Business AdviserCharles Murphy

Reducing taxes can increase wealth

By Charles Murphy
Partner,
KPMG Enterprise/Toronto


As an owner of an incorporated business, it is important to take steps to control and reduce your corporate and personal income taxes. Overlooking these taxes today could significantly reduce your wealth in the future. Experience has shown that the following basic tax planning ideas can help owner-managers get income and capital out of their businesses tax-effectively.

Determine the Optimum Salary/Dividend Mix

Owner-managers of incorporated businesses have several alternatives for getting remuneration from their corporations, such as receiving a salary and dividends on their shares. Unfortunately, there is no “one-size-fits-all” when it comes to determining the most tax-effective split between salary and dividends. The optimum split depends on cash flow needs, the owner’s other income levels, the corporation’s status and its income level, and many other factors.

In the past, it was often a good strategy for a privately-owned corporation to pay enough salary to reduce the corporation’s income to the small business limit (currently $500,000 for federal purposes). This maximized the amount of income that is taxed at the low small business rate, without having corporate income taxed at the higher rates that apply to income beyond the small business limit. If you’re using this strategy, you may want to revisit it because recent changes to the taxation of dividends have upset the old rules of thumb.

Consider Other Tax-Effective Ways to Extract Funds from Your Corporation

Repay loans from shareholders
If you have lent funds to the corporation, it can repay any amount of the loan without tax consequences. Such a repayment is neither deductible to the corporation nor taxable to you.

Alternatively, you could arrange to have the corporation pay you interest on your loan. The interest paid will normally be taxable to you as investment income. The tax effect would be about the same as if the corporation paid you that amount in salary. The interest will generally be deductible to the corporation as long as it has a legal obligation to pay the interest.

Return paid-up capital
Any amount that is less than the corporation’s “paid-up capital” (PUC) may be paid out to the shareholders as a repayment of capital, generally with no tax consequences.

If the corporation was originally funded with a substantial amount of capital, consider extracting funds by a reduction of the corporation’s PUC. Make sure the corporation remains sufficiently capitalized to satisfy any requirements of its creditors or bankers.

PUC is essentially the amount of capital contributed to the corporation in exchange for its shares. However, the figure can be adjusted in various ways for tax purposes. As such, the legal PUC often differs from the tax PUC.

Pay capital dividends
Only one-half of capital gains are taxed. When a private corporation realizes a capital gain, the untaxed portion is added to its “capital dividend account”. Similarly, one-half of any capital losses reduces the capital dividend account.

Any amount in the corporation’s capital dividend account may be paid out entirely tax-free to its shareholders. This preserves the non-taxability of the appropriate fraction of the capital gain. So if the corporation has realized any capital gains (net of realized losses), you should generally cause it to pay out capital dividends as your first choice for extracting funds.

For the dividend payment to qualify for tax-free distribution, the appropriate tax election forms and directors’ resolutions must be filed with the CRA before the dividends are declared payable from the corporation. If you do not file the tax elections in advance, penalties could apply.

Note also that if you allow a capital dividend account to build up in the corporation without paying capital dividends, the account can be reduced or wiped out by future capital losses. Once you have paid out capital dividends, however, they are safely out of the corporation, and subsequent capital losses will have no effect on them.

Other tax planning ideas you may want to explore include estate planning, lifetime capital gains exemption planning, income splitting, life insurance and incorporating your investments.

Business owners that reduce their corporate and personal income tax can help to maximize their wealth and effectively save for the future.


Business Adviser is published by KPMG Enterprise™ specifically for owners and executives of private companies. KPMG Enterprise is devoted exclusively to helping business owners and entrepreneurs build thriving enterprises. For further information about how KPMG Enterprise can help private companies, visit www.kpmg.ca/enterprise.