.5% in 2011 and 25% from 2012 to 2015.
Each province presents difference rates:
|Newfoundland & Labrador||14.0||3.0|
|Prince Edward Island||16.0||4.5|
If your company is making profit in more than one province, the regional rate is applicable on the portion of profit generated in that province.
On all government levels, there are two applicable rates on the corporate taxable income:
- The lower rate and the higher rate. The lower rate is a reduced rate reserved for company eligible to small business deduction (SBD)
- On the federal level, the business limit is established to 500,000$ and its lower rate to 11%
- On the provincial level, both business levels and lower rates can differ from one province to another
A business is eligible to SBD if its taxable capital of the previous year is lower than 15 million. This taxable capital is usually the shareholder’s equity, retained earnings, loans made to the corporation, minus certain investments made to other companies. Deposits are excluded in the case of financial institutions.
The lower rate is applied on the minimum value between the business limit and the annual taxable income.
You have access to the lower rate on the full business limit if your taxable capital is lower than 10 million, however if it is between 10 and 15 million, the business limit for both the provincial and the federal is reduced in a linear way.
For example: If the limit is 500,000$, it is reduced by 1$ for every bracket of 10$ over 10 million. The higher rate for its part is applicable on the rest of the taxable revenue.
The following calculator (in the link below) can estimate the taxes you will have to pay from commercial activities in one province.
Getting money out:
There are multiple ways to take money from corporate earnings while keeping your tax bill to a minimum. Sometimes, you can even access corporate earnings tax free.
Often, business owners (and family members) opt to receive a portion of corporate earnings through a salary for services provided to the business, just like other employees. Tax savings may be available if a salary is paid to a family member for work performed and the family member is in a lower tax bracket than the corporation. Tax savings can also be achieved if you distribute the money as dividends to yourself or other family members either directly or through a family trust.
Many owners extract profits using a mix of salary and dividends to maximize their tax savings. Finding the optimal combination depends on the following:
- cash flow needs
- their income level
- the corporation’s income level
- payroll taxes on the salary
- and many other factors
If the corporation was funded with a good deal of capital, you may be able to extract funds tax free by reducing their corporation’s paid-up capital; essentially the amount of capital contributed in exchange for its shares.
Generally, you are allowed to pay shareholders any amount less than the corporation’s paid-up capital without tax consequences, where you also reduce the paid-up capital by that amount.
Another option is to repay shareholder loans. If you loaned funds to their corporation, you can receive any amount of repayment on these loans tax free. You may also arrange to have the corporation pay interest on said loan.
Using this method, youshould pay about the same amount of personal tax on the interest income as if the corporation paid them that amount in salary.
The most tax-effective and often overlooked strategy:
Maximize the company’s capital dividend payments.
When your client has a capital gain, the untaxed portion (one half of the gain) is added to its capital dividend account. The corporation can pay any amount from this account to your client without attracting personal tax. Still, you must ensure that you and your client make the appropriate tax elections and file the directors’ resolutions with the Canada Revenue Agency.
- You could transfer a capital asset personally owned (ex. Participating Life Insurance) that has an accrued gain to the company through a tax-free rollover. That allows you to effectively receive tax-free funds from the corporation equal to the basis of the asset transferred to it.
- Sell corporate assets in the market (or an internal sale) that have accrued capital gains to create a capital dividend account in the company. That would allow you to pay out this capital dividend account as a tax-free dividend.
- Extract funds from the corporation by transferring certain types of life insurance policies to the corporation for consideration equal to fair market value.
Understanding the tax treatment is vital to ensure that the maximum amount is then left to be invested, whether it’s personally or corporately held. Starting with more will help you end-up with more.
Investment income earned inside a corporation is classified as, “passive income,” since it is not generated by business operations. The combined Federal and average Provincial tax rates are 46.17% on the taxable portion of earnings. In the case of interest, that is the entire earned amount. For capital gains, half the gain is subject to the 46.17% tax and for dividends the tax rate is 33.33%.
