# Private Canadian Corporations and Taxes – Scenarios

Yesterday’s article explained the basics of the taxation of private Canadian corporations. Today, we’ll go through a couple of scenarios to see the tax implications of withdrawing money from the corporation.

Scenario 1: Say that Jim from Newfoundland had a private incorporated business that made \$10k/yr. Jim also makes \$65k/yr in his regular job.

If the money was kept as a sole proprietorship, Jim would have to pay 38% on his business income.

If held in a corporation, he would only have to pay 16.0% on the business income. However, if he wanted to withdraw the money for personal use, there would be additional tax on his personal income tax.

• If the \$10k business income is distributed to Jim via salary, the corporation would get a tax deduction, but the income would be added to Jim’s existing \$65k job income. This would result in net tax of 38% on business income.
• If the \$10k is distributed to Jim via dividends, the money would be distributed to Jim with corporate after tax dollars, but Jim would get the dividend tax credit for private Canadian corporations (25% gross up). The personal dividend would be taxed 24.58%, but that’s after the money has already been taxed 16% via the corporation. This scenario would actually result in net tax of 41.58% on the business income.

Scenario 2: Say that Jim’s business income has grown to \$65k/yr but decides to quit his day job to pursue growing his business full time. Jim needs to withdraw \$30k/yr to cover his personal expenses.

• If the business was held as a sole proprietorship the \$65k/yr would be taxed at an average rate of 30.30%.
• If the small business was under a corporation, and only \$30k was withdrawn as salary, \$35k of the business income would be taxed 16%, and \$30k of the salary would be taxed 21.61% including CPP/EI. The net taxation on the annual income would be: 18.5%
• What if the money was withdrawn as dividends? In that case, the whole \$65k would face the 16% corporate tax, with the \$30k personal dividend facing 4.35% in tax. The net taxation on the annual income would be: \$11706/\$65000= ~18%

### Conclusions

As you can see from the scenarios above, whether you withdraw from your corporation in the form of salary or dividends, it works out to be approximately the same taxation.

If going with the private corporation full time, it may be preferred to take a salary as it will provide RRSP contribution room. In terms of taxation, the biggest benefit of holding a private corporation is for the tax deferral and the capital gains exemption if the company is sold.

Please note that i’m not an accountant or tax professional. Use the information above at your own risk.

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About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from \$200,000 in 2006 to \$1,000,000 by 2014. You can read more about him here.

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• Chuck August 19, 2008, 10:44 am

Just wondering on scenario 2. You mention a rate inclusive of EI & CPP. As a small business owner you’re not at arms length from the business and should be EI exempt. Not sure if you factored that into your calculation of tax burden?

• FrugalTrader August 19, 2008, 10:50 am

Hi Chuck! Good point, I did not know that. I simply used the calculators at taxtips.ca to come up with my tax rates for my province. Any ideas how CPP works in this case? My understanding is that the corp has to pay a portion along with the salaried employee?

• Dividend Growth Investor August 19, 2008, 11:41 am

As for withdrawing money, can Jim establish a retirement plan through his “corporation” and then contribute the entire 10,000 to a retirement account? ( if the contribution limit is 5,000 he should then contribute 5,000)

In the US, if you are a business owner and your company earns \$10,000 and you then want to take the money as dividends, the IRS ( the internal revenue service)might challenge that and make you pay it to yourself asa salary not as a dividend.

• MoneyGrubbingLawyer August 19, 2008, 11:42 am

The employer pays the same rate as the employee- 4.95%. So if you’re self employed or paying yourself through a corp, you pay a total of 9.9%.

• DAvid August 19, 2008, 12:15 pm

In the article above Frugal Trader said: the biggest benefit of holding a private corporation is for the tax deferral and the capital gains exemption if the company is sold.

That is a doubly big if, as the shares of the company must be sold. If it is a sale of assets, then the rule does not apply, unfortunately. This can make big difference in your tax planning, but your crystal ball has to be in fine form to make the prediction. The second ‘if’ is of course that you have created a business that another sees sufficient value to purchase, rather than parallel it by creating a competing business.

DAvid

• MikeG August 19, 2008, 1:53 pm

My Tax accountant suggested this rule of thumb:

Retain all the earnings you want to reinvest in the business. Then pay yourself a salary upto the max for CPP. Then dividends for any additional money you want to take out.

I dont know the facts or figures around that rule of thumb, just that she said it and she’s been an accountant for a very long time..

-MikeG

• ThickenMyWallet August 19, 2008, 3:56 pm

One HUGE caveat. There are tax rules about corporations paying its owner-managers nothing but dividend month after month. I can’t cite the rule (any accountants out there?) but at the very least, you may trigger GAAR (general anti-avoidance rule) if someone reported \$60,000 in dividend and \$0 in salary. This is the reason why MikeG’s accountant uses that rule of thumb. You have to mix up salary and dividends and cannot rely solely on the latter as a way to pay yourself.

