Among the many benefits of owning a small-business corporation is the option to withdraw money via routes that attract income tax at reduced rates.
If your farm or small business is incorporated, you're in the fortunate position of having different ways to pay yourself and, in some cases, your employees and shareholders.
- Shareholder loans
- Directors' fees
And that's not the end of the list.
To figure out the ideal combination for you, it's best to involve your tax, financial and legal advisors in a careful analysis of your specific circumstances. You'll want to consider your cash flow needs and income level, the corporation's income level, the corporation's status for tax purposes, and other issues.
Taking a salary for the services you provide to the corporation is the most common form of compensation. While it's probably wise to take at least some income in this form, a mix of salary and other types of payment is often the best strategy.
Salary Builds RRSP Contribution Room
You'll want to pay yourself enough salary so that your level of "earned income" allows you to make a reasonable tax-deductible contribution to a registered retirement savings plan (RRSP). But taking more salary than you really need risks moving your personal tax rate into a higher bracket. Other types of payment also qualify as earned income, so consider them in your overall pay arrangement.
From the corporation's perspective, if you can pay out enough salary to yourself and other employees to hold corporate annual income down to $500,000, you'll be able to shelter this income at the small-business tax rate, which is considerably lower than the tax rate once your company's income exceeds $500,000.
Taxable Dividends Earn a Tax Credit
You might also consider taxable dividends from your corporation. Generally speaking, a dividend is the distribution of a portion of the corporation's after-tax profits to its shareholders. Taxable dividends earn a tax credit, which effectively taxes them at a lower rate than ordinary income like salary or income from an unincorporated business.
This doesn't mean, though, that taking all your pay in taxable dividends is the most tax-effective strategy. You still need earned income to participate in pension and income deferral schemes based on salary. Also, taxable dividends are not deductible (salary is), which becomes significant if company income exceeds $500,000.
Capital Dividends Can Be Paid Tax Free
Capital dividends, unlike taxable dividends, can be paid tax-free to shareholders to the extent available from the capital dividend account. Capital dividends usually arise when a company incurs a capital gain from sale of assets such as land. The 50% non-taxable portion of capital gains triggers a step-up to the capital dividend account.
For example, if your corporation sells a piece of land and makes a $100,000 capital gain this year, it can make tax-free capital dividend payments totaling $50,000 to you and other shareholders. To pay yourself in this fashion, you must file an election with Canada Revenue Agency (CRA).
Shareholder Loans Don't Incur Tax
Repayment of shareholder loans is another tax-effective way for a company to pay you money it owes you for assets such as equipment, land or buildings that you either sold or transferred to the corporation. This money is not taxable in your hands.
As a shareholder, you may also borrow money from the corporation at prescribed rates without incurring a taxable benefit. Any unpaid balance on the loan left owing to the corporation at the end of the second year, however, will be deemed income unless you applied the loan to the purchase of shares, a house or an automobile to be used in the performance of work duties.
Directors' Fees Also Build RRSP Room
Another option is to pay yourself and other directors of the corporation directors' fees for the time and responsibility committed to making business decisions and bearing liability for those decisions.
This is one way to pay parents who are still involved in the family business but have given up some of their direct management and operating responsibility. And even if your spouse or other family members aren't physically active in the farm business, if they are directors you can also pay them reasonable fees.
Directors' fees, like salary, qualify as earned income for RRSP contributions.
If you lease land or equipment to your corporation, you are entitled to rental payments. These are also classed as earned income for RRSP purposes. Such payments also can be used to reduce your corporation's taxable income and should definitely be considered if you need ways to keep your corporate income under the $500,000 small business threshold.
A retiring allowance is yet another way to take money out of your farm corporation and offset large levels of income and the resulting tax at the time you retire. While a retiring allowance is treated as employment income, its advantage is that you can transfer a portion of the amount for years of service prior to 1996 to your RRSP without affecting your RRSP deduction limit and without immediate taxation.
The maximum amount of retiring allowance transferable to an RRSP for any given year is $3,500 up to 1988 and $2,000 for years 1989 to 1995. The amount you take in the form of a retiring allowance must be reasonable based on length and type of service your or your employees gave to the business (see Include a retiring allowance in your tool bag of financial strategies).
Finally, funds can also be withdrawn from a corporation through share redemption. This involves a shareholder selling shares back to the company for their fair market value (FMV). If FMV is greater than the adjusted cost base (ACB), the capital gain may be offset with any available capital gains exemption for qualifying shares in a family corporation.
Take care, however, that redemption proceeds do not exceed paid-up capital of the shares. Otherwise, a deemed dividend, rather than a capital gain, might be triggered. That would not qualify for the capital gains exemption. Definitely consult with your tax practitioner before proceeding with share redemptions to access corporate funds.