SALARY/DIVIDEND MIX. J. R. Grossman TOUCHE, ROSS & CO.

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1 SALARY/DIVIDEND MIX J. R. Grossman TOUCHE, ROSS & CO.

2 SALARY/DIVIDEND MIX This segment is concerned with minimizing tax on the withdrawal of profits from a closely-held private corporation - taking into account both the taxes payable by the corporation and those to be incurred by the shareholder/employee. Although references throughout this segment of the material are to be the choice between salary and dividends, it should not be overlooked that other types of payments by a corporation to its shareholders may be applicable. For example, interest paid to the shareholder on an interest-bearing 'obligation (debentu'rs, note; 'etc., ren't' for the use of property (e. g. building owned by the shareholder pe"rsonally, in which the corporation carries on its business, royalties for the use of a privat'ely-held patent, etc. would be deductible in' computing the co:rporation's income and would be taxable to the recipient in much,the same way as salary. If a salary (or bonus payment would be considered unreasonabl'e in the circ'umstances (perhaps because of the amount Or becausetheshareh6lder is not employed by the company these alternatives should not be overlooked. Another factor to keep in mind is that in some 'cases the choice of methods may- not be possible. If, for example, two persons each 'own 50% of the shares but only one of them is actively employed in the business, shifting from salary to dividends would \ also involve a shift of part of the income from one shareholder

3 (the employee to the other. Conversely, if. the employed shareholder has been adequately remunerated for his services, any further allocation of profit to him (e.g.,a sub~t~ntial bonus might be unfair to the other shareholder. Subject to those cautionary c9mments, the purpose of the salary/, dividend mix calculation is to determine the most effective method for distributing corporate profits. For purposes of simplicity, the following notes approach the subject on the basis that the manager is also the principa~, or 601e shareholder of the company. In all cases, an effective mix of. salary, anq. dividend should achieve two principal objectives; satisfy the working capital requirements of the corporation. and the after-tax cash requirements of the shareholder/ manager" and: minimize the total taxes paid by the individual and the corporation. As a tax planning tool, the salary/dividend mix is used to reduce corporate taxes by -preserving the small busines~ deduction and by taking maximum advantage of existing refundable dividend tax on hand in the corporation. For the shareholder/manager, the salary/dividend mix is used to shelter and level the individual's income, to maximize the benefi:ts of the revised divi lend tax credit and, where appropriate, to split income between family members.

4 SMALL BUSINESS DEDUCTION/CUMULATIVE DEDUCTION ACCOUNT } A key factor in balancing the tax liabilities of the corporation and its shareholder/manager is the effect of any salary or dividend payments on the company's small business deduction. The small business deduction is controlled in part by the cumulative deduction account. In general terms, the cumulative deduction account is intended to reflect the amount of post-1971 business income retained by the corporation; i.e. it excludes accumulated investment income represented by refundable dividend tax on hand. The cumulative deduction account is reduced by 4/3 of the amount of taxable dividends paid, except to the extent that they are. considered paid out of accumulated investment income. Since taxable dividends paid trigger a dividend refund (of RDTOH to the extent that there is a balance of RDTOH at the end of the year, they effectively represent payments first out of any available investment income, and only the excess will reduce the cumulative deduction account. If the cumulative deduction account exceeds $600,000 at the end of a taxation year, this will normally restrict the amount of the corporation's small business deduction in the following year. In this connection, a loss in a particular year does not per se reduce the cumulative deduction account (i.e. - a negative amount of taxable income for a year is treated as nil.

