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Reducing immediate taxes leaves the funds in your “jeans”

As a firm, we have “lunch ‘n learn” sessions to keep us current so that we may appropriately advise our clients as to changes in taxation and accounting principles and philosophy.

As a firm, we have “lunch ‘n learn” sessions to keep us current so that we may appropriately advise our clients as to changes in taxation and accounting principles and philosophy. Recently, we heard about the changes to the salary/dividend mix, which was a great reminder for me to talk to my clients about this and other tax planning strategies.

As an owner of an incorporated business, it is important to take steps to control and reduce your corporate and personal income taxes. Oversights today could impact your wealth in the future. There are some basic tax planning ideas you can follow that may allow you to get income and capital out of your business tax-effectively.

Determine the optimum salary/dividend mix

Owner-managers of incorporated businesses have several alternatives for compensation from their corporations, such as receiving a salary and dividends on their shares. Unfortunately, there is no “one-size-fits-all” when it comes to determining the most tax-effective split between salary and dividends. The optimum split depends on current cash requirements, the owner’s other income levels, the corporation’s status and its income level, RRSP contribution preferences, and other factors.

In the past, it was often a good strategy for a privately owned corporation to pay enough salary to reduce the corporation’s income to the small business limit (currently $500,000 for federal purposes). This maximized the amount of income that is taxed at the low small business rate, without having corporate income taxed at the higher rates that apply to income beyond the small business limit. If you’re using this strategy, you may want to revisit it because recent changes to the taxation of dividends have upset the old rules of thumb.

Consider other tax-effective ways to extract funds from your corporation

Repay loans from shareholders

If you have loaned funds to the corporation, it can repay any amount of the loan without tax consequences. Such a repayment is neither deductible to the corporation nor taxable to you. As with everything else, there are other considerations, including banking covenants, as they may relate to a drawdown.

Return paid-up capital

Any amount that is less than the corporation’s “paid-up capital” (PUC) may be paid out to the shareholders as a repayment of capital, generally with no tax consequences.

If the corporation was originally funded with a substantial amount of capital, consider extracting funds by a reduction of the corporation’s PUC. You will want to be sure the corporation remains sufficiently capitalized to satisfy any requirements of its creditors or bankers.

PUC is essentially the amount of capital contributed to the corporation in exchange for its shares. However, the figure can be adjusted in various ways for tax purposes. As such, the legal PUC often differs from the tax PUC.

Pay capital dividends

Only one-half of capital gains are taxed. When a private corporation realizes a capital gain, the untaxed portion is added to its “capital dividend account.” Similarly, one-half of any capital losses reduces the capital dividend account.

Any amount in the corporation’s capital dividend account may be paid out entirely tax-free to its shareholders. This preserves the non-taxability of the appropriate fraction of the capital gain. So if the corporation has realized any capital gains (net of realized losses), you should generally cause it to pay out capital dividends as your first choice for extracting funds.

For the dividend payment to qualify for tax-free distribution, the appropriate tax election forms and directors’ resolutions must be filed with the Canada Revenue Agency before the dividends are declared payable from the corporation. If you do not file the tax elections in advance, penalties could apply.

If you allow a capital dividend account to build up in the corporation without paying capital dividends, the account can be reduced or wiped out by future capital losses. Once you have paid out capital dividends, however, they are safely out of the corporation, and subsequent capital losses will have no effect on them.

Other tax planning ideas you may want to explore include estate planning, lifetime capital gains exemption planning, income splitting, life insurance and incorporating your investments.

Business owners that reduce their corporate and personal income tax can help to enhance their wealth and effectively save for the future. It is not that any of you will ever want to retire, but isn’t it nice to know that you could?