It also bears mentioning that pre-incorporation expenses and money put into the business by the owner-manager before it was profitable can be classified as a shareholder loan to the corp. and with-drawn tax free (assuming that the loan to the corp. was using after-tax monies). An accountant can set up the proper ledgers to support this method of with-drawing money.

• MoneyGrubbingLawyer August 19, 2008, 4:16 pm

FT, there is another scenario that may work in some cases- issuing preferred shares and dividends to a spouse or adult child with a lower income.

Let’s say that in the first scenario, Jim’s wife is a stay-at-home mom with minimal income. Rather than distributing dividends to Jim, the full \$10k could be distributed to his wife. Rather than being taxed at Jim’s higher rate, these would be taxed at her lower rate of 4.35%, saving the couple \$3,723.

I know that there are a few traps to this approach, but my understanding is that this is a viable option. Anybody with more expertise care to correct me on this?

• FrugalTrader August 19, 2008, 4:22 pm

MGL, the only issue with that is that the corp would have to be structured so that the wife would receive dividends and not the husband, is this a big process?

Another issue is that the added income would take away from the spousal credit. I would need to work out the numbers to see which case is more tax efficient.

• MoneyGrubbingLawyer August 19, 2008, 4:30 pm

It isn’t very difficult to set up separate share classes where one class could receive dividends without having to pay on all classes. Jim could have common and his wife could have preferred, or you could create multiple classes of preferred if needed.

Good point about the spousal amount- that would wipe out a good portion of the savings. However, if the wife had a low income rather than no income, I’m thinking it wouldn’t make a difference.

• blaze August 19, 2008, 5:18 pm

OK let’s see if this is right.

Let’s say I had 300K invested in my corp. I bought a business (non corp, unless I wanted to hold it for 24 months .. right?), prettied it up, and flipped it for 360K. The corp only has to pay 50% of the gains as taxes, right? The business would go under the heading of ‘eligible capital property’, correct?

Now, let’s say I did that several times, until I reached my upper limit exemption of 750K.

Then I sold the whole kit and kaboodle.. Nothing goes to the tax man, correct?

I parlayed 300K into 750K, paying only a 9% tax rate along the way of each flip.

Am I missing something here? Gaar, maybe? I don’t think Gaar gets called upon that often, from what I know. It’s a pretty sucky law (it’s tax avoidance if we say so)

• ThickenMyWallet August 19, 2008, 5:21 pm

MGL- “Dividend sprinkling” is, indeed, a viable strategy and usually pursued by entrepreneurs with some sophistication. As you indicated, you file articles of incorporation with Class A, B, C, D etc. of shares. Each class of shares is issued only to a family member (i.e. owner-manger is issued Class A, spouse is issued Class B, Jr. is issued Class C). The key is that the articles of incorporation allow the directors to sprinkle dividends to any class of shares as they see fit to the exclusion of the other classes of shares (since each individual holds separate class of shares, you are not treating anyone unfairly in the eyes of the law) or to all the classes of shares in whatever proportion the directors wish.

It is a “safer” approach to income splitting than employing your spouse or kids since CRA will not engage in a reasonableness test for the payment of dividend but when you employ a family member CRA will look at how much you paid your spouse in relation to the work done (since people abuse this income splitting move).

FT: The advantage of dividend payments and dividend sprinkling is that it is at the discretion of the directors assuming after the corporation can meet its obligations as they become due after the payment of the dividend (the only real test of declaring a dividend). Thus, if in any given year, you are better off claiming the spousal credit, then don’t declare a dividend and keep the money in the business or sprinkle the dividend to another class of shares rather than the shares owned by your spouse. Dividend sprinkling, however, is usually only done when the corporation has a lot of free cash flow.

• blaze August 19, 2008, 5:35 pm

By flipping several times, I think it’s like roughly 5 times. Maybe the tax rate would be 7% instead of 9%, depending on your province.

If I tried to do this as a real estate person sole propietor, I’d have to pay 50% of my marginal rate on each flip, which would mean there’d be up to a 20% tax rate on each flip. Which means I’d have to flip 6 and a bit times.

Which, in the scheme of things, probably isn’t a big deal. What’s one more flip if you’ve done it 5 times already?

• blaze August 19, 2008, 5:56 pm

I guess the other approach is to retain earnings, and then when you get close to 750K, buy a business with your retained earnings, and then keep it for 24 months, and then sell the whole thing tax exempt.

• Chuck August 19, 2008, 6:31 pm

Blaze, flipping a property as a business is not a capital gain, in the eyes of the CRA it may be construed as active business income.