There are often very good reasons to subject this income to higher tax rates inside a corporation such as:
- Building a nest-egg inside the business to fund future expansions
- Cover short-falls during difficult periods
- Or to facilitate borrowing
Lifetime Capital Gains Exemption
For 2015 the Lifetime Capital Gains Exemption (LCGE) per person is $813,000 and is indexed to inflation. A married couple who both own shares, and can both utilize the exemption could shelter $1.626 million from tax. Farms and fishing operations that qualify have the individual limit at $1 million per person, allowing a couple to shelter a maximum of $2 million.
Depending on your goals, a short-term increase in tax and the legal and accounting fees to establish the appropriate corporate structure could save you $400,000 in tax later. ($2 million capital gain, 50% of which is taxed, subjects $1 million to tax at 40% marginal tax rate = $400,000 tax).
However, the largest risk lies in losing the capital gains exemption on the sale of shares of a “qualified small business corporation”. As the invested assets build over time and operating assets are depreciated as they decline in value, the asset mix could be off-side. To have the capital gains be exempt, the “passive” invested assets cannot exceed 10% of the fair market value of the corporations assets. In addition, throughout the twenty-four months prior to the sale, the shares must not be held by anyone other than the individual (shareholder) or a, “related” person. Also, more than 50% of the fair market value of the assets must have been used principally in an active business in Canada by the corporation. At the time of disposition, 90% of the fair market value of the assets must have been used in the active business.
Since this is, “fair market value”, the current value of investments (not book value) will be compared against the current value of business assets. The calculation often excludes owned business premises since they are not usually considered to be part of “operations”, and are often owned in a separate corporation.
Salary or Dividends:
Salary pros and cons
- If the corporation pays a salary, the big advantage is that you have a personal income
- You will be able to contribute to an RRSP (depending on your age)
- You will be paying into the Canada Pension Plan
- The salary or bonus paid out will be a tax deduction for the corporation
- You can income-split by paying salary to related employees
- Salary is one hundred percent taxable (unlike dividends, which are taxed at a lower rate) so it’s possible that paying a salary could increase your tax load.
- You will have to do payroll. You will have to set up a Payroll account with the Canada Revenue Agency and do all the related paperwork such as preparing T4 slips
- If profits vary from year to year, paying a salary can cause tax problems because you won’t be able to carry back a business loss in future years
Dividend Pros and Cons
- Dividends are taxed at a lower rate than salary, which can result in you paying less personal tax
- Not having to pay into the Canada Pension Plan can save you money
- Paying yourself with dividends is comparatively simple. You write a cheque to yourself from your corporation and at the end of the year, you update your corporation’s minute book and prepare a director’s resolution for the dividends paid.
- Besides the fact that you might want to be paying CPP (Canada Pension Plan) anyhow because not paying it will lessen the amount of CPP you are entitled to when you retire
- Receiving dividends doesn’t allow you to contribute to an RRSP as you don’t have any income, and;
- Receiving dividends instead of salary can “kill” other possible personal income tax deductions for you, such as child care expense deductions
Is a Mix Best?
Often, salary/bonus is paid out to ensure the corporation doesn’t earn over $500,000, and then dividends are paid out if more income is required.
$500,000 is the Small Business Deduction. Up to this amount of income, a privately controlled Canadian Corporation (CCPC) pays income tax at a lower rate.
It almost always makes sense to pay enough salary to the owner to reduce the corporate income to this $500,000 level.
The “correct” answer to the salary or dividends question, taking money out of the corporation and tax issues can be completely dependent on the business owner’s own personal financial circumstances.
- What is your income level?
- What are your cash flow needs?
- What is the corporation’s predicted income for the year?
- Is RRSP room or other personal income tax deductions important?
- How old are you?
Because of the complexity involved, all of these issues and the decisions needed to ensure the best possible outcome is best made with professional advice such as that of a financial planner.
Jeff Devlin, CFP
Elementus Wealth Management Inc.