TAX CLINIC

En­trepreneurs should re­ceive the same amount of cash through ei­ther their cor­po­ra­tion or per­son­ally

National Post (Latest Edition) - Financial Post Magazine - - COLUMNS & DEPARTMENTS - Jamie Golombek, CPA, CA, CFP, CLU, TEP is man­ag­ing direc­tor, Tax & Es­tate Plan­ning, at CIBC Wealth Ad­vi­sory Ser­vices in Toronto. Email: Jamie.Golombek@cibc.ca

Why en­trepreneurs re­ceive the same amount of cash through ei­ther their cor­po­ra­tion or per­son­ally.

Own­ers of an in­cor­po­rated small busi­ness likely know that the first $500,000 of ac­tive busi­ness in­come is gen­er­ally and ini­tially taxed at low cor­po­rate tax rates and is not taxed a sec­ond time un­til the funds are re­moved from the cor­po­ra­tion by way of a div­i­dend. To avoid pay­ing tax twice on the same cor­po­rate in­come, the Tax Act has de­vel­oped a “gross-up” and div­i­dend tax credit mech­a­nism that at­tempts to achieve per­fect “in­te­gra­tion.” The prin­ci­ple of in­te­gra­tion means that, in the­ory, you should be able to re­ceive the same amount of cash af­ter tax by earn­ing in­come per­son­ally or through your cor­po­ra­tion.

For ex­am­ple, if you earn $1,000 of in­come and you’re in a 45% tax bracket, you would pay $450 of tax and be left with af­ter-tax cash of $550. If you earn the same $1,000 through a pri­vate cor­po­ra­tion, as­sum­ing a small busi­ness cor­po­rate tax rate of 20%, the com­pany would be left with $800 af­ter it paid $200 of cor­po­rate tax. This $800 would then be paid out as a div­i­dend that is then “grossed-up” by 25% and re­ported as $1,000 on your per­sonal tax re­turn. You would pay tax of $450 on this in­come, but get a div­i­dend tax credit of $200, re­sult­ing in net per­sonal tax payable of only $250. Per­fect in­te­gra­tion is there­fore achieved since you end up with $550 re­gard­less of whether you earned the in­come per­son­ally or through your cor­po­ra­tion.

Re­lated to this con­cept, a re­cent On­tario fam­ily law de­ci­sion in­volved a re­quest by a mother to ob­tain in­creased in­terim child sup­port for her two chil­dren. The mother wanted ad­di­tional money based on the fa­ther’s prior year’s in­come, which came from the div­i­dends he re­ceived from his wholly owned pri­vate cor­po­ra­tion. The is­sue was whether the ac­tual amount of div­i­dends the fa­ther re­ceived ($50,000) or the 25% grossed-up amount ($62,500) should be used to de­ter­mine the fa­ther’s level of sup­port. The mother ar­gued that by pay­ing him­self a div­i­dend, rather than a salary, the fa­ther re­al­ized a tax sav­ings and would have had to pay him­self a higher salary to achieve the same af­ter-tax cash. The judge con­cluded that it was in­deed ap­pro­pri­ate to ad­just the fa­ther’s in­come to take this into ac­count and stated that “one way in which this can be ac­com­plished is by in­clud­ing in the payor’s in­come the full amount of the tax­able div­i­dend (i.e., the grossed-up div­i­dend), rather than the ac­tual div­i­dend re­ceived.” He or­dered the fa­ther to pay ad­di­tional in­terim sup­port.

TO AVOID PAY­ING TAX TWICE ON

THE SAME COR­PO­RATE IN­COME, THE TAX ACT HAS DE­VEL­OPED A “GROSS-UP” AND DIV­I­DEND TAX CREDIT MECH­A­NISM

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