5 However, a:,loss carried back would have the effect of reducing ' th_e taxable income for the immediately preceding taxation j'ear, and would~ r~duce,that year accordingly.,the cuml.,llative deduction account at the end of A corporation can control the balance of its cumulative deduction account at the end of a year in at least two significant ways: by reducing the amount of its active business income (e.g. by accruing a bonus - is in e~cess,.,, deduction, 'arid especially where the active business income o~'the 'amount eligible for the small business by paying. t.ixable dividends in exc'ess of the amount required to eliminate any available ROTOH. '; J, The following 'illustration provides an example of the overall,,! ",," distributing $80,000 of active business income as effect of lj ', ' I salary or (after tax as a taxable dividend of $60,000. Where the $80,000 is paid and deducted as salary, the corporation pays no taxes but the individual is subject to tax on salary income of $80,000 at regular personal tax rates. If, on the other hand, the corporation pays tax at the 25% rate and distributes $60,000 of taxable dividends, the shareholder/manager grosses up the dividend by 50% and includes $90,000 in income. He pays tax on this amount at regular personal tax rates, subject to a federal dividend tax credit of $22,500 (75% of the amount of the grossup, which has the effect of also reducing his provincial tax 'significantly.' In- the example, payment 'Of: a taxable dividend,. results in an overall tax saving of approximately $8,000 as compared with following the salary route.

6 SALARY COMPANY'S A. B. 1. (BEFORE SALARY PAYMENT ---= $80,000 ~ $80,OOO~' - - ~ TAXABLE DIVIDEND $60,000 TAXABLE INCOME NIL TAXABLE INCOME $M,OOO TAXES PAYABLE NIL TAXES PAYABLE (25% 20,'000 DIVIDEND PAID ( 60,000 SHAREROtpER'S INCOME SALARY RECEIVED INCLUDED IN INCOME $ 80,000 80,000 DIVIDEND RECEIVED $, 60,000, GROSS-UP ( ,000,INCLUDED IN INCOME 90,000 FEDERAL TAX (GRADUATED RATES $ 25,000 FEDERAL TAX (GRADUATED $ 28,900 DIVIDEND TAX CRED,IT (22,500' PROVINCIAL TAX (SAY 50% 12,500 PROVINCIAL TAX (50% TOTAL PERSONAL T~ $ 37,500 TOTAL PERSONAL T~ I i NET AFTER TAX $ 42,500 NET AFTER TAX $, CUMULATIVE DEDUCTION ACCOUNT, OPENING BALANCE (ASSUME $500,000, OPENING BALANCE (ASSUME$500,OOO ACTIVE BUSINESS INCOME NIL ACTIVE BUSINESS INCOME 80,000 LESS: 4/3 DIVIDENDS PAID 500,000 NIL ~80,OOO LESS: 4/3 DIVIDEND PArD 80,000 CLOS ING BALANCE, $ 500,000 CLOSING BALANCE, $500,000,.

7 No-te that there is no difference in the closing balance of cumulative deduction account under the two alternatives illustrated. The $80,000 salary payment eliminates the company's active business income and therefore no amount is added to the cumulative deduction account. Using the dividend route, $80,000 of active business income is added to the cumulative deduction account, which is then offset by 4/3 of the $60,000 taxable dividend paid. EFFECTIVE TAX RATES In making an appropriate choice between salary and dividends, it is important to recognize the effective rate of tax incurred - immediately and overall. The overall tax rate, to the corporation on its income and to the shareholder on the dividend out of the corporation's after tax income, wi~l vary widely depending on the above factors, the level of the shareholder's income in the year in which the dividend is received, and the province of residence. There are no general rules which can be guaranteed to produce the optimum salary/dividend mix at all income levels. A salary/ dividend mix which is benefical to a shareholder/manager whose only source of income is from the corporation may be quite different from the optimum mix for an individual receiving large amounts of income from sources outside the company. _ lr~ _

8 Similarly, the best salary/dividend mix for a newly incorporated company with a' low cumulative deduction account balance may not be the same as that computed for a corporation whose' cumulative account is approaching' $750,000. The optimum salary/dividend mix can only be computed after con-s'idering all the relevant factors for each case. Thi's wouldnormally require:,- 'a review of the current and projected future income levels of the corporation and its shareholder(s, and how much of this represents i active business iricoine, a-determination of 'the' effect 'of the current and anticipated future income levels on the corporation I s' cumulative deduc'tion I account,- whether the company is 'a' Canadian Controlled Private'- Corpo'ration and, if 'so," \oihether it is ass6cia'ted with other co"rporations; if so, this will require a review of the income earned'b'y each member of the group and the amount of the annual and total business limi"ts'to be allocated to- 'each corporation, an examination of the- company I s share s'tructure to determine whether minority shareholders would' benefi,t from large' dividend payments that'- would otherwise be used to remunerate the owner/manager, and consideration of personal income factors such: as' whether the', shareholder is able t.o fully utilize' any resulting dividend tax credit, whether full advantage is being' taken of the' i.

