For those of you who have a family business and thinking about incorporating, there is a tax strategy that you can use to your advantage that will minimize the overall taxation of company income.   It’s called “Dividend Sprinkling”.

We’ve mentioned dividend sprinkling briefly before in the discussion about holding corporations, but lets explain it with a bit more detail.

What is dividend sprinkling

Dividend sprinkling is where family members are given shares of a private corporation setup with the intention of paying dividends to the members with the lowest tax bracket.  The result is that the corporate income gets paid to the family at the lowest tax rate possible.

Why use this strategy?

In my previous article about taxation of private corps, we concluded that when money is withdrawn from a private corporation, the net taxation is about the same as if the company was a sole proprietorship.  However, that was assuming that all the of income was withdrawn under the one shareholder/owner.

With the dividend sprinkling strategy, the director can “declare” dividends for specific classes of shares while excluding others.  That is, if one spouse/shareholder makes less income than another thus in a lower tax bracket, then simply declare dividends for that shareholder only

How to set up dividend sprinkling?

When creating a private corporation, the business owner has the option of setting up the share structure in any way that they see fit.  In this case (check the rules of your province/jurisdiction):

• The majority owner/director would be assigned common shares
• The spouse is assigned non-voting Class A Preferred Shares
• Any other family members are assigned non-voting  Class B, C and so on.  Note though that if dividends are distributed to children under the age of 18, there is a “kiddie tax” which taxes dividends at the highest possible rate.

A lawyer would help greatly with structuring your private corporation to take advantage of dividend sprinkling.

An example of the tax benefits

Lets assume that there is a new company to be setup, ABC Inc. in Ontario.  Wife is the director/business owner and at a higher tax bracket than husband.  Common shares would be assigned to Wife while non-voting Class A Preferred shares would be given to Husband.  Assume that Wife makes $60k/year while Husband makes $30k/year.

If they wanted to withdraw $20k from the company to pay down the mortgage (assuming that the company is cash flow rich) in the form of a dividend, the director would declare a dividend for the class A shares (husband) only, the lower income spouse.  If the dividend was declared for the common shares (wife), the tax on the dividend would be approximately $4,108.  On the other hand, if the dividend was declared for Class A shares (husband), then the tax on the dividend would be about $2,733, a significant difference of $1,375 more in pocket.  Do this a few times over the years and the savings are quite substantial.

Conclusions

While it may take a bit more work to setup a corporation with proper share structure, it is well worth it if there is a significant difference in income between spouses.  As I mentioned before, it is recommended that you consult with an experienced lawyer to setup your private corporation properly.

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Kevin, from Canadian Money Forum, started a forum topic asking for advice on his financial situation.  Check it out:

I’ve chosen to write this topic in order to have an idea about what you would do in my situation. I’ve read most of the MDJ blog, as well as several other websites, but the more I read about it, the less confidence I have to actually do something. With the current economic crisis, this could easily turn into one-of-a-lifetime opportunity, and staying on the sidelines isn’t a valid option.

Here is my background:

I recently turned 22 and am working in downtown Montreal at a job paying me $33k/year. I currently live in a 4 and a half appartment at $630/month and I’m renting a room in it. I’m single and don’t have any kids. Here are my assets: 36000$ in cash rotting in bank accounts, a car worth about 3000$ now. I don’t have any RRSP, no TSFA ( Yeah, I really need to get one! ). I just started out a non-registered account at work, a stock offering at 2% matched by the company, which I took. The company doesn’t pay dividends and the growth seems limited. In any case, that account has virtually nothing at the moment.

My liabilities are a student loan of 16000$ currently at 3.3% ( not locked ). My budget averages out on the course of the year at around 400$/month free. It may be higher as I don’t take into account tax returns, etc.

My goals in life : I don’t have any particular goal at the moment. I would like to retire early, although I don’t expect to have any expensive hobby during the course of my life ( although that may change, but knowing myself, it’s unlikely ). I currently don’t want kids until I’m maybe 27, and by then, I’ll see if I want any or not. I’ve looked to buy real estate in Montreal ( a condo where I could rent a room, a duplex or whatever ), but by the time I started looking them ( around the same time last year ), prices don’t seem to have went down at all. I’m not the handy type of person also.

I’ve looked into Reits, but with the real estate crash ( and from what I’ve read, the crash is likely not at the bottom yet ), I’m more or less afraid to see Reits with interesting yields ( 5+% ) go bottom-up. I’ve looked into dividend stocks, mainly banks. But, with the RE and credit crisis worsening, is it safe to invest in them? I’m not afraid of them going bankrupt, but more like seeing them reduce dividends greatly, bringing the stock prices way down.

I’ve looked quickly bonds, but they’re not really interesting due to very low yields. With the upcoming inflation that is likely coming, RRBs could be an option, but I would need to read more about them. I’ve also looked in starting my own business over the Internet ( I have tons of free time at work (2-3 hours a day), but I haven’t found anything that could work, most ideas I’ve had being already realized, and free to the general public.

That’s pretty much a good summary of my situation right now. Knowing this, what would you do if you were me?

After reviewing Kevins financial profile, it appears that he’s in great shape.  Having $36,000 in cash from a single 22 year old making $33k/year is quite the feat.  Here is what I would do:

1.  Pay off the Debt

To begin, even though the student debt is at a fairly low rate right now, it is floating, so it could go higher in the next couple years.  Even with the low rates, paying off the debt would provide a return much greater than idle cash in addition to freeing up more cash flow.  Besides the financial benefits of paying off the debt, there is the psychological benefit of “freedom” when outstanding debt is eliminated.

2. Save for your goals

Kevin mentioned that he is interested in buying a house in the future.  One thought would be to start his RRSP so that he can take advantage of the RRSP home buyers plan in the future.  As Kevin is currently in the lowest tax bracket, I would suggest to claim the tax deduction in a future higher income year.

An alternative would be to use a TFSA for his savings or a combination of a TFSA and RRSP.  At least that way, he would have access to some cash without having to worry about being taxed on the withdrawals.

3. Get Rid of Company Stock

I would get rid of the company stock.  The reason is that too much of Kevin’s wealth would be tied into the one company as it’s his main source of income.  One strategy could be to exercise the company stock options immediately upon receiving them (if they are in the money).  Note though that this would generate tax payable in the form of capital gains.

4. Build a Portfolio

Once he has money set aside for his immediate financial goals, then it’s time to start building a long term portfolio.  What should he invest in?  For most investors, the best bet would be to index.  I know, I know, I don’t entirely practice what I preach (only a portion of my portfolio is indexed) but indexing really is a smart (and passive) way to invest for someone who doesn’t watch the market all day long.

Investors can index via mutual funds or ETFs.  Mutual funds can be cheaper if investing small amounts per month, but ETFs have lower MERs overall.  A popular, and cheap, set of index funds are the TD e-Series.  For ETFs, you can check out my low cost diversified ETF portfolio.

5. Start a Business

For a young (and single) guy like Kevin with some free time on his hands, I would definitely recommend going into business.  As he seems to be Internet savvy, I can suggest what I’m doing.  That is providing free content and adding value to an audience about a subject that he is enthusiastic or even passionate about.  Not only can this be fulfilling, it can pay for beer, diapers or even your mortgage.  The sky is the limit.

6. Stay Frugal

If Kevin can remain fairly frugal, keep his expenses low, and banks his raises, he will achieve his financial independence in a relatively short period of time.  In saying that, I would recommend that Kevin stay the course, invest for the long term but of course splurge a little every now and again to enjoy what money can buy.

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