My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, March 27, 2017

The Federal Budget - Where is the Incentive For Success and Entrepreneurship?



Last Wednesday’s federal budget was pretty benign. Personal tax rates did not rise to 60% and the capital gains inclusion rate remained unchanged. However, many professionals, in particular accountants and lawyers, suffered a direct hit. The budget proposes that certain professionals must now pay tax on income they have not billed, by including work in progress in their taxable income. Small business owners escaped unscathed from this budget, but there are storm clouds on the horizon, as there could be some very punitive tax measures coming in the near term. 

If you wish to read a detailed summary of the budget, here is a link to BDO Canada's budget summary. However, for the purposes of today's post, I am just going to discuss the budgets impact on professionals and the warning shot sent across the bow of small business owners.

Let me state upfront, that I am of the view that government policy should not be to punish success and those willing to take risk (i.e. the so called top 1%, but probably the top 5-15%) but to encourage success and entrepreneurship. My view, which I will readily admit may be distorted because of my job and the high-net-worth individuals I deal with, is that small business owners and entrepreneurs (which in many cases includes professionals) are the largest creators of jobs for the “middle class”. Most prosperous people have risked much to achieve their success, in both financial capital and family time. They feel they deserve to be rewarded for that success, not penalized; which if I read the Liberal tea leaves correctly, is what is going to happen in the very near future. 

Professionals – A Change in Income Recognition – Billed Basis to WIP Basis


Currently certain professionals (accountants, dentists, lawyers, medical doctors, veterinarians and chiropractors) may elect to exclude the value of work in progress (WIP) pursuant to Section 34 of the Income Tax Act. This allows professionals to essentially recognize income for tax purposes only when it is actually billed (billed basis). The budget proposes that going forward, professionals will no longer be eligible for a Section 34 WIP deduction and will have to recognize income when services have been provided, even if not billed. The legislation provides a two-year transition period.

So in English. Let’s say I am doing some estate planning for Mary Smith. Mary engaged me to start the planning in November, 2016 and I spent $5,000 of time in November and December gathering information, corresponding with her estate lawyer and researching her issues. 

For accounting purposes, I must include the $5,000 of time I have spent on the file in my 2016 income under generally accepted accounting principles (accrual accounting). However, currently, I can elect under the aforementioned Section 34 to deduct the $5,000 of WIP from my 2016 taxable income since I have not yet billed Ms. Smith. Thus, for tax purposes my income in relation to Ms. Smith is nil. It should be noted that some professional firms have not even bothered recording their WIP, since it would net out with the offsetting Section 34 deduction. These firms will now be forced to change their reporting systems, so they can capture WIP. 

Back to my example. Let’s say I need to spend $2,000 more in time to finish the project in January, 2017 and finally get around to billing the client $7,000 in February, 2017. But Ms. Smith is one tough cookie. First she waits until March and calls me to argue about my bill and wears me down, so I reduce her fee to $6,000. She then takes three months to pay me so I finally receive $6,000 in June, 2017. 

Under current tax law, other than the fact she is a bit of a pain in the butt, I don’t really care about all this since I will pay tax on the $6,000 in 2017 and have the money in hand. 

Under the proposed rules, I will have to include in my 2016 income up to $5,000 of WIP even though I have not yet billed the client and I am not paid until June of the following year. I will thus potentially have a significant cash flow issue. I have to pay tax on money I have not yet billed and collected. Part of the government’s rationale for this proposed legislation is that professionals expense the costs of their WIP in the current year. While that is a fair concern to some extent, those costs are actually paid in the year, so expenses are being matched to payment, while the new legislation does not match billing to income inclusion.

I have been asked if contingent or success based fees could be considered WIP. I don't have an answer at this time; this will need to be clarified by the CRA.

Many professionals have used this WIP deduction to defer their current tax burden to their retirement years when their tax rates are lower. This will no longer be available.

Transitional Rules


In addition to the future cash flow issue discussed in my example above, professionals will face a short-term cash flow issue in that their current Section 34 WIP will be taxed over the next couple years, causing significant and unexpected increases to taxable income for which they had not expected to pay tax.

For the first taxation year that begins after March 22, 2017, in computing income, the budget proposes that 50% of the lesser of the cost of the WIP and its fair market value will be allowed as a deduction. For subsequent taxation years, 100% of the lesser of the cost of WIP and its fair market value will be required to be included in income. For professionals with December 31st year ends, these income inclusions will come in their December 2018 and 2019 year-ends. This additional tax comes on the heel of the increase in marginal rates to 54% further exacerbating the issue.

