Knowing More about the Company You Keep: Learning How Small Businesses Are Taxed So You Can Plan and Invest Intelligently
Part One – Taxation of Active Business Income, Dividends and Integration Theory
A lot of financial planning is learning how to move your pieces effectively around the chessboard of life in order to get the best possible outcome. This is particularly so when doing tax planning – by merely rearranging who owns what and how they use it can have a profound affect on a family’s overall tax bill. As I like to repeat so often that it’s become a mantra: it’s not what you make, but what you keep after appeasing the tax man is what matters. And, when clients get sick of hearing this, I then tell them that no one cares more about your money that you do – no matter who’s helping you, the more you know yourself the better off you’ll be. Today’s article speaks to both of those maxims.
In particular, I want to talk about how small private companies, aka “Canadian-Controlled Private Companies” or “CCPCs” are taxed. The tax rules for CCPCs are not simple and seem to be written in a tongue not known to common man. Accordingly, when I start working with new clients, many of them are either paying more tax than is necessary right now or will overpay in taxes in the future because they don’t know the rules, have not got the necessary advice from their other advisors and have not planned 10 or 20 years down the road. Moreover, even if they have received good advice at some point, life and the law both change. Thus, yesterday’s pearls of wisdom may no longer apply to today’s realities. This is particularly true in light of the changes imposed on small business owners by the current federal government since last July that are either now in effect or coming soon.
With all of this in mind, this article, and those to follow, are designed to outline some of the basic principles of corporate taxation in (more or less) simple English so anyone taking the time to muddle through will be able to make better tax decisions going forward, ask better questions of their professional advisors and hopefully, sleep better at night by having more control over their own situation. Accordingly, pour a good cup of coffee, or perhaps something even stronger, and let’s begin.
Integration Theory and How It Works When Earning Active Business Income
Why small businesses are taxed as they are comes down to something that tax types call “integration theory.” Although it sounds like something from the civil rights movement of the American 60’s, it’s a really far less exciting and involves far more math. The basic premise is that a businessperson running a sole proprietorship (I’ll call him “Jack”) and someone running the same business inside a company (why not call her “Jill”) should pay about the same amount of tax on the profits they use to support their families and spend on exotic vacations abroad. Tax rates and policy are designed to achieve this result. For this article, I’ll use exclusively B.C. personal and corporate tax rates.
One of the main differences between Jack and Jill is that Jack is taxed completely in his own name on all business income. He will have a lot more deductions since he is a business owner than someone who is an employee, but all his income will be taxed in most cases in the year that it is earned based on his level of income and marginal tax rates. In other words, if he earns a lot in one year, he will pay a lot more tax on the last dollar of income since it will be taxed at a higher marginal rate than if he hadn’t earned as much that year. He really can’t delay his day of reckoning and pay tax on some of the extra money he earned this year until a year when his business is not faring so well. Thus, even if he wanted to reinvest a bunch of the money back into his business, he might only have $.50 on the dollar or less, depending on where he lived, on at least part of his earnings in high income years.
Jill, on the other hand, has far more tax control. In her case, she can decide how much money to pay out of her company to herself in salary, which means she can avoid paying tax personally at high marginal rates by not paying out money she might want to reinvest to either grow her business or to set aside for a rainy day which, as you may know, are not uncommon in Vancouver. In B.C., the first $500,000 of profit, after Jill pays herself a salary and deducts all other expenses, is taxed at about 12% at this point. Accordingly, instead of having only the $.50 after taxes that Joe might have to buy a new business laptop or a new widget-maker, Jill would have perhaps $.88 left to do so. The same principle would apply if they both wanted to buy office space or use the extra money to invest in some crazy investment their neighbour talked about that they’re positive will double within a year.
If Jill’s net profits exceeded $500,000 or she gets caught by a provision in the new tax rules for investment income inside CCPCs just announced in March’s budget that can reduce how much of her active business income can be taxed at 12%, the excess will be taxed at around 27% out Vancouver way. Thus, even though she won’t have as much money left to reinvest on the excess portion than the money that was taxed at 12% (i.e. $.73 vs. $.88 per dollar), she’ll still have a lot more cash for widget-buying than Joe who might have only $.50 or even less if living in places like Toronto on money that was taxed at really high personal rates.
