You’ve worked hard to build your business and create a profitable company. Perhaps you are now at a point where your business has become more established and you are ready to start withdrawing some of the profits out of your corporation. Or maybe you want to bolster your personal cash flow for lifestyle reasons or to fulfill your family’s financial obligations.
Whatever the reason, simply withdrawing cash from your business’ bank account will likely result in a significant tax bill. So the question then becomes: how do you tax-efficiently take money out of your business?
Unfortunately, the answer to this question isn’t as straightforward as you might think. The way in which it makes the most sense for you to take money out of your company may not be the same for another business owner. Consideration must be given to many factors, including the personal federal and provincial tax rates where you live, the corporate federal and provincial tax rates where your business is located, your cash requirements both in the short and long-term, and whether your company possesses certain favourable income tax attributes that can be utilized to minimize tax.
Let’s look at some of the more general approaches that you can use to tax-efficiently take money out of your business. Some of these strategies may even allow you to access corporate profits on a tax-free basis. But, keep in mind that recently introduced tax rules add more complexity to the decision-making process, resulting in additional benefits and costs to weigh when determining the most tax-efficient approach. Let’s look at some of the options.
Paying a salary
Typically, business owners will pay themselves a salary from the business in a way that is similar to an employee being remunerated. If family members work in the business, a reasonable salary can be paid to them as well. This is especially beneficial if family members have little or no other sources of income. Generally speaking, a reasonable salary in this instance would be one that approximates what would be paid to an unrelated third party for the same work activities.
From a tax perspective, business owners and family members will be taxed on salary at regular personal marginal tax rates that apply based on the jurisdiction in which they live. The corporation will be allowed a deduction for salary paid when determining its taxable income.
Paying a dividend
Dividends can be used to distribute money from the corporation to both you and your family members. This would require that you, your spouse, and your children hold shares of your corporation either directly or indirectly (i.e. through a trust or a holding company). To ensure this is a tax-efficient method of withdrawing money from the corporation, it will be critical to consider both the tax on split income (TOSI) rules and the corporate attribution rules before any distribution is made.
TOSI rules, in short, is taxable dividend from a private corporation that is subject to the highest personal tax rate, unless an exclusion from the TOSI rules is available. Corporate attribution rules relates to the transfers or loans to a corporation in order to effectively shift income to another family member. This may result in additional tax for the individual making the transfer or loan, unless certain conditions are met. Careful tax planning should be carried out to avoid any punitive tax results under the corporate attribution rules.
The optimal mix
Most small businesses in Canada are eligible for specially reduced rates of both federal and provincial corporate tax due to the Small Business Deduction. In order to maximize the potential for this tax savings, it is common for business owners to pay themselves a combination of both salary and dividends.
As a cautionary note, if you decide to retain income in your corporation to take advantage of the tax deferral and invest in passive assets, this may increase the passive investment income earned by the corporation. If that is the case, it will be necessary to consider the impact of the passive investment income rules. These rules restrict the Small Business Deduction that can be claimed by a business where passive investment income of an associated group exceeds $50,000 in the year.
You should also consider other factors can influence your decision to take a salary versus being paid dividends. Your cash flow needs must be taken into account, since retaining income in your business won’t work in cases where you need money for other purposes. Also, bear in mind that drawing dividends alone will not provide you with earned income for purposes of your RRSP contribution. Moreover, on the corporate side, you will want to consider the impact of any relevant payroll taxes, as well as any remittance requirements and filing obligations that may arise.
Repay outstanding shareholder loan
To help finance the start-up or growth of your business, you may have loaned funds to your company in the form of a shareholder loan. Now that your corporation is profitable, it may be a good time to consider having the company repay all or a portion of this loan. Any amount that you receive in settlement of your shareholder loan will be a tax-free distribution, similar to a return of capital.
Alternatively, you could consider having your company start paying you interest on your shareholder loan. However, keep in mind that while any interest paid would be deductible to the corporation, it will be taxable to you as investment income. It is also important to note that in certain circumstances the TOSI rules will apply to tax interest income earned by individuals from private corporations at the highest tax rate. Therefore, before any interest is paid, consideration should be given to whether the TOSI rules are a concern in order to avoid any negative tax consequences.
Paying a capital dividend
Another potential tax-free distribution to consider is to pay yourself a dividend out of your corporation’s Capital Dividend Account (CDA). In simple terms, CDA is a notional balance that most commonly represents the non-taxable portion (ie. 50%) of any capital gains that a private corporation has realized on the disposition of capital assets. A positive balance in a corporation’s CDA can be distributed to you as a tax-free dividend, ensuring that the non-taxable portion of the company’s capital gains do not subsequently become taxable.
You should note that CDA is calculated on a net cumulative basis, so the balance will be eroded by any capital losses realized by the corporation. However, capital losses realized subsequent to a distribution of the CDA will not have a retroactive effect on having previously received this distribution tax-free even if the loss is carried back. Accordingly, you should pay out the balance of the CDA as it becomes available.
That said, calculating the CDA can be complex. There are rules that govern what can and cannot be included in the CDA, as well as timing considerations with respect to the recognition of additions to its balance. Unfortunately, there can be negative income tax consequences when a capital dividend is paid in excess of the corporation’s available CDA. Moreover, specific filing requirements must be met when paying a capital dividend.
Withdrawing cash from your business can result in a significant tax bill if not done properly. Consult with a qualified tax specialist if you have any questions on how to tax-efficiently take money out of your business.