For those wondering what exactly is the cost of WIP, that is a good question, still to be determined. In the old days, a billable hour was set based on the formula of  1/3 salary, 1/3 overhead and 1/3 profit. So is the cost of WIP under this old school calculation the 1/3 salary, 2/3 salary and overhead or some other variation? That does not even consider the significant historical discount firms take on their WIP, anywhere from 10-30%.

Tax Planning Using Private Corporations


The budget discussion highlighted several tax planning strategies using private corporations, which the government feels can result in high income individuals gaining unfair tax advantages that are not available to other Canadians. The government is reviewing these areas and will be releasing a paper in the upcoming months setting out these issues in more detail and their policy responses. Every small business owner should be concerned significant changes are coming in respect of many of the standard current tax planning strategies they utilize.

The budget specifically noted the Liberals are reviewing the following strategies:

“Sprinkling income using private corporations, which can reduce income taxes by causing income that would otherwise be realized by an individual facing a high personal income tax rate to instead be realized (e.g., via dividends or capital gains) by family members who are subject to lower personal tax rates (or who may not be taxable at all)”. 

I interpret the above to mean the government will be reviewing family trusts and the use of discretionary dividends amongst other tax planning strategies.

“Holding a passive investment portfolio inside a private corporation, which may be financially advantageous for owners of private corporations compared to otherwise similar investors. This is mainly due to the fact that corporate income tax rates, which are generally much lower than personal rates, facilitate accumulation of earnings that can be invested in a passive portfolio”. 

This discussion point is very disconcerting. I interpret this to mean that the Liberals are not only going to review the use and availability of the small business deduction which has been rumored from day one, but they are even going to look at the after-tax earnings and the use of holding companies.

It should be noted there is no tax advantage to having an investment portfolio inside a corporation. The issue is that if a small business makes $10,000 from its active business activities, it would only pay $1,500 in corporate income tax and have $8,500 to invest, whereas a middle class Canadian would only have only say $6,000 to $7,500 to invest depending upon their income and marginal tax rate.

“Converting a private corporation’s regular income into capital gains, which can reduce income taxes by taking advantage of the lower tax rates on capital gains. Income is normally paid out of a private corporation in the form of salary or dividends to the principals, who are taxed at the recipient’s personal income tax rate (subject to a tax credit for dividends reflecting the corporate tax presumed to have been paid). In contrast, only one-half of capital gains are included in income, resulting in a significantly lower tax rate on income that is converted from dividends to capital gains”.

There is some planning that goes on along these lines, but I don’t see this as a major issue for the vast majority of small business owners.

Associated Companies


The government is proposing to change the rules regarding association such that if you have one corporation owned legally by one spouse and another legally by another spouse, they may become associated because they are factually controlled by one spouse. As result, instead of each corporation having a small business deduction, both the husband and wife’s corporation may have to share one small business deduction. 

Government’s Objective


In the budget paper, the government said it “will ensure that corporations that contribute to job creation and economic growth by actively investing in their business continue to benefit from a highly competitive tax regime”. How it intends to do this is the $64,000 question. My concern is that you risk shrinking the middle class that the government is so keen on helping, if you de-incentivize small business owners and entrepreneurs to take the personal and capital risks needed to start new companies and invest in new ones. I can tell you I already have significant negative feedback from my clients who have to pay 54% tax; if you also remove their ability to income split and small business tax preferences, my personal opinion is you will have a disenfranchised a segment of the population that like it or not, is a large part of the engine behind the economy.  

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Monday, March 20, 2017

What Small Business Owners Need to Know - Management Fees - The Importance of Having Proper Support


Management fees may be used to reduce taxes amongst a corporate group and/or to gain access to a greater small business deduction (i.e.: a company with taxable income pays a management fee to reduce its taxable income to a related company with losses that can absorb the management fee income and not pay taxes).

In other cases, management fees are used by an owner-manager as a “lazy” way to pay salaries to the owner.

Sometimes these fees are well thought out and supported with documentation. However, I also see these fees paid recklessly. In either case, the use of management fees have some risk associated with them, as they are often challenged by the Canada Revenue Agency ("CRA") where they are not considered reasonable and justifiable. 