9 section investment income exemption, and whether inc'ome sp1itb.ing opportunites are available by paying dividends to family members (bearing in mind that family members employed in the business would normally expect a' g~eater share of' the profits than others who are passive shareholders. After reviewing all relevant factors, the next step is to decide' what combination of salary and dividends will best balance the'!' income ta,x position of the shareholder/manager and the corporation. Where the corporation I s active business income j,'s below say $10,000 and the shareholder/manager has no other source of;,income, it is, generally beneficial to pay salaries.' ',This is because, the initial graduated personal :tax r,ate,s (together with, personal exej.!lp,tions produce a 'lower personal tax l.iabil~ty than the s,mgtll - business in,come tax rate which would otherwise app+y, to the corporatio,n. Where corporate activ,e business income is between say $10,000, and, $45,000, a combination of -salary and dividends may be- required to ensure that the shareholder/manager is able,to full-y, utilize his available,dividend tax credit. Thisl is illustrated in the following example of a company earning $24,000 of active business income: (A paying $10,000 as salary and distributing the balance of after-tax income as a taxable dividend" and (B where all aftertax income is distributed as a taxable dividend.

10 Active business income Salary CORPORATION'S INCOME A $24,000 (10,(}(0 B $24,000 Taxable income Taxes payable (26% Dividend- paid 14,000 24,000 (3,640 (6,240 $10,360 $17,760 Salary SHAREHOLDER/MANAGER'S INCOME $10,000 $ Dividend (grossed-up Personal exemptions (say Taxable income 15,540 (5,000 $20,540 26,640 (5,000 $21,640 Federal and" provincial-tax Dividend tax credit Taxes payable (Unabsorbed tax credit Net after-tax $ 4,375 (3,885 $ 490 $19,870 $ 4,634 (6,660 ($ 2,026 $17,760 Note that, in the latter case, the individual cannot take advantage of $2,026 of the available dividend tax credit and the after-tax income is therefore less than where a combination of salary and dividend was used. For purposes of the example, it was assumed that the individual had no income from other sources. If the shareholder/manager had received other income, the tax on such in_corne could, of course l be offset against the unabsorbed dividend tax credit.

11 In general, the best results are achieved where active business income in the $45,000 to $150,000 range (and qualifying for the small business deduction is distributed to the shareholder/ manager as a taxable dividend rather than as salafy. EFFECT"OF REFUNDABLE DIVIDEND TAX The question arises as to whether the existence of refundable dividend tax on hand (RDTOH, refundable to the corporation when taxable dividends are paid, will haye an effect on the salary/ dividend mix. Where a company has RDTOH r the decision as.tq whe:.h~r the sa-lary/ dividend.mix.should include s u.fficient:.. dividends to, trigger full refund of RDTOH will depend on a number of variables; for example, the shareholder/manager's cash requirement, the company's cumulative deduction account level, the possibility of using the corporation as a tax shelter for investment income, and the income levels of the corporation and its shareholder/manager. Assume, for example, that a corporation qualifies for the small business deduction on all its active business income, that it is in no danger of losing its right to claim the small business deduction, and that the shareholder/manager simply requires. funds.from the corporati9n (for living expenses/ etc.. In this case, except perhaps at low corporate income levels, it would be

12 preferable to payout the funds as taxable dividends and generate a refund of refundable dividend tax on hand. In these circumstances ' payment of dividends would be preferable to salary payments even if the company had no RDTOH..The ability to claim a dividend refund simply makes the option more attractive. If the shareholder/manager does not require funds from the corporation I the question arises as to whether from a.tax planning point of view, it is beneficial to pay taxable dividends.simply to.trigger a refund of any available RDTOH. If the dividend payments are not required to protect the cumulative deduction account,.. there is usually little to re_commend the payment 0. d_ividend~ to shareholders in high tax brackets just to trig:ger a r'efund of the RDTOH. In these cases- it may be-' bett.er to use the corporation to shelter the investment income. Where dividends are to be paid,to protect the company I s small business deduction, the important point to bear in mind is that the cumulative deduction account is not reduced by dividends to the extent that they generate a refund of ROTOH. Where l for example, a company1s cumulative deduction account balance is $700,000 after including the yearls profit, a dividend of $75,000 wo"uld be required before "the year end if the company wished to claim the full small business deduction" in the following year. If the company had $12,000 of RDTOH, however, $48,000 of the dividend would first be applied to produce a dividend refund and

