How to optimize after-tax income
When running a private business, you need cash flow to support your lifestyle. The challenge is minimizing personal taxes, while optimizing income. But removing money from your company for your benefit requires careful planning.
Here are some of your options to extract cash. Each has unique considerations and income tax consequences.
Salary and/or bonus
These options are deductible by the company and taxable. Generally, to be a tax deductible expense, the payment must be considered reasonable for business purposes. And, yes, it’s probably unreasonable to pay your 14-year-old child $50 an hour to stuff envelopes.
Payments to active owner-managers for salary and bonuses aren’t subject to that rule. They are, however, subject to withholding at source, which means income taxes together with the employer and employee portions of CPP/QPP contributions. If you’re a significant shareholder who owns 40% or more of the corporation, or have employees who aren’t eligible for employment insurance, then there are no employee or employer contributions required.
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 where you live in Canada.
Dividends are derived from your 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 are 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, depending on province.
There is no withholding mechanism on dividend income, so you net 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 you’ll have to pay tax in quarterly installments.
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. Review dispositions or receipts from these sources to evaluate the opportunity for payment.
Paid-up capital reduction
Your company can return your 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. But there’s a possibility of inadvertently creating a capital gain. 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 your 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
You 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 you personally own 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 you and, although tax consequences may arise, the low-tax nature of capital gains can be more efficient than other options.
Alternatively, if your 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.
Evaluating each option to scrutinize the tax costs will help you get the money you need for your lifestyle in the most efficient manner.