Today, Howard Kazdan, a tax expert with BDO Canada LLP, discusses management fees and what kind of support is suggested to strengthen the payer’s case for deducting such fees.

I thank Howard for his excellent post

Management Fees – The Importance Of Having Proper Support

By Howard Kazdan

As noted above, management fees are often used as a tax planning tool. Of course, to be effective, the fees must be deductible to the payer.

The criteria that are required for the management fees to be considered deductible, were established by the courts many years ago:

1. The expense must have been incurred (either actually paid or subject to a legal liability to pay);

2. The fees must have been incurred for the purpose of income from a business and

3. The fees must be reasonable in the circumstances.

In order to make a determination of whether the fees are deductible, the courts may:

1. Require documentation to support the expense, for example an intercompany agreement and/or invoices for work done.

Where the only documentation for intercompany fees is an accounting journal entry, the courts have concluded that such entries are not sufficient to establish that the amount was incurred during the year and represent a true liability at year end.

2. Require evidence from the corporation describing what services were provided and how incurring the expense contributed to the process of earning income.

3. Require evidence of the basis for the amount of fee, since a bona fide fee for service should be based on services performed and not profit. If a payment is based on profit (which may not be known until after year end) the CRA may argue that the payment is a distribution of profit and not a deductible expense.

The CRA has administratively allowed corporations to bonus down to the small business limit and considered such bonuses as reasonable when paid as salary to owner-managers. This administrative position is not available when such amounts are paid as management fees. In the latter case, the CRA will look at the nature of services performed, the time spent to perform those services and whether the fees paid are similar to what would be paid to other arm’s length sources.

Taking the above into consideration, successful claims of management fees that have been subject to CRA review and the courts have the following similarities: 

(a) written management fee agreements/service arrangements be in place describing services, fees, responsibilities

(b) documentation of a bona-fide business purpose for the intercompany fee (for example, use of a management corporation to keep compensation of key management confidential). 

(c) adequate records to keep track of services provided (time sheets)

(d) periodic invoicing rather than only once at the end of the year

(e) company rendering the servicing invoice should have the staff and ability to provide the services. 

(f) the fee should be based on services provided, not profit.

Claims which have not been as successful generally lack the above noted characteristics (for example, there is no agreement; could not provide details of services provided; company earning the income did not have the ability to provide the services; general lack of documentation other than journal entries).

In reviewing management fees, the CRA may send a questionnaire. It is possible that even if the deduction is disallowed in one entity, the company including the fees as income will still be taxed (effectively double taxation). This is why you will want clear documentation that fees are bona-fide management fees and treated consistently each year. 

Don’t forget that such fees may be subject to GST/HST unless the entities qualify for the closely related exception and the Form RC4616 has been properly filed. 

In addition to the criteria already discussed, an additional reason to issue invoices is GST/HST. An invoice will provide clarity on timing of when GST/HST is payable (i.e. when fee becomes legally enforceable) and ensure there is adequate documentation for the company incurring the expense, in support of any ITCs claimed.

If you or your related companies use management fees as a tax planning tool, ensure you review the criteria noted above with your accountant. 

Howard Kazdan is a Senior Tax Manager with BDO Canada LLP. If you would like to engage Howard for tax planning, he can be reached at 905-946-5459 or by email at hkazdan@bdo.ca

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Monday, March 13, 2017

What Small Business Owners Need to Know - The Debits and Credits of Shareholder Loans

As an owner-manager, you can withdraw funds from your corporation as a salary and/or a dividend or as a shareholder loan. The Canada Revenue Agency (“CRA”) has incorporated strict guidelines into the Income Tax Act (”Act’) when shareholder loans have to be repaid and the tax consequences therein. These rules are often misunderstood by shareholders and can result in adverse income tax consequences where care is not taken.

The following discussion relates to situations where you have taken more shareholder loans than you have contributed to your corporation. This is often known as a shareholder “debit” as opposed to a shareholder “credit”. A shareholder credits results when your corporation owes you money, since you have advanced funds or loaned back salary or dividends in a prior year on which you were personally taxed.

The Rules


Section 15(2) of the Act outlines these rules which also encompass loans to a person or partnership who does not deal at arm’s length (i.e. family members) with the shareholder.