On the other hand, when Jill wants to take the same $.88 or $73 left over after her company paid tax on it out of the company, she will have to pay some tax personally on that money in order for her to be left in a similar position as Joe, who has probably already paid a lot more tax on the money. It could be Jill takes the money out in the same year that it was earned or perhaps a decade later. For now, let’s just assume that this happened during the same year as her company (“Jillco”) earned the profits in the first place. In this instance, perhaps Jill decided to pay herself through dividends instead of salary because she didn’t want to pay any more into the CPP and was willing to forgo earning any more RRSP room and some of the other perks that can come from taking salary instead of dividends.
In any event, whatever the reason behind Jill’s decision, this is where integration theory comes into play once again. It wants Jill and Joe to pay about the same amount of tax on their personal earnings that year. Since Jill will be earning dividends paid from money that was already taxed in Jillco, it’s only fair that she gets credit for either the 12% or 27% that the company already paid on these business earnings.
Salary vs. Dividend Comparison – Integration Theory in Action
This example shows the different tax results if Jill was already earning $100,000 and needed to decide what to do if her company made an extra $1,000 in profits. The size of any dividend cheque will depend on whether the income was first taxed corporately at the 12% or 27% rate, as this tax bill needs to be deducted from the $1,000 profit before paying out dividends. If taxed at the lower rate, the $880 dividend ($1,000 minus $120 in tax) paid out will be taxed as a small business dividend, while if taxed at the general rate, the $730 dividend ($1,000 minus $270 in tax) will be an eligible dividend. When they talk about “eligible dividends”, they just mean a dividend that is eligible for more tax relief in the recipient’s hands. In this case, the higher tax credit generated on eligible dividends is intended to compensate Jill for having to pay tax at a higher rate on the money corporately than if she had been able to pay tax on it at the 12% rate.
To further make the numbers jibe, the actual amount of Jill’s dividend payments will be increased (“grossed-up”) by 16% (i.e. increased from $880 to $1020.80 in taxable income) if a small business dividend and by 38% (i.e. increased from $730 to $1007.40 in taxable income) for an eligible dividend for income tax purposes. The purpose behind this additional mathematical madness is to make sure that Jill is paying tax on the same $1,000 (give or take) and in the same tax bracket as would have been the case if she’d taken the money as salary. As you’ll see below, after the gross up, Jill will be declaring about $1,000 worth of income any way you slice it. On the other hand, she will get a dividend tax credit of 25.0198% of the grossed-up amount of $1,007.40 if she receives an eligible dividend (which is 34.53% of $730 she actually received) received in order to compensate her for the 27% tax Jillco had already paid on that same $1,000.If she gets an ineligible / small business dividend instead, she’ll get a dividend tax credit of 12.1013 of the grossed-up amount of $1,007.40 (14.0348% of the $880 she actual receives).
Crunching the Numbers
If Jill takes the extra $1,000 as salary or if Joe had been the one earning the extra $1,000 as a sole proprietor after already making $100,000 that year:
- $1,000 – 38.29% (the marginal tax rate for someone earning $100,000 in income).
- After-tax amount in Jill or Joe’s jeans: $617.10
In other words, if Jill takes the extra $1,000 in salary rather than as dividends, she’d be left with exactly the same amount as Joe. It’s only when the money gets paid out as dividends that things start to change.
If Jill first paid 12% small business tax in Jillco and took the remaining amount as small business dividend:
- Amount paid out as dividend ($1,000 net of 12% small business tax): $880. (“A”)
- Grossed-up Dividend: $1,020.80 (A ($880) x 1.16 (i.e. a 16% gross-up) (“B”).
- Tax on Grossed-up Amount: $390.86 (B ($1,020.80) x .3829 marginal tax rate) (“C”)
- Small Business Dividend Tax Credit: $123.53 (B ($1020.80) x .121013) (“D”)
- Total Personal Income Tax Owing (C-D or $390.86 – $123.53): $267.33 (“E”)
- After-tax money in Jill’s jeans (A-E) or $880 – $267.33: $612.67
If Jill first paid 27% on the $1,000 in Jillco and received the remaining amount as an eligible dividend:
- Amount paid out as dividend ($1,000 net of 27% small business rate tax): $730. (“A”)
- Grossed-up Dividend: $1,007.40 (A or $730 x 1.38) (“B”).