13 the cumulative deduction account would only be reduced by $36,000 (4/3 of the remaining $27,000. In this case, a dividend of $123,000 would be required to fully protect the following year's small business deduction. UNPAID AMOUNTS An obvious "gimmick" to defer tax would be to accrue a bonus to a key shareholder/employee and then not pay it. Such a deduction would reduce taxable incqme for the corporation in the year of accrual, but would not be taxed immediately in the employee's hands, because employment income is taxed on a cash basis. If it were not for the provisions of section 78 there would be a deferral of tax for as long as the amount remained unpaid. Subsection 78 effectively blocks, or at least limits, the above scheme by requiring that unless the amo~nt is paid within a specified time, it must be added back to the income of the payor. If the amount is paid subsequent to the time linitations it will be added to the income of the recipient but will not be deductible at that time to the payor. More specifically, subsection 78(3 applies where an amount is deductible in computing income of a business as salaries, wages or othe_r remuneration and the amoun t remains unpaid at the end of the taxation year following the year in,which the expense was incurred. When this situation arises, either

14 the unpai~ amount is ~ncluded in cqrnput.j.ng the employer's,.:i,.ncorn_e, {or the seco,nd, tax~tion yea,r followi~g, the taxation year in which the outlay or expe?nse was in,curred t, or (b where the employer and ernploy~~ fi1,6 an agref!3,rnent (Form T2049 on or before the date when the employer is ~equired to' f~le his ;tax! re,turn for the taxation year following the,, taxation year in which the outlay o,r expense was incur,red, the followiijg J;ules apply, 1,the employer, is considereq, to have paid th~ amount to tl1e employee o,n the first day of the second ta>;ation year after the year,-,the exp~nse.wa~ incurred, and ~s requ,il;:'ed to withhold and remit tax on the "payrnentll,attl1at time.?j.. the employee is, considered to have,,received the -remuneration, (less the- tax withholding on the first day of the second taxation year and to have made a loan back to the employer of that net amount. Accrual of a bonus to defer tax in the employee',s hands until the following year (or for the purpose of keeping the corporation's income down to the small business deduction level can be an effective part of planning in conjunction with the salary/ dividend mix calculation, but only if the bonus is reasonable and represents a bona fide liability of the corporation at the end of the accrual year. Although not mandatory, it may be desirable in a closely-held corporation to have the bonus minuted in an appropriately worded Director's resolution before the year end.

15 However, -to a'void the implications' of the 'unpaid amount 'rules in subsection 78 (3,' th~re- should 'also be a bona fide intention, recognized by' t:he corporation and the individual, to' pay the bonus be'fore the end of the following taxation year. In passing, and as mentioned earlier, it should be noted that other type's of income payments can be accrued (deducted from' the corporation I s income and need only be incltide'd' in the' shareholder/ manager I s income...,-hen late'r paid. This could include interest on amounts owing to the shareholder (if the terms of the loan stipulate a rate 6f interest, rent 'on 'premises owned by the shareholder and leased to the company, etc. The "un,j?aid amounts" rules in section 78 apply equally to such items, but with an addi tional year I s g'race before' the "payor' elect II : choi6;e' mjs't be made.