The basic rule for shareholder loans is that they must be repaid within one year after the end of the corporation’s taxation year in which the loan was made. For example, if you borrow money from your corporation in 2016 and the corporation's fiscal year end is December 31, 2016, the loan must be repaid by December 31, 2017. If the amount is not repaid within the time frame above, it will be added to the income of the shareholder in the year the loan was received (i.e. 2016 in this example). Therefore, a T1 adjustment may be necessary for the shareholder to correctly include the loan in income in that particular year (2016) plus accompanying interest. If anyone related to the shareholder receives the loan the amount will be included in his/her income and not the shareholder.

The Exceptions


There are some exceptions to the 15(2) shareholder loan rules which would allow the loan amount not to be included in an individual’s income. If any of the criteria below are met than 15(2) does NOT apply:

i) If the loan was repaid within one taxation year;

ii) If the loan was made in the course of a money lending business i.e. bank, and bona fide terms of repayment are made.

Employees/Shareholders Exceptions


Absent of the criteria above, certain types of loans may still be exempt from 15(2) as described below for shareholders who are also employees of their business.

If the loan is to a specified employee (person who owns directly or together with related persons more than 10% of the shares of the business) the loan must be made for one of the following purposes:

1) Purchase a home (includes a house, condo, cottage);

2) Purchase a vehicle used for employment purposes; or,

3) Purchase newly issued shares of the business.

Each of these loans must have bona fide arrangements for repayment within a reasonable time period and the loan must be provided as a result of the individual’s employment rather than shareholdings. This has generally been interpreted to mean that loans must be available to other employees who are not shareholders or related to shareholders, which could be difficult to prove if the owner is the sole employee of the business and preclude the loan where you have employees (unless you provide such loans to all other employees, which is very unlikely).

Where loans are made for a home purchase, the CRA often audits the loan and it can be problematic if not impossible to prove such a loan would have been made to other employees if there actually were such. As result of this burden of proof, where housing loans were once routinely recommended by accountants, they are now typically selectively recommended.

If the loan is to an employee-shareholder who deals at arm’s length with the corporation and together with related persons own less than 10% of the shares then the loan can be made for any purpose. This provides an exception for many employees who are minority shareholders. However, similar to specified employees above, the loan must have bona fide arrangements for repayment within a reasonable time period and the loan must be provided as a result of the individual’s employment rather than shareholdings.

Interest Benefits


Section 80.4(2) of the ITA provides for an imputed interest benefit if 15(2) does not apply. Meaning if the shareholder loan does not have to be included in income, a deemed interest benefit will still need to be reported by the individual. This interest benefit arises when the interest rate charged (if any) on the shareholder loan is less than the CRA prescribed rates per quarter - currently at 1%. The amount of the interest benefit is reduced by any interest actually paid on the loan no later than 30 days after the end of the calendar year.

If the loan is included in income by virtue of 15(2) than no imputed interest benefit would be reported.

Questions to Ask


Some of the key questions to ask when an individual shareholder or connected person (e.g. daughter) receives a loan:


1) Is it reasonable to assume the loan was received by virtue of employment?

2) Is the individual receiving the loan a specified employee? (I.e. owns more than 10% of any class of shares of the corporation). If so, was the loan made to acquire a dwelling, vehicle or shares are described above?

3) Are there bona fide terms of repayment?

If the answer is NO to any of the questions above, 15(2) applies to include the loan in income, unless the entire loan is repaid within one taxation year. Repayment of all or part of the loan that has been included in income will be eligible for a deduction by the individual on his/her personal tax return in the year of repayment.

It is very important that the loan(s) not be considered to be a series of loans and repayments or else CRA could deny the deduction upon repayment. E.g. repaying an amount at the end of 2016 only to borrow again in 2017. One of the more common ways to reduce or eliminate a shareholder loan is to convert it into a salary, bonus or dividend. Since this gives rise to taxable income, it is generally not considered to be a series of loans and repayments.

See Archived IT119R4 for more details and exceptions regarding shareholder loans.

Section 15(2) is one of the most commonly applied and misunderstood sections of the Act. You should always consult your accountant or tax specialist when dealing and planning with your shareholder loans.

I would like to thank Lorenzo Bonanno, tax manager for BDO Canada LLP for his extensive assistance in writing this post. If you wish to engage Lorenzo for tax planning, he can be reached at lbonanno@bdo.ca

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Monday, March 6, 2017

Legacy Stocks - To Sell or Not Sell? That is the Question?

