Your corporation is through its startup years and has become a successful and well-established business. Now seems like the right time to start withdrawing some of your hard-earned profits, but is it really that simple?
The short answer, unfortunately, is no.
While your corporation may have surplus funds, accessing them is often a complicated and challenging process. The methods you use to structure your withdrawals can have a significant impact on your overall tax liability and financial situation. To extract your money successfully, you need to understand the different strategies involved and how to apply them to your specific situation to maximize your tax savings.
In this article, we delve into common methods your corporation can use to pay you, discussing the implications and incentives of each. You’ll gain useful insights into the integration of corporate and personal tax systems as we touch on the distribution of capital dividends, income splitting, shareholder loans, the reimbursement of invested capital and more. By effectively utilizing these strategies, you can withdraw money from your business in the most tax-efficient way for you and your corporation.
1. Salary vs. Dividends
Owners of Canadian-Contolled Private Corporations (CCPCs) have two primary options for withdrawing money from their business – taking a salary or declaring dividends. Both methods have pros and cons, and the best choice depends on individual circumstances, including the company’s structure, the owner’s personal income level, and the future plans for the business.
Salary – You are entitled to withdraw a salary from your corporation for the services you perform. As a general exception, the Canada Revenue Agency (CRA) will not question the salary or bonuses paid to owner-managers, provided they are actively involved in the daily operations of the CCPC. While salaries are subject to regular personal marginal tax rates, they do offer several advantages:
- Business Expense – Salaries are considered a business expense and can therefore be used to reduce your corporation’s taxable income
- Predictability – A regular salary provides a predictable and steady income stream, which can be beneficial for personal budgeting and financial planning
- Consistency – As they are taxed at the source throughout the year, salaries result in a smaller lump sum payment at tax time
- RRSP Room – A salary increases your RRSP contribution room, providing more opportunities for tax-deferred savings
- Retirement Contributions: Salaries require Canada Pension Plan (CPP) contributions, which can lead to higher benefits upon retirement
Dividends – Corporations can also distribute earnings to shareholders in the form of taxable dividends. When funds are withdrawn from the business in this manner, it appears that they are taxed twice, once at the corporate level and then again at the personal level.
However, the Canadian tax system is designed to accommodate this double taxation through what is known as integration. This means that the combined corporate and personal tax applied to dividend distributions should be equal to what the personal tax would be if the income was earned outside of the corporation.
However, integration is not a perfect system, and thanks to reduced corporate tax rates and the Small Business Deduction (SBD), dividends can sometimes be a more tax-efficient way for your business to pay you. By utilizing taxable dividends as a means of withdrawal, owners can take advantage of the following benefits:
- Tax Credit – To offset double taxation, dividends are eligible for dividend tax credits, which can reduce the amount of tax paid at the personal level
- Lower Tax Rate – For corporations with income below the small business limit, the combined tax rate for dividend distribution will generally be less than the top marginal personal tax bracket applied to salary/bonuses
- Flexibility – Dividends can be declared at any time, providing flexibility in how and when you receive your money
- No Payroll Obligations: Dividends are not subject to payroll taxes, such as CPP and Employment Insurance (EI) contributions, reducing administrative burdens and costs
- More Money Upfront – As corporations do not need to remit any CPP deductions or taxes at the source, dividends result in a higher immediate payout
Deciding between salary and dividends requires a careful evaluation of your current financial situation. Ultimately, there is no one-size-fits-all answer, and it’s often beneficial to use a combination of both to optimize tax efficiency. The key is to find a balance that supports your financial goals while minimizing your overall tax liability.
2. Capital Dividends
Capital dividends represent a unique financial mechanism available to corporation owners in Canada. Unlike regular dividends, which are paid out from a company’s after-tax profits and are taxable for the recipient, capital dividends are drawn from the corporation’s capital dividend account (CDA).
When a business realizes a capital gain, only 50 percent of the gain is subject to tax, and the other half can be credited to the CDA. This allows the corporation to distribute these funds to its shareholders as capital dividends, which are tax-free in the hands of the recipients. Capital dividends provide a particularly advantageous strategy, as they allow funds to be withdrawn from the business without incurring tax consequences at a personal level.
