You may have heard the recent unconfirmed report coming from the Canadian military. Apparently, the men of Charlie Company had been in the field for two weeks when the captain announced: "I've got good news and bad news men. First, the good news. Today we're going to change our underwear."
Evidently, the troops started cheering wildly at this announcement. "Now the bad news," the captain continued. "Smith, you change with Jones. Andrews, you change with Murphy. And McFarlane, you change with Johnston."
Speaking of good news and bad news, last week's federal budget offered a little of both. The bad news? Finance Minister John Manley has confirmed that there are no planned surpluses for the next three years, which means that Canadian taxpayers shouldn't expect new tax cuts during that time. The good news? The military will see additional funding of $800-million annually, which will likely mean new underwear for the troops.
And there's even better news if you're the owner of a small incorporated business.
When an incorporated business is a Canadian-controlled private corporation (CCPC), which includes the majority of privately held companies, the company is eligible for a pretty attractive rate of tax on its first $200,000 of active business income. Without getting into all the technical mumbo jumbo, the reason for this low rate of tax is the "small-business deduction," which reduces the company's effective tax rate.
How low is the tax rate? Try 18.6 per cent, which is the Canada-wide average on the first $200,000 of active business income for a CCPC in 2003. Active business income over $200,000 can be taxed as highly as 41 per cent.
The low rate of tax in a corporation can provide you with a deferral of tax to the extent you can leave some of your profits in the company without drawing the money out for personal use.
Consider Jack's case. Jack's business, XYZ Inc., is expected to earn $200,000 of active business income in 2003. This is the taxable income retained in the company after Jack has paid himself a salary he's comfortable with.
The company will pay taxes of $37,200 (18.6 per cent) on that income, leaving $162,800 in the company after taxes. Not a bad rate of tax.
But what if Jack pays some of the $200,000 to himself as additional salary or dividends instead of leaving it in the firm?
Consider salary first. If Jack were to pay some or all of that $200,000 out to himself as additional salary or bonuses, the company would pay less tax since it could deduct the payment. But Jack would face tax on those dollars personally at about 46 per cent, assuming he's in the highest bracket.
Hey, 46 per cent in Jack's hands is a much greater tax hit than 18.6 per cent in the company.
What about dividends? If Jack were to pay some of the $200,000 to himself as dividends, he would face personal tax on those dollars at about 31 per cent (a Canada-wide average) if he's in the highest tax bracket.
When you add the tax paid personally on the dividend to the tax paid in the company on the earnings, the combined rate of tax on those dollars paid out as dividends is 43.8 per cent in this example. That's much greater than the 18.6-per-cent hit faced in the company when those dollars are retained in the company.
The bottom line? Keep as much of your profits in the company as possible and you'll defer tax. Once you pay the earnings out as salary or dividends, the tax catches up to you and your deferral ends.
How the did the 2003 federal budget make it even easier to defer tax? Simple. The budget proposes to increase the dollars in a company that will qualify for the low rate of tax.
The $200,000 small-business limit is scheduled to increase to $225,000 for 2003, $250,000 in 2004, $275,000 in 2005, and $300,000 after 2005.
You see, as a small-business owner, you may now enjoy more dollars in your company taxed at the low 18.6-per-cent rate (varies by province and year). The more dollars taxed at that low rate, the greater the opportunity to defer tax by retaining those dollars in your company.
Next time, I'll take a closer look at what you might do with those dollars you've retained.
Tim Cestnick, CA, CFP, TEP is author of The Tax Freedom Zone and Winning the Tax Game 2003. He is managing director, Tax Smart Services, at AIC Ltd.
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