Many people, typically seniors/baby boomers have owned stocks for decades, either through direct purchase or an inheritance of some kind (stocks transferred from a deceased spouse pursuant to their will generally have an adjusted cost base equal to what the deceased spouse originally paid for the shares; shares inherited from a parent or grandparent will generally have a cost base equal to the fair market value on the day of inheritance). These stocks are commonly known as Legacy Stocks; more often than not, they will include shares of Bell Canada, the Canadian bank(s) and/or insurance
companies.

Several weeks ago, Rob Carrick, The Globe and Mail’s excellent personal finance columnist  mentioned to me that several of his readers had asked him about selling their legacy stocks (or as more typically is the case, not selling their legacy stocks). I told him I thought the issue would make a good blog topic and asked him if he was okay with me using his idea to write a post. He gave me his blessing, so today I am writing about the issues and considerations for those of you holding legacy stocks and similar type securities.

The Common Quandary


The issue with selling legacy stocks is that they:

1. Typically have huge unrealized capital gains and thus the sale of these stocks creates a large tax bill

2. The realization of the capital gain can result in a clawback of Old Age Security ("OAS"), which seniors are loathe to ever repay

I know some readers, especially my millennial readers are thinking to themselves “Is Mark really going to write about minimizing the large capital gains of baby boomers that have already benefited from the huge increases in real estate? Cry me a river that they owe some tax.” The answer is yes, since a tax issue is a tax issue and this blog, although meant for everyone, is targeted to high-net-worth individuals and owners of private corporations.

There Is No One Size Fits All Answer


If you have a legacy stock(s) you are considering selling, there is not a standard “one size fits all” answer. There are however, various investment and income tax considerations. I discuss these issues and considerations below.

Capital Gains Rates


The marginal tax rate for capital gains in Ontario for income in the $45-$75k range is approximately 15%. This rate jumps to 22% or so between $90-$140k in taxable income and hits 26.8% once your taxable income exceeds $220,000.

These capital gains rates are the lowest tax rates you get in Canada. So from my perspective, the taxes you would pay from the sale of a legacy stock should not be the determinant in deciding to sell. The key factor (subject to the discussion below) should always be what the best investment decision is. Watching a stock drop 15%, to save 20% in capital gains tax, makes absolutely no sense, when viewed in isolation.

Some tax pundits think the upcoming (no date yet announced) Federal budget may change the taxable inclusion amount of a capital gain from 1/2 to 2/3 or even 3/4. If you are one of those people, now may be a time that the capital gains rate becomes a more significant factor in making your decision to sell a legacy stock (some people are selling and buying back). However, this is only a rumour and if there is no change in legislation, you would accelerate your tax payable.

Old Age Security Clawback


As noted above, the capital gains tax tail should not wag the tax dog. However, there is one issue that complicates the matter for seniors and that is the Old Age Security Clawback.

As evidenced by many accountants’ scars and wounds, never cause even the sweetest senior to have an OAS claw back, because all hell breaks loose :). I am only half-joking; seniors really resent having their OAS clawed back. I assume it is because they feel they have an entitlement to this money and the government does not have the right to claim all or some portion back (even though, they did not directly fund this program).

Seniors must pay back all or a portion of their OAS as well as any net federal supplements if their annual income exceeds a certain amount. For 2017, if your net income before adjustments is greater than $74,789 ($73,756 for 2016) then you will have to repay 15% of the excess over this amount, to a maximum of the total amount of OAS received. The maximum repayment is hit around $119,000.

So if you have a capital gain on a legacy stock of $90,000 ($45k taxable) and you are right at the $74,789 OAS limit before the capital gain, the tax cost of the capital gain would be around $15,000 or 17% of the $90,000 gain. However, when you add the OAS clawback that would be applicable, the combined tax and OAS clawback could approach $22,000 or 25% or so. That is why you cannot look at the gain in isolation.

If you do not have an investment reason to sell your stock, you may want to consider selling the stock over a few years to minimize the tax and OAS clawback, assuming you wish to keep the stock each year.

