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