Just to draw your attention to CRA IT-218. http://www.cra-arc.gc.ca/E/pub/tp/it218r/it218r-e.html It discusses whether the sale of property is a capital gain, or business income

Drawing your attention to two sections the CRA can treat habitual property flipping as business income.

5. A taxpayer’s intention at the time of purchase of real estate is relevant in determining whether a gain on its sale will be treated as business income or as a capital gain. It is possible for a taxpayer to have an alternate or secondary intention, at the time of acquiring real estate, of reselling it at a profit if the main or primary intention is thwarted. If this secondary intention is carried out any gain realized on the sale usually will be taxed as business income.

6. The more closely a taxpayer’s business or occupation (e.g. a builder, a real estate agent) is related to real estate transactions, the more likely it is that any gain realized by the taxpayer from such a transaction will be considered to be business income rather than a capital gain (see 3(f) and (j) above).

For example, my university tax prof used to talk about the hard luck farmer who would buy properties, discover they’d be marginal for farming but he’d “find” tonnes of gravel on the property and sell them for a large (capital) gain. The CRA caught him because he was expensing geological survey reports.

• blaze August 19, 2008, 8:20 pm

OK, that’s sounds likely.

What about scenario 2, then, retaining earnings in your corp until you get enough to purchase a business when you then sell all the shares for your \$750K capital gains exemption?

Only at the time of sale, does 90% of the assets have to be engaged in active business.

And if you only do this once (just before you cash out) in the entire lifetime of your corp.. that’s hardly habitual, and I’m sure you can manage the optics to make it appear as if you were ‘intending’ on running it as a real business.

The advantage to this is that you only pay corp tax on your retained earnings and some transactional fees for buying the business in the middle (which I suppose, can be large or smaller depending on how well you negotiate).

Does this make sense?

• blaze August 19, 2008, 8:23 pm

I suppose, though, really your best bet is just to try to grow your business to be worth \$750K.

• Chuck August 19, 2008, 10:43 pm

My thought with my own business was to transfer retained earnings (cash) from one corp to another one that generates a fairly steady income stream. I was figuring that would help the business grow to the 750k threshold and I could sell it in whole or piecemeal if I got bored of it in retirement.

• Sarlock August 20, 2008, 12:57 am

You’re not really going to save much in the end from the tax man with funds you are pulling out of the corporation, either as salaries or dividends. Dividends enjoy a bit of a break, but salary allows RRSP contribution room and CPP contributions.

The biggest advantage of a corporation is being able to flow expenses through and pay them with pre-tax dollars. The larger your business is, the easier it is to flow more and more expenses through that you would normally have to pay with after-tax dollars and easily justify them in the eyes of CRA as being legitimate business expenses. The real advantages start to occur in the \$100k-\$500k revenue range. Below that and whatever you manage to save will just get eaten up with added corporate fees (accounting, legal, etc).

• Amit August 20, 2008, 9:02 pm

If I have a partnership with my spouse, and I do all the work (no other employees) and hence split the income between my wife and myself, will CRA cause any issues? The partnership income may reach upto ~200K/yr while my wife does have a regular job of \$30K – effectively making her income at the end of the year as \$130K while mine as \$100K. Will there be any benefit in incorporating? We have two kids under 6.

Can anyone suggest a good accountant that they use in either Vancouver or in Calgary?

• FrugalTrader August 21, 2008, 10:06 am

Amit, I don’t see CRA having any issues with splitting the income providing that your wife is a legitimate partner.

With regards to incorporation, it would allow retained earnings to grow at a lower tax rate. As mentioned in the article, as soon as money is withdrawn, the taxation equals out. In your situation, it might work out for the better as your wife already works and has an income. Of course, you would have to work out the numbers yourself or with an accountant first.

• Melinda August 20, 2008, 10:17 pm

Hi FT,

I believe awhile back you had a link to a John Chow blog post about setting up your blog as a corporation. According to John Chow, an individual with no other income can withdraw about \$33k per person (\$33k for himself & \$33k for his wife per year) tax free as dividends per year and have the corporation being taxed at about 15%. Maybe you might want to write another blog entry following up on John Chow’s blog entry on the topic.

• FrugalTrader August 21, 2008, 10:08 am

Melinda, it really depends on the province that you live in. But regardless, it still works out to be about the same if you withdraw as dividend or salary. I will have to look over the tax rules for BC again, I may do a post about it!

• Chuck August 21, 2008, 11:28 am

Amit, you should also check with your accountant / lawyer to ensure that your business won’t be considered a PSB (personal services business). If the CRA deems you so, you have less deductions available to you and end up paying more tax than if you remained self-employed.