Holding Company


A “sexier” alternative, especially for seniors is to transfer your stocks to a holding company. You should be able to do this on a tax-free basis under Section 85 of the Income Tax Act. The benefit to doing this is any dividends earned and the eventual capital gain are taxed in the holding company and thus, do not affect your OAS clawback. In addition, if you have any potential U.S. estate tax exposure (see this prior blog post on estate tax), the U.S. stocks in your holding company will not be subject to U.S. estate tax (if there is U.S. estate tax -President Trump intends to eliminate the tax). So while you do not save any actual income tax, you can save your OAS from being clawed back and possibly gain some U.S. estate protection.

The downside to this strategy is the cost to transfer the stocks (legal and accounting) and ongoing accounting costs, which can be high for a holding company and thus, potentially a significant part of the OAS clawback savings is now paid to your accountant instead of the government, so you have to weigh the savings versus the costs.

Capital Losses


If you plan on triggering capital gains on legacy stocks, you should review if you have any capital losses you can apply against these gains. The CRA notes your capital loss carryforward balance on your notice of assessment and if you have a My CRA account, you can get this information online. It should be noted, the application of the losses only reduce the capital gains tax, not the OAS clawback.

Charitable Donation


Where you donate public securities to a registered charity, the capital gains inclusion rate is set to zero. Thus, there would be no capital gain to report on the donation of a legacy stock (have your accountant run the numbers, but this should minimize or eliminate the clawback) and you receive a donation credit. This is reported on Form T1170 . This strategy is effective if you make large donations every year or were planning to make a substantial donation and helps the charity since you have more funds to donate than with an after-tax donation.

The decision to sell a legacy stock is not a simple one. The overriding decision should still be an investment decision; however, where you are indifferent to selling, you need to consider the various issues and options I have noted above. Before undertaking any legacy stock selling, you should consult your accountant and investment advisor to account for all your personal circumstances.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Monday, February 20, 2017

The Salary vs Dividend Dilemma 2017 Version - RRSP or Not? - What Small Business Owners Need to Know


In part one of my salary vs dividend dilemma update, I provided you with a summary of the absolute and deferred income tax savings available in respect of paying a dividend versus a salary. I concluded that in Ontario, from an absolute income tax basis, you are somewhat indifferent as to whether you receive a salary or dividend, from your
corporation, if you are a high-rate taxpayer. For the other provinces, this nominal tax (dis)advantage also holds true (except for some provinces where your active business income is not eligible for the small business deduction). However, speak to your accountant, to review your specific situation.

I also reflected that there is a significant tax deferral advantage for active income, whether eligible for the small business deduction or not.

An issue that naturally falls out of the above tax rate discussion is whether you as a small business owner/professional are better off financially paying a salary and contributing to your RRSP or leaving the money in your corporation, creating your own "corporate RRSP", so to speak?

Funding Your RRSP vs Leaving the Money in Your Corporation?


Jamie Golombek, the Managing Director, Tax & Estate Planning of CIBC has written several outstanding papers on whether small business owners should take a salary or dividend and whether they should contribute to their RRSP or leave the money in their corporation.

When I initially wrote the draft for this blog post a couple months ago, I had a summary of Jamie's papers by year and their conclusions. But as fate would have it, Jamie and CIBC just issued a new report earlier this month, titled "RRSPs: A Smart Choice for Business Owners". Thus, I just deleted all my prior work to avoid any confusion.

In his latest paper, Jamie now concludes, that for a 30 year time horizon, with a 5% rate of return, where tax rates remain constant, small business owners are better off to take a salary and make a RRSP contribution where their RRSPs earn interest, eligible dividends or they realize capital gains annually. This is also true where you hold a balanced portfolio in your RRSP.

The exception is where you have deferred capital gains (not typically likely). This conclusion may come as a bit of a shock to many small business owners who have been leaving their excess cash in their corporation and creating their own "Corporate RRSP".

As you would expect, the paper notes that where your personal tax rate is lower at RRSP/RRIF withdrawal, this strategy is more beneficial and where your tax rate is higher, the strategy is less beneficial or possibly detrimental.

The conclusions in this paper reflect that income tax strategies must be fluid and answers are not static. Jamie's strategy/conclusions in respect of funding a RRSP have changed significantly since the issuance of his first paper back in 2010, due to changes in personal and corporate tax rates and there effect upon the integration of the income tax system.

Here is a link to a recent interview Jamie did on BNN where he discusses his new paper.

