How to take money out of your business in a tax-efficient manner? This is a common question that we get asked from a lot of our clients. Many business owners put their salaries, dividends, or other compensation on hold during the early phases of their business in order to reinvest the gains in the company to help it expand. At some point though, the business owner would want to take some cash out for personal needs as the business becomes more established.
However, withdrawing funds from your business is not as simple as it sounds and can have tax consequences. Though there are tax-efficient ways to take money out of your business, but it will differ for each business owner depending on their specific situation. Several factors may influence which method is better, including the tax rates where you reside, the tax rates where your business operates, and whether the corporation has certain tax attributes that can be utilized to minimize tax.
In addition, while some methods of withdrawing cash from your corporation are taxable, some could be tax-free. In this article, we will explore different ways to take money out of your business, discussing the pros and cons of each method and highlighting important tax implications to consider.
Taxable dividends can also be used to withdraw funds from your business. Dividends are the profits a company keeps after paying off taxes from its net profits. They’re paid out to shareholders of the company, thus you, your spouse, and your children must own shares of your corporation directly or indirectly (i.e., through a trust or a holding company).
At the individual level, dividends are taxed more efficiently than a salary since the tax rate depends on the characteristics of the dividend (i.e., eligible or non-eligible). However, in contrast to salary, dividends can result in a larger reduction to Old Age Security benefits because of the dividend gross-up mechanism. At the corporate level, the payment of dividends will not be deductible to the corporation. In addition, payroll taxes such as CPP/QPP contributions and employment insurance (EI) premiums will not be an added cost to the corporation or the shareholder.
Under this option, consideration should also be given to both the tax on split income (TOSI) rules and corporate attribution rules before any distribution is made. Generally, taxable dividends from a private corporation to family members who don’t contribute to the business will be taxed at the top marginal rate under the TOSI rules.
Similarly, corporate attribution rules under the Income Tax Act (“ITA”) can also apply when an individual tries to income split with family members in lower tax brackets by transferring or lending property to a corporation. For corporate attribution to apply, the main purpose of the transfer or loan would be to reduce the income of the transferor or to benefit a designated person such as spouse or minor child, thus resulting in the income being attributed back to the transferor.
Generally, the most common method owners will use to withdraw funds from their business is via a salary which is similar to an employee being remunerated. In addition, other family members that are working for the business can also be paid a salary as long as the amount is reasonable.
From a tax perspective, at the corporate level, the business is able to deduct the salary expense from its taxable income and lower the corporate tax rate. However, for a salary or bonus payments to be deductible for the corporation, the amount paid must be reasonable. Based on Canada Revenue Agency (“CRA”). a reasonable salary would be equivalent to the amount the business would pay a third party for the same work activities.
Note that there is an exception for salary paid to owner-managers. The CRA would not question the amount of salary paid by a Canadian Controlled Private Corporation to its Canadian resident owner who actively participates in the operations of their company. Another thing to consider at the corporate level is the additional employer cost associated with payroll taxes such as CPP/QPP contributions and employment insurance (EI) premiums.
At the individual level, the taxpayer or business owner will be fully taxed on the salary amount at their personal marginal tax rates that are applicable based on the jurisdiction in which they live. In addition, payment of salary or bonus is considered earned income for the purpose of generating Registered Retirement Savings Plan (RRSP) contributions room for the individual.
Another tax-efficient way to withdraw funds from your business is to pay yourself a dividend through the corporation’s capital dividend account (CDA). The CDA is a notional account that tracks the non-taxable portion of the capital gains and the non-allowable portion of capital losses that is earned by a private corporation. In addition, other amounts such as capital dividends received or paid by the corporation and certain life insurance proceeds received in excess of the policy’s adjusted cost base are also included in the CDA calculation.
A positive balance in a corporation’s CDA is usually a result of net capital gains and can be distributed to Canadian resident shareholders as a tax-free dividend. However, because the CDA is calculated on a cumulative basis, a capital dividend must be paid as soon as capital gains incur to avoid the realization of capital losses. Capital losses incurred after paying a capital dividend will not retroactively affect the tax-free distribution previously received, even if the loss is carried back. Accordingly, it is advisable to pay out the balance of the CDA as soon as it becomes available.
Having said that, calculating the CDA can be complex. In addition to rules regarding what is allowed and what is not allowed in the CDA, timing considerations must also be taken into account when calculating the CDA balance. For these reasons, it is imperative that you speak to a tax professional in advance of paying a dividend from your corporation’s CDA.
The paid-up capital (PUC) of your shares represents the consideration your corporation received in return for the shares it issued. In some cases, your corporation can return the PUC to you tax-free as return of capital . This may be a good strategy if you have a high PUC on your shares and the corporation no longer requires the funds. In this case, you can take out a tax free distribution by reducing the PUC on your shares.
Another option to withdraw funds from your business is by obtaining a shareholder loan from your corporation. Shareholder loans can be a useful way to manage short-term personal cash needs. However, the ITA contains very specific rules limiting the ability of a shareholder to borrow funds from their corporation. The general rule is that if you borrow funds from your corporation and the loan is not repaid, the amount borrowed is included in your personal income in the year you borrowed the money, unless the loan meets certain exceptions.
The most common exception is if the loan is repaid within one year after the end of the taxation year of the corporation in which the loan was made. However, this exception will not apply if the repayment was part of series of loans and repayments.
Generally, if the business owner needs a short-term loan for less than a year, a shareholder loan could be an easy way to obtain the funds. If used properly, shareholder loans are a great tool for tax planning and cash management. However, the shareholder rules under the ITA are complex, so speak to a tax professional to avoid negative tax consequences. For more details on shareholder loans, read our blog article titled “Shareholder loans and their tax implications.”
Unlike the option above, if the shareholder has loaned funds to their company, there would be no tax consequences if they want the corporation to repay a portion or all of this loan. Any amount the shareholder receives as settlement for the shareholder loan will be considered a tax-free distribution.
When taking money out of your business, it's easy to make mistakes that can have serious consequences. Here are some of the most common mistakes to avoid:
The most important thing when taking money out of your business is to take the time to properly plan how you are going to withdraw the funds to ensure you are paying the minimum amount of tax. The most tax-efficient way to extract funds depends on your unique situation and various factors can influence the end result. The above-mentioned options are available as a general guideline but the best possible solution can be determined with the help of a tax professional as different options can have different tax consequences.
If you need assistance in navigating the complexities of taking money out of your business, contact our team of experts today. We can provide valuable insights and help you make informed financial decisions.
If you want to learn more about other tax and accounting topics, explore the rest of our blog
Disclaimer
The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting/tax professionals. NBG Chartered Professional Accountant Professional Corporation will not be held liable for any problems that arise from the usage of the information provided on this page.
