You’ve worked hard to build your business and create a profitable company. During the start-up years, you may have forgone paying yourself in favor of reinvesting in your business and growing your enterprise. Perhaps you are now at a point where your business has become more established and you are ready to start withdrawing some of the profits out of your corporation. Maybe you want to bolster your personal cash flow for lifestyle reasons or to fulfill your family’s financial obligations. Or instead, perhaps you are concerned about maintaining your corporation’s status as a small business corporation for the purpose of one day claiming the capital gains exemption. Whatever the reason, simply withdrawing cash from
your business’ bank account will likely result in a significant tax bill. So the question then becomes: how do you take money out of your business in a tax-efficient manner?
Unfortunately, the answer to this question isn’t as straightforward as you might think. The way in which it makes the most sense for you to take money out of your company may not be the same for another business owner. Consideration must be given to many factors, including the personal federal and provincial/territorial tax rates where you live, the corporate federal and provincial/territorial tax rates where your business is located, your cash requirements both in the short- and long-term, and whether your company possesses certain favorable income tax attributes that can be utilized to minimize tax.
This article discusses some of the more general approaches that business owners can take to withdraw money out of a business in a tax-efficient manner. Some of these strategies may even allow you to access corporate profits on a tax-free basis. But, keep in mind that recently introduced tax rules add more complexity to the decisionmaking process, resulting in additional benefits and costs to weigh
when determining the most tax-efficient approach. Let’s consider the more general approaches.
Remunerate Yourself And Family Members
Typically, business owners will pay themselves a salary from the business in a way that is similar to an employee being remunerated. If family members work in the business, a reasonable salary (or wages) can be paid to them as well. This is especially beneficial if family members have little or no other sources of income. Generally speaking, a “reasonable” salary in this instance would be one that approximates what would be paid to an unrelated third party for the same work activities.
From a tax perspective, business owners and family members will be taxed on salary (or wages) at regular personal marginal tax rates that apply based on the jurisdiction in which they live. The corporation will be allowed a deduction for salary (or wages) paid when determining taxable income, but only to the extent the amounts are reasonable. Note that there is an exception for salary (or bonuses) paid to owner-managers. Under this exception, the Canada Revenue Agency (CRA) will generally not question the amount of salary (or bonuses) paid by a Canadian-controlled private corporation (CCPC) to a Canadian resident owner-manager who is actively involved in the day-to-day operations of the CCPC. The CRA’s position allows more flexibility in making remuneration decisions for owner-managers.
Pay A Taxable Dividend
Dividends can be used to distribute money from the corporation to both you and your family members. This would require that you, your spouse, and your children hold shares of your corporation either directly or indirectly (i.e., through a trust or a holding company). To ensure this is a tax-efficient method of withdrawing money from the corporation, it will be critical to consider both the tax on split income (TOSI) rules and the corporate attribution rules before any distribution is made.
TOSI Rules – Taxable dividends from a private corporation will be subject to the highest rate of personal tax, with restrictions on personal tax credits that would otherwise offset this tax, unless an exclusion from the TOSI rules is available.
Corporate Attribution Rules – Transfers or loans to a corporation in order to effectively shift income to another family member may result in additional tax for the individual making the transfer or loan unless certain conditions are met. Planning will help to avoid any punitive tax result under the corporate attribution rules.
With complex rules in place to restrict income splitting, it is important to consult with your tax advisor before paying any dividends to adult family members (including spouses), as well as minor children.
Optimize Your Salary Versus Dividend Mix
Remember, active business income of a CCPC is eligible for specially reduced rates of both federal and provincial/territorial corporate tax due to the small business deduction. In order to maximize the potential for this tax savings, it is common for owner-managers of CCPCs to pay themselves a combination of both salary and dividends. Some time ago, in situations where the active business income of a company exceeded the federal small business limit, it was common practice for a corporation to automatically “bonus down” to that limit. The reason was that the total corporate and personal tax associated with retaining the excess income and paying it out as a dividend often exceeded the personal tax cost when paying the excess income as a bonus. This concept is referred to as the “tax integration cost.”
However, with changes to the rules governing the taxation of dividends in 2006 and the gradual reductions to the federal and (some) provincial general corporate tax rates, the cost of retaining income within a corporation has declined. As a result, paying a bonus may not always yield the most tax-efficient result. Furthermore, where profits are left in the business (to be distributed at a future date as a dividend), the additional personal tax on the dividend will be deferred.
As a cautionary note, if you decide to retain income in your corporation to take advantage of the tax deferral, and invest in passive assets (rather than back into your active business), this may increase the passive investment income earned by the corporation. If that is the case, it will be necessary to consider the impact of the new passive investment income rules. These rules generally apply to taxation years that begin after 2018, and will restrict the small business deduction that can be claimed by a CCPC where passive investment income of an associated corporate group exceeds $50,000 taking into account all taxation years
in the previous calendar year.