Jim Yih, a well-known financial commentator and author of the popular blog Retire Happy had this to say on my LinkedIn page after I posted Jamie's article: "Hey Mark, my accountant did the same calculation for me based on being in Alberta, the math in this article and results marginally favoured investing in the company over RRSPs. People need to do the math because the assumptions might change the results. Still a thought provoking article!"

Thus, as Jim notes and Jamie discusses in his BNN interview, it is very important you review the CIBC paper in context of your individual circumstances. Various factors such as age, time to retirement (CIBC uses a 30 year time horizon), other income sources, family income, rates or return and provincial tax rates all need to be considered. For example: if both spouses are shareholders of the corporation, have limited or no other income and do not have significant lifestyle needs, then paying dividends would likely be the way to go.

Other Considerations for Paying a Salary in Lieu of a Dividend


Based on Jamie's data, you would likely lean to paying a salary and contributing to your RRSP. However, there are other factors you may wish consider. I briefly discuss some of these factors below.

Self-Discipline - I have noted in the past, that as a consequence of utilizing a dividend only strategy, you “park” your retirement savings in an easily accessible and tempting location (an operating company or a holding company) and human nature being what it is (I have observed this on many an occasion), one may tend to dip into this cash for personal use purposes ranging from home renovations to vacations to buying an expensive sports car. Thus, financial discipline and restraint is very important if you leave your money in your corporation and don't make a RRSP contribution.

CPP - If a salary is not paid, your CPP entitlement at retirement will be significantly reduced or eliminated. However, as Jamie notes in his paper, "it is conceivable that, over the course of a 40 years career, the premium savings might be independently invested in a diversified portfolio to ultimately produce a larger pension income". I would suggest most people do not have the financial control to invest non-contributed CPP funds each month and thus, I personally still favour contributing unless you are extremely disciplined.

OAS Clawback - For income tax purposes, the actual dividend you receive from a private corporation will be grossed-up for tax purposes. This "artificial increase" in income can result in a partial clawback of your old age security, subject to your actual net income.

Child Care - For those of you with young families, if you are the lower income spouse and paid solely by dividend, you will not have any earned income and will not be entitled to claim your child care costs. If you and your spouse are both shareholders and take only dividends, you may need to take some salary to maximize your child care claim.

Capital Gains Exemption - To be eligible to access the $835,716 capital gains exemption (this amount is indexed each year) upon the sale of your corporation’s shares, certain criteria must be met (see this post I wrote on this complex topic). If you utilize the dividend strategy, your corporation may accumulate too much cash and put the corporation offside the rules.

Asset Protection – If you accumulate substantial funds in your corporation, they could be at risk should the company be sued. You may be able to alleviate this concern by utilizing a holding company or a family trust with a holding company beneficiary.

Research and Development – If your corporation is engaged in R&D, a dividend only strategy will likely result in a reduced Investment Tax Credits claim as the company’s taxable income will be higher.

Remuneration planning is very fact specific. You should always consult your professional advisor before making a decision in regard to paying a salary and/or dividend.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Monday, February 13, 2017

The Salary vs Dividend Dilemma 2017 Version - What Small Business Owners Need to Know

In January 2013 (my, how time flies), I wrote a three-part series on the question of whether small business owners were better off taking a salary or dividend. I have been asked numerous times by readers, to update the series, but since it took 15 hours or so to write, I resisted.

However, I have cried uncle and decided to provide a short update on the absolute and deferred tax savings rates and re-iterate some of the issues you need to consider in making this decision.

Bloggers Note: I live and work in Ontario, so I have used Ontario tax rates in my analysis. The discussion should be relevant for most provinces, although there are a couple outlier provinces, so please discuss any tax planning with your accountant.


Absolute vs Deferred Tax Savings


There are two concepts that need to be understood in relation to this discussion:

1. Absolute income tax savings
2. The power of the deferral of income tax and the time value of money  

I illustrate these two concepts below.

I had some issues with the formatting of the charts that I could not fix, so I apologize in advance that they are not aligned perfectly. 

Absolute Income Tax Savings


Absolute income tax savings are the actual tax savings a business owner would have by utilizing a dividend only strategy over a salary strategy or vice versa. In 2013, using a dividend only strategy resulted in a significant absolute tax savings benefit (3.38%). i.e. you would have $338 more dollars in your pocket if you paid yourself a $10,000 dividend in 2013 than if you paid yourself a salary. However, due to the various increases in income taxes implemented by the Liberals, there is essentially no difference in 2017 on income eligible for the small business tax rate for a high rate taxpayer.