- Tax on Grossed-up Amount: $385.73 (B or $1,007.40 x .3829 marginal tax rate) (“C”)
- Small Business Dividend Tax Credit: $252.05 (B or $1,007.40 x .250198) (“D”)
- Total Personal Income Tax Owing (C-D) or $385.73 -$252.05: $133.68 (“E”)
- After-tax amount in Jill’s jeans (A-E) $730 -$133.68: $596.32
In summary, although it’s not perfect integration, the size of the wad in the back of Jill’s jeans is pretty similar in all three scenarios after the dust settles. Eligible dividends are more valuable to recipients because they produce a bigger tax credit. Fortunately, you won’t have to do all of my calculations going forward, as there are tax charts that cut to the chase and tell your net tax rate after applying the dividend tax credit when receiving any type of dividends at any income level. Unfortunately, you should still calculate the grossed-up amount of any dividends you wish to pay out in advance to ensure that you don’t mistakenly push yourself into a higher tax bracket than intended. In the end, tax planning involves trying to pay the right amount of dividends to the right person during the right tax year so that they don’t receive too much total income from their particular mix of company salary, eligible and small business dividends, as well as other income they earn personally from other sources like pensions, personally-held investments and so on. This requires both knowing how dividends are taxed and at what income levels the different tax rates kick in. Hopefully, this article and a link to current tax rates in your province of residence will steer you in the right direction: https://www.taxtips.ca/marginaltaxrates.htm
Before wrapping up today’s missive, we need to talk about one final type of dividend that Jill might receive from Jillco from time to time. If Jillco realizes capital gains, such as from selling an office building or from the stock that crazy neighbour talked her into buying several paragraphs ago, integration theory needs to account for the 50% that Joe would have received tax-free in his own hands if he was the one selling the building or stock. Likewise, if Joe owned life insurance on his key employee, Dick (of Dick and Jane fame), he’s receive the entire death benefit in his own hands tax-free.
I’ll have a lot more to say about capital dividends going forward, when I talk about how passive or investment income is taxed inside Jillco. For now, the key is that our tax system is designed so that Jillco can pay out the non-taxable 50% of any capital gains it earns and a portion (although not necessarily all) of any life insurance death benefit it receives to Jill. Jillco receives both the 50% non-taxable portion of any capital gain and 100% of the death benefit of a qualifying life insurance policy tax-free, just as Joe does. The problem was that both eligible and small business dividends would require Jill to pay tax on any amount received, which would put her in a worse position than Jack, who gets that money for his own use tax-free.
To solve this problem, the government created “capital dividends”, which Jill can receive from Jillco tax-free. Jillco’s accountant is in charge of tracking the non-taxable portion of any capital gain, minus any capital losses Jillco earns that year, such as if Jillco sold the stock Jill had heard about from her crazy neighbour at a loss. Jillco would also get credit for the death benefit of any life insurance policies it received minus a tax adjustment. In simple terms, most or all of any term life insurance policy could be paid out to Jill for free through capital dividends, but for permanent policies with a cash or investment portion, some of that value would still go to Jillco tax-free but would have to be paid out to Jill as taxable small business dividends, which all depends on the type of policy, the size of the investment portion and the age of the deceased at the time of his passing (the older the deceased, the greater the percentage of death benefit that can be paid to Jill for free). Fortunately, insurance companies track these tax values, which will change from year to year. To this total, her accountant would also add any capital dividend room on hand that hadn’t been paid out to Jill in previous years.
In any event, that’s probably more than enough for today. For now, let’s just focus on the fact that sometimes Jill can receive tax-free capital dividends from Jillco when it sells assets that produce capital gains or someone covered by a company life insurance policy dies. We’ll have more to say how the taxable portion of any capital gains (i.e. the 50% that is taxed, as opposed to the 50% paid out as capital dividends) are taxed next time.
If you’ve made it this far, you will hopefully have a better idea of how active business income is taxed and how the different types of dividends fit into the system. You probably have also already heard far too much about integration theory as well. Although today’s article focused on active business income and Jill’s tax situation if she paid out all her corporate earnings as soon as possible, many businessowners benefit the most when they stockpile excess earnings within their company so they have more to invest for the future and in the expectation that they might be able to pay less tax on the money in the future when they withdraw it as dividends if they are then in a lower tax bracket. Accordingly, my next article will attempt to start deciphering the mystery of how investment income is taxed in CCPCs, since investing corporately rather than personally is one of the main benefits of incorporating your business. Today’s article is hopefully a useful first step along that convoluted road. Just don’t be surprised if integration theory once more makes a surprise appearance.