16 EFFECTIVE DIVIDEND TAX COST IN 1979 Marginal Tax Brackets ($99,481 and up ($64,663 to $99,480 ($39,792 to $64,662 Federal, tax Gross up Dividend tax credit.ll.:2..ll.: , provincial tax % Effective rate applied to actual dividend received 27.0.l:2..:.i = === EFFECTIVE SALARY COST IN 1979 Federal Provincial Total 43,0 ll! = ~ 36: =

17 COI1PARISON OF SALARY COST VERSUS DIVIDEND COST OF CANADIAN CONTROLLED PRIVATE CORPORATION QUALIFYING FOR SHALL BUSINESS DEDUCTION % 39% ($99,481 ($64,663 and up to $99,480 36% ($39,792 to $64,662 Salary corporate income $1,000 $1,000 Salary 1,000 1_,000 Taxable income Nil Nil Individual tax cost $ 681 $ 617 Net after tax $ 319 $ 383 $1,000 1,000 Nil $ 570 $ 430 = Dividend, Corporate income $1,000 $1,000 Taxes thel;eon Net after tax $ 740 $ 740 Individual tax cost $ 317 $ 246 Net after tax $ 423 $ 494 Difference in net after tax $ 104 $ 111 $1, $ 740 $ 193 $ 547 $ 117

18 COMPARISON, or SALARY COST VERSUS DIVIDEND COST OF CANADIAN, controlled PRIVATE CORPORATION WHOSE INCmlE DOES, NOT QUALIFY "OR SMALL BUSINESS DEDUCTION OR ' MANUFACTURING AND PROCESSING DEDUCTION ' 43% 39% ($99,481 ($64,663 and up to $99,480 Income retained in co~~qr~tion, corporate incbine $1,000 $1,000 Tax thereon 50% Available for distribution $ 500 $ 500 Dlv;i4end received $ 500 $ 500!: ' Gross up Taxable. incoro,e $ 750 $ 750 Tax' thereon 'I $ 214 $, 166 Ultimate tax cost 71.4% 66.6% Net after tax $ 286 $ % ($39,792 to $64,662 $1,000 5pO $ 500 $ 500 ' 250 $ 750 $ 130 6:3.0% $ 370 Payment of salary Individual $1,000 $1, Ta~ co_st thereon (68.1% (61. 7% Net after tax $ 319 $ 383 $1, (57.0% $ 430

19 COMPARISON OF SALARY COST VERSUS DIVIDEND COST OF CANADIAN CONTROLLED PRIVATE CORPORATION QUALIFYING FOR MANUFACTURING AND PROCESSING DEDUCTION COST NOT SMALL BUSINESS DEDUCTION 1979 Income retained in Coq:~ora tion Corporate income. Tax thereon 4:4 % ~, I Available for distribution Dividend received Gross up,., Taxable " incom,e Tax' the'reon U1 timate tax cost Net after tax 43% ($99,481 and up $1, $ %0 $ $ 840 $ % $ % 36% ($64,663 ($39,792 to to $99,480 $64,662 $1,000 $1, $.',I 560 $ 560 $ 560 $ $ 840 $, 840 $ 186 ' $, % "\ _. 58.6% $ 374 $ 414, Payment of Salary Net after tax - from previous schedule $ 319 $ 383 $ 430

20 SALARY OR DIVIDENDS? COIi~AR1SON Of TAX TREATNENI.. SALARY 1 DeDUCTED IN COMPUTING COMPANY'S INCOME CORPORATION'S INCOME, TAXABLE DIVIDEND '" J NO DEDUCTION IN COMPUTING TAXABLE INCOME REDUCES CUMULATIVE DEDUCTION ACCOUNT ON $ FOR $ BASIS C~~TIVE DEDUCTION ACCOUNT REDUCED BY 4/3 TAXABLE DIVIDENDS PAID (LESS AMOUNT OF DIVIDEND GENERATING REFUND OF ROTOR NO GENERATION OF REFUND OF ROTOH 1 SHAREHOLDER/MANAGER'S INCOME r SALARY INCLUDED IN COMPUTING TAXABLE INCOME J NO DIVIDEND TAX CREDIT REFUND OF ROTOH GENERATED ON BASIS OF $1 REFUND FOR EACH $4 OF TAXABLE DIVIDENDS PAID SHAREHOLDER/MANAGER'S INCOME J 150% OF TAXABLE DIVIDE,~S INCLUDED IN COMPUTING INDIVIDUAL'S INCOME 1 DIVIDEND TAX CREDIT AVAILABLE, I