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Consider the Taxes - Madan CA

Consider the Taxes

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consider-the-taxes

TAXATION

Develop a strategy for distributing earnings
and reducing corporate income taxes.

For most owner-managers, their goal is to create
personal wealth through the operation of a successful
business. Unfortunately, corporate and personal
tax liabilities (among other things) stand in the way.

Owner-managed businesses must struggle with tax
on two fronts:

  1. making a profit while minimizing the corporate
    tax liability
  2. minimizing personal taxes while taking remuneration
    out of the company.

Have a Strategy

The first step to minimizing personal and corporate
taxes is to put a tax strategy in place. Such a strategy
depends on each individual owner’s personal
cash-flow needs. Because tax rates applicable to
corporate income are often lower than to personal
income and because this differential is only levied
when the owner-manager withdraws the funds, taxes
can be deferred to the extent such income is left in the
corporation.

Often, this is not a realistic option since the owner-
managers may need all or most of this business
income for personal use. Then the owner-managers
must remunerate themselves in the form of:

  • salary
  • dividends
  • a combination thereof.

Deducting salary expenses reduces taxable income
and lowers corporate income taxes. However, because
dividend payments are not a deductible expenditure
(i.e., it is a distribution of profits), personal taxes will
be higher. Personal income taxes applicable on the
dividends are lower than on salary to adjust for the
difference (i.e., tax integration).

Tax integration works well for corporations earning
active income under $500,000 as the “combined”
(i.e., corporate and personal) tax rate differential is
minimal (though it varies for different provinces).
Therefore, employees are normally indifferent whether
they receive salary or dividends, aside from how each
affects CPP deductions or RRSP contribution room.
However, this is not the case for corporations earning
active income above $500,000 as the “combined”
tax rate applicable to this layer of income is higher
roughly by two-to-five percentage points depending
on the provinces.

Avoiding High Tax Rates

Because profits in excess of $500,000 are not eligible for
the small-business deduction, consideration must be
given to declaring a salary that will drop the corporate
taxable income below the $500,000 limit. By declaring
a salary, taxpayers do not have to lose two to five percentage
points.

After this decision is made, however, employees may
find themselves in a higher personal income tax bracket
because this remuneration must be added to the regular
salary and other benefits received.

Once your personal taxable income exceeds predetermined
thresholds, the rate on any excess amount rises
significantly. For example, the rates in Ontario for tax
year 2016 are scaled as follows for taxable income in
excess of:

  • $150,000 (47.97%)
  • $200,000 (51.97%)
  • $220,000 (53.53%).

Sometimes corporate taxpayers may want to be taxed
at the higher corporate rate (i.e., decide not to pay the
corporate income out in salaries) and leave the corporate
income in excess of $500,000. Because the higher
corporate rate still provides much lower “immediate”
taxes, the corporate taxpayers may choose to pay the
extra two-to-five percentage points if their rate of return
on the deferral can exceed this eventual cost. Again,
such strategy depends on the particular owner-manager’s
annual cash flow needs and circumstances.

Be careful when purchasing capital assets.

Purchasing Capital Assets To Save Corporate Taxes

Many owner-managers believe that purchasing capital
assets will significantly reduce corporate taxable
income. Certainly, purchasing assets will reduce taxable
income, but not as significantly as one might believe.

Two factors come into play:

  1. The capital cost allowance permitted by the
    Canada Revenue Agency (CRA) is a percentage
    of the cost of the asset and not the entire cost.
  2. The half-year rule usually comes into play in
    the year in which the asset is purchased, which
    restricts your percentage by another 50%.

Example:

Your business purchases equipment for $300,000,
which is subject to the prescribed depreciation at the
rate of 20%. Therefore, in the year of purchase, your
business can deduct $30,000 (i.e., $300,000 × 20% ×
50% half-year rule) which only represents 10% of the
total purchase price. Assuming the 15% small business
rate in Ontario, this provides a tax benefit of $4,500,
which is minuscule compared to the actual spending.
The primary purpose of purchasing capital assets should
be the need for the capital asset in the business; the tax
savings should never be a main objective in arriving
at this decision. The need to consider other aspects of
purchasing, such as cash flow requirements to meet
loan obligations as well as additional expenses for
insurance, upkeep and operational costs, should be
primary considerations in the decision-making process.

Family

To achieve tax effectiveness, owner-managers may
consider bringing family members into the business.
There may be benefits to distributing profits through
salary or dividends to family members earning lower
incomes. However, a caution must be given in both
situations. For salary, the amounts paid to the family
members must be reasonable and should be a fair
consideration for their efforts. For dividends, the
family member must own the shares and ensure there
is no conferral of benefit when transferring the shares
to them. Also, the owner-manager must consider any
ownership and control issues consequent upon giving
shares to family members.

Bringing family members into the business may also
be useful as a long-term strategy in order to reduce or
defer the overall impact of personal and “combined”
taxes should the owner-manager suddenly die or
decide to take early retirement.

Aside from tax objectives, succession planning is also
essential should family members want to be part of
your successful business. When there is more than
one owner, bringing family members into the business
needs to be discussed before any problems arise.
Original owners will not only want to protect their
percentage ownership in the business but will also
want to ensure their remuneration is not impacted by
distributions to others.

Tax and succession planning require careful review of
everyone’s intentions and circumstances and are often
technically complex. Your CPA and solicitor should be
able to provide guidance as to how to structure ownership
through different classes of shares that protect
existing owners while providing new shareholders with
the rewards of ownership. Such carefully restructured
shareholdings can selectively distribute dividends so all
shareholders can receive the rewards of ownership and
tax savings without undue stress on corporate cash flow.

Plan Early

Because most tax-planning strategies cannot be put
in place retroactively, leaving tax planning until the
end of your fiscal year end is not a good idea.

Owner-managers should work with their CPA early
in the development of the business to establish longterm
goals. From then on, they should meet with their
CPA annually to monitor whether the goals are being
realized. Any adjustments necessary to ensure current
financial needs are being met and that the long-term
strategy required to build wealth for retirement or
succession is on track can be made at these meetings.

 

Disclaimer

The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.

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