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When entrepreneurs donít know tax rules, results can be costly
Monday, October 20, 2003
There are not too many mysteries in the procedure for minimizing taxes on small business, yet it's surprising that many owner/managers whose financial fates are tied to tax issues don't know the rules well.
Small-business corporations are often advised to pay enough salary to reduce their annual income to $225,000. This payout maximizes the amount of income that is taxed at the small-business rate without having corporate income taxed at the higher rates that apply to incomes of more than $225,000. In 2004, the small-business deduction will rise to $250,000, to $275,000 in 2005 and $300,000 in 2006. But there is a risk in this strategy of bonusing down to the top of the small-business tax rate or, alternatively, maximizing the amount of income left in a company to make full, current use of the small-business tax rate.
Grant McDonald, KPMG's Ottawa-based national partner in charge of enterprise taxation, says that owner/managers should not use corporate tax minimization as their sole determinant of income they will pay themselves.
If the business gets into tough times, the salary it paid in good times can block efforts to carry back a later year's loss. For example, if a company earns $500,000 in 2003 and pays $275,000 as a salary to the owner/manager, and if the company then were to lose $500,000 in 2004, there is no way to carry the loss back against personal income. If the owner/manager had left the funds in the company as business income on which corporate tax had been paid and then paid the net income as dividends, the owner/manager would be able to carry back the loss to 2003 and so generate a corporate tax refund, McDonald notes.
There are other criteria, he says. "In the current economy, many small businesses are not making large incomes at the corporate level this year. They have to rethink their strategies, and that means that in times of economic downturn, they have to save for the future. They should at least pay out enough earned income to max out their CPP [Canada Pension Plan] contributions and to ensure maximum RRSP [registered retirement savings plan] contributions. For 2003, the limit is $14,500, which requires a salary over $80,555 in 2002, since RRSP limits are set on prior year income. The RRSP contribution limit will be $15,500 in 2004, which requires $86,111 to be earned in 2003 and $16,500 in 2005, which requires $91,666 to be paid as salary in 2004 and finally $18,000 in 2006, which will require a $100,000 salary in 2005."
As an alternative to paying salaries to their owner/managers, small businesses can pay them dividends, McDonald notes. Dividends are not deductible in calculating corporate income. Unlike a salary, the dividend payout will not reduce the taxable income on which the corporation pays its tax.
Dividend planning strategies cannot reduce the total tax payable to the owner/manager, because the Department of Finance uses a process of tax-rate convergence, usually called integration, to ensure that taxes payable at the corporate level plus what the owner/manager pays on a dividend will be equal to what one would have paid in tax had it been earned directly.
Nevertheless, the Income Tax Act may allow an intermission between the time the dividend is paid and when the tax must be paid by the individual shareholder. That's a role of a holding company that can be interposed between an operating company and taxpayer.
"Intercorporate dividends based on operating income are not subject to tax," McDonald notes, "until they are paid out to the individual shareholder. As well, a holding company makes it harder for creditors to reach the assets and funds of the operating company." And although this is generally true, McDonald notes that it is essential to take legal advice when setting up holding companies, especially if creditor proofing is an objective.
The integrated tax system also allows capital dividends to be paid without tax liability as the non-taxed half of capital gains. The sum payable comes from the capital dividend account. This should be an owner/manager's first choice for taking money out of the company. The reason: The capital dividend is a tax-free withdrawal. What's more, the capital dividend account can be wiped out by future capital losses. So delaying taking a capital dividend may result in denial of the opportunity to pay it out, McDonald says.
"The tax system allows the taxpayer to organize his affairs to pay the least amount possible consistent with the law," McDonald says. "The trick is to observe the law closely and to be well advised."
Tax minimization today is a prelude to tax planning for the future, he notes. "The successful entrepreneur may ponder transfer of an enterprise to family members. Usually, this is done through an estate freeze.
"The idea is to fix the value of an estate and, in particular, to realize value in the shares of an operating company. You freeze value in the present and defer taxes payable to the time of the death of the owner/operator, while transferring appreciation to the next generation, which will own the common shares of the operating business."
Current income splitting with family members is another potential benefit. This is done by creating two share classes -- preferred shares of fixed value that are held by the business owner and new common shares that participate in future earnings and growth, he explains.
At the time of the estate freeze, the current owner can trigger all or part of the accrued capital gain on the shares to date, which may allow the owner to use the $500,000 capital-gains exemption. McDonald notes that the business must qualify as a small-business corporation that, among other tests, means that at the time of crystallization, 90 per cent or more of the value of its assets are used in carrying on its active business in Canada.
"It is important in a freeze not to give away too much too soon. The owner/manager should not wind up feeling badly about the amount he gave away. If the future value of the company soars, then the parents can wind up regretting that they gave away too much too soon. However, in the economic doldrums that are affecting many sectors of the economy, this may not be a current issue," he cautions.
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