Take note that other factors can influence your decision to take a salary versus being paid dividends. Your cash flow needs must be taken into account, since retaining income in your business won’t work in cases where you need money for other purposes. Also, bear in mind that drawing dividends alone will not provide you with earned income for purposes of your RRSP contribution. Moreover, on the corporate side, you will want to consider the impact of any relevant payroll taxes, as well as any remittance requirements and filing obligations that may arise. Lastly, your corporation’s ability to claim scientific research and experimental development (SR&ED) credits may be impacted by remuneration decisions, although this has become less of a concern due to a beneficial federal tax change made in 2019.
As you can see, establishing the best possible remuneration strategy can be a complex undertaking, so it is important to work with a tax advisor.
Convert “Hard ACB” Into Cash
If you purchased your business from someone else, it is possible that the shares you acquired have “hard” adjusted cost base (ACB), which can become relevant when planning to withdraw cash from your business. Essentially, “hard ACB” is a tax term that represents the amount that you paid for the shares when you purchased them, and it can potentially be converted into cash (or debt that can be repaid later) using a holding company, thereby allowing you to access the capital you invested on a tax-free basis.
In simple terms, a holding company would be set up for the purposes of acquiring the shares of your operating company in return for consideration equal to the ACB of your operating company’s shares. In this way, you could potentially receive proceeds, as cash or debt, in an amount up to the cost base of your shares without attracting any tax. There are additional advantages of incorporating a holding company, as well as a number of issues to consider. Your BDO advisor can help determine if setting up a holding company makes sense for your business situation.
You should note that attention must be paid where you acquired the shares of your business from a non-arm’s-length person, such as a relative, who would have either claimed V-day protection (for capital properties owned on December 31, 1971) or the capital gains exemption (CGE) on the disposition of those shares to you. This is because hard ACB on acquired shares does not include the amount of the gain realized by a non-arm’s-length person that was reduced either by the application of the V-day rules or the CGE. If ACB related to a non-arm’s-length person’s V-day protection or CGE is cashed in, then a deemed dividend could arise. Since these rules can be very complex, make sure you involve your tax advisor if you’re interested in converting the hard ACB of your shares into cash.
Repay Outstanding Shareholder Loans
To help finance the start-up or growth of your business, you may have loaned funds to your company in the form of a shareholder loan. Now that your corporation is profitable, it may be a good time to consider having the company repay all or a portion of this loan. Any amount that you receive in settlement of your shareholder loan will be a tax-free distribution, similar to a return of capital.
Alternatively, you could consider having your company start paying you interest on your shareholder loan. However, keep in mind that while any interest paid would be deductible to the corporation, it will be taxable to you as investment income. It is also important to note that in certain circumstances the TOSI rules will apply to tax interest income earned by individuals from private corporations at the highest tax rate. Therefore, before any interest is paid, consideration should be given to whether the TOSI rules are a concern in order to avoid any negative tax consequences.
Pay A Capital Dividend
Another potential tax-free distribution to consider is to pay yourself a dividend out of your corporation’s capital dividend account (CDA). In simple terms, the CDA is a notional balance that most commonly
represents the non-taxable (currently 50%) portion of any capital gains (or similar receipts) that a private corporation has realized on the disposition of capital assets (tangible and intangible). A positive balance in a corporation’s CDA can be distributed to Canadian resident shareholders as a tax-free dividend, ensuring that the non-taxable portion of the company’s capital gains (and similar receipts) do not subsequently
become taxable in the hands of the shareholder.
You should note that CDA is calculated on a net cumulative basis, so the balance will be eroded by any capital losses realized by the corporation. However, capital losses realized subsequent to a distribution of the CDA will not have a retroactive effect on having previously received this distribution tax-free even if the loss is carried back. Accordingly, it is advisable to pay out the balance of the CDA as it becomes available.
That said, calculating the CDA can be complex. There are rules that govern what can and cannot be included in the CDA, as well as timing considerations with respect to the recognition of additions (and depletions) to its balance. Unfortunately, there can be negative income tax consequences when a capital dividend is paid in excess of the corporation’s available CDA. Moreover, specific filing requirements must be met when paying a capital dividend. For these reasons, it will be imperative that you speak to your tax advisor in advance of paying a dividend from your corporation’s CDA.
Whether you find yourself in a situation where taking out some cash from your business is a question of necessity, or whether this is an issue that has arisen as a matter of course, taking the time to properly plan how you’re going to withdraw money from your business will ensure that you’ll pay the minimum amount of tax necessary. However, as we’ve seen, there is no cookie-cutter approach to taking money out of your company in a tax-efficient way. Instead, there are numerous potential avenues to explore, and many factors to consider when selecting the most tax-beneficial plan for your unique situation.
This is a modified version of an article released on www.bdo.ca in November 2019. The article is current to November 1, 2019. This article has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The article cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees, and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this article or for any decision based on it. BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.
Article Written By BDO CANADA LLP