While this method can be a powerful tool for business owners, calculating the CDA can be complex. There are specific rules that govern what can be included, as well as strict timing and balance considerations that must be met.
3. Shareholder Loans
If you need short-term funds, you can borrow money tax-free from your corporation in the form of a shareholder loan. This process works under the principle that the loan is expected to be repaid to the company, and as such, does not constitute taxable income when it’s received.
For tax purposes, the CRA requires that the loan be repaid within one year after the end of the fiscal year in which the loan was made. If the loan is repaid within this timeframe, the shareholder avoids being taxed on the loan amount as personal income.
Shareholder loans can be a flexible way to access funds for immediate purposes without triggering unwanted tax consequences. However, they are not interest-free, and the interest rates attached to them must be at least equal to the CRAs prescribed rate.
4. Income Splitting
If you employ any family members in your business, you can take advantage of income splitting to withdraw money from the company in a more tax-effective manner. Essentially, this involves transferring income from a higher-earning individual (e.g. the business owner) to a low-earning individual (e.g. a spouse or adult child). This income can be distributed in the form of salaries/bonuses or dividends.
Salary – By paying family members a salary/bonus, you can distribute income across lower personal tax brackets and reduce the overall tax burden. Remuneration must be reasonable for the actual work performed, as the CRA has strict guidelines to prevent abuse of this strategy.
Dividends – Another method of income splitting that business owners can take advantage of is dividend sprinkling. This involves reorganizing the corporation to make your spouse and/or adult children shareholders, to whom you can then distribute dividends. As shareholders are not required to be involved in the daily operation of the business, dividends are not subject to the same “reasonability” test as salaries and bonuses. This method also allows the capital gains exemption for qualified small business corporation (QSBC) shares to be multiplied, with each family member entitled to claim the full exemption amount.
It’s important to note that the CRA has implemented rules, such as the Tax on Split Income (TOSI), which limit income-splitting opportunities to counteract what it views as unfair tax advantages. These rules are designed to ensure that income splitting is done within the framework of legitimate family contributions to the business.
5. Reimbursement of Amounts Owed
There are several situations in which your business can end up owing you money personally. Suppose you’ve paid out of pocket for any costs related to your corporation, such as entertaining clients or using your own vehicle. That money can be returned to you tax-free, while also providing a deduction for the corporation.
Alternatively, if you’ve transferred personal assets to the corporation and received shares in return, you can access your invested funds in a tax-efficient manner by withdrawing your paid-up capital (PUC). The shares that you received in exchange for your assets should have a PUC amount that is disclosed on your company’s balance sheet.
To withdraw your PUC, the corporation’s directors can declare and pay a dividend to you as a return of capital, reducing the PUC on the balance sheet accordingly. The amount you receive will not be subject to additional tax, as the original investment was made from your after-tax personal income.
Lastly, business owners who purchased an existing corporation may have acquired shares that have a “hard” adjusted cost base (ACB). Similar to PUC, “hard” ACB effectively represents the amount paid for these shares at the time the corporation was purchased.
The process of converting shares with a “hard” ACB into cash involves setting up a holding company which can be used to acquire the shares. This transaction is typically executed at the ACB value, which means no capital gain is realized, and consequently, no capital gains tax is incurred.
Final Thoughts
As business owners in Canada navigate the complexities of managing their finances, understanding the most tax-efficient methods for withdrawing money from their business is essential. This article is intended to provide a brief overview of the benefits and considerations of the most commonly used strategies.
The successful implementation of these methods is a complex endeavour with far-reaching tax and financial implications. It is therefore essential to consult with knowledgeable CPAs and advisors who can create a tailored strategy specific to your personal and professional situation.
By adopting a strategic approach to withdrawing money from your business, you can maximize your after-tax income and create a more prosperous financial future for you and your business.
This article was written by the NVS Professional Corporation team, your knowledgeable Barrie and Markham accountants. The content is intended as a general guide for informational purposes only. For specialist advice tailored to your specific situation, please reach out to our expert team.