This is demonstrated below. Please note I have excluded employer health tax.

Income Eligible for the Small Business Deduction ("SBD")


Income earned by the business                                         100.00
Corporate taxes payable                                                   (15.00)
Income available as an ineligible dividend                              85.00
Personal tax payable on ineligible dividend                          (38.51)
Net cash to shareholder                                                       46.49

Total corporate and personal tax                                      53.51

Personal tax at top rate                                                        53.53

Savings/(cost) of earning income in a corporation
and paying it as an ineligible dividend                               0.02

If you account for employer taxes, there is approximately a .009% tax savings in paying an ineligible dividend vs taking a salary.

Income not Eligible for the SBD


Income earned by the business                                            100.00
Corporate taxes payable                                                      (26.50)
Income available as an eligible dividend                                   73.50
Personal tax payable on eligible dividend                               (28.91)
Net cash to shareholder                                                         44.59

Total corporate and personal tax                                        55.41

Personal tax at top rate                                                         53.53

Savings/(cost) of earning income in a corporation
and paying it as an eligible dividend                                  (1.88)

If you account for employer taxes, the tax cost of earning income not eligible for the small business rate comes down to about 1%.

The long and short of all this is; from an absolute income tax perspective, you are pretty much indifferent on taking salary or dividends unless tax rates are changed in future budgets.

The Deferral on Corporate Income


The chart below reflects the amount of income that is deferred when a business owner leaves excess funds in their corporation.

Active Income Eligible for SBD

Tax at top personal rates                                                     53.53
Tax at small business corporate tax rates                             15.00
Tax deferral from retaining income                                 38.53


Active Income not Eligible for SBD

Tax at top personal rates                                                     53.53
Tax at general corporate tax rates                                        26.50
Tax deferral from retaining income                                 27.03


The above reflects there is a substantial tax deferral when you leave income in your corporation. This deferral allows you to invest that money in your corporation to grow your company, or just invest it passively in stocks, real estate or other investments. However, it is important to understand, this is just a tax deferral, not an absolute tax saving.

The "Bonusing Down" Decision


In the old days (5 years ago) the “conventional wisdom” was to pay a bonus when your corporate taxable income exceeded the small business limit. However, these days, most accountants suggest their clients pay the higher general rate of corporate income tax, if the money is not needed in the short-term (3-5 years depending upon various investment return assumptions) or better yet, the long term (10-25 years). The reason for this is there is a tax deferral of 27.03% as noted above, while the absolute tax cost is 1.88% or less. In most cases where money is not required, the investment returns on the 27% deferral should significantly exceed the small absolute tax cost.

What Jamie Says


Jamie Golombek, the Managing Director, Tax & Estate Planning of CIBC has written several outstanding papers on whether small business owners should take a salary or dividend.

In 2011, he wrote a paper titled “Bye-bye Bonus! Why small business owners may prefer dividends over a bonus”. This report was updated in 2015 and can be found here. In that report Jamie stated that “Although dependent on the long term assumed rate of return and time horizon, if funds are not needed to fund current lifestyle, it may be advisable to have SBD Income initially taxed inside the corporation at relatively low corporate tax rates. The after-tax SBD Income can then be retained and invested in the corporation with the after-tax amount later paid out as a dividend to the shareholder, so as to enjoy a significant tax deferral of SBD Income within the corporation.” This was essentially the same conclusion Jamie came to for active business income not subject to the small business rate.

With the 4% increase in personal tax rates since the publication of Jamie’s 2015 paper, one would assume his conclusions would still hold true. To be sure, I asked him recently to confirm my assumption.

One of the members of his CIBC tax estate planning team confirmed that because of the significant tax deferral advantage for active business income, they would still support payment of dividends over salary in many cases. However, there are two exceptions to this rule.

1. TFSAs - In Jamie’s 2015 report, TFSAs for Business Owners, he commented that it may be better to invest in a TFSA than in a corporation for most types of income (the main exception being deferred capital gains). That is the same conclusion I came to in this blog post.

2. RRSPs - I will discuss this exception next week (in context of a new paper Jamie released just last week) when I review whether you should pay a salary and contribute to a RRSP, or just leave the money in your company and pay dividends, as required, over time.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.