Types of Remuneration

We'll begin by looking at three common types of remuneration that are available: bonuses, dividends and interest. Besides the immediate tax consequences to the shareholder-manager, we will see that there are other tax-related matters which have to be taken into account when examining each of these forms of remuneration.

Bonuses

Bonuses will reduce a corporation's taxable income and be taxable to the individual shareholder. Important factors which make this form of remuneration desirable are that it is considered "earned income," which increases the shareholder's RRSP deduction limit for the following year, and it allows the shareholder to participate in the Canada Pension Plan (CPP) and other registered plans. However, when paying a bonus, the corporation must withhold tax and CPP premiums.

A shareholder-manager of a corporation having a fiscal year end which is within 179 days from the end of the calendar year, may have an additional incentive to pay bonuses. Bonuses are not taxable to the shareholder-manager until paid. However, they can be accrued and therefore deducted by the corporation, as long as they are actually paid within 179 days from the date of accrual. Therefore, a tax deferral is achieved. For example, a corporation with a July 31 year-end declares a bonus payable to its sole shareholder on July 31, 2000. The corporation gets the deduction in its July 31, 2000 fiscal year. The bonus does not have to be paid until January 26, 2001. Assuming it is paid on that date, the shareholder-manager would report it as employment income in 2001. However, a major drawback is that the corporation is liable for withholding tax at the time of payment.

Dividends

Dividends are after-tax distributions of corporate income and therefore will not reduce a corporation's taxable income, however dividends are taxed more favourably in the hands of the shareholder than employment income through the dividend tax credit.

Interest

Shareholders can hold part of their investment in a corporation in the form of debt, for example, by loaning money to the corporation. Interest charged on the loan is deductible to the corporation and taxable in the investor's hands. Although this would be taxed at the same rate as a bonus, no deductions at source need to be made.

Rules of Thumb

Bonus-Down

A general rule of thumb in situations involving corporations earning income eligible for the Small Business Deduction (SBD), is to "bonus-down" corporate income to $200,000, assuming the corporation's taxable income is greater than $200,000 before bonuses and taxes. This is because the SBD is only available on the first $200,000 of active business income, resulting in a low, combined federal and provincial corporate tax rate on that income of approximately 20% (the actual combined rate depends on the particular province). Any active business income above $200,000 is taxed at approximately 45% for corporations not involved in manufacturing and processing activities (again, the actual rate depends on which province we are dealing with). In a bonus-down situation, the shareholder will pay tax on a bonus equal to the amount by which the corporation's taxable income exceeds $200,000. This will result in a net tax savings any time the shareholder's combined marginal tax rate is less than 45%. Figure 1 gives an example of the tax savings that may be possible by following a bonus-down strategy.

Figure 1: Bonus-Down Strategy

Without Bonus Bonus- Down Corporation's taxable income, before bonus (all Canadian active business income) $250,000 $250,000 Bonus to shareholder-manager 0 (50,000) Taxable income $250,000 $200,000 Combined federal and provincial tax - 20% on first $200,000 $40,000 $40,000 - 45% on remainder $22,500 0 Total corporate tax $62,500 $40,000 Personal tax on $50,000 bonus (assume 40% combined marginal tax rate) 0 $20,000 Total tax paid $62,500 $60,000

A word of caution about bonuses. Bonuses must be considered "reasonable" in order to be deductible, a term not defined in the Income Tax Act. The CCRA has indicated that if a corporation's policy is to distribute earnings to shareholder-managers in the form of bonuses, or the company has adopted a policy of declaring bonuses to shareholders to remunerate them for the profits the corporation has earned based on their entrepreneurial or other special skills, the bonuses will be considered "reasonable."

Personal Tax Credits

For corporations earning active business income of less than $200,000, tax savings can be realized by ensuring bonuses are paid at least to the extent that the tax on such remuneration is offset by the shareholder-manager's personal tax credits. By doing so, income tax on those amounts would be avoided altogether, since neither corporate nor personal tax will be paid on them. Figure 2 demonstrates this strategy.

Figure 2: Utilizing Personal Tax Credits

Assumption: Shareholder-manager has personal tax credits of $2,300 Without Bonus With Bonus Corporation's taxable income, before bonus (assume active business income) $110,000 $110,000 Bonus to shareholder-manager 0 (9,200) Taxable income $110,000 $100,800 Total corporate tax (20%) $22,000 $20,160 Personal tax on bonus before credits (assume 40% combined marginal tax rate) 0 $2,300 Less: personal tax credits 0 ($2,300) Total tax paid $22,000 $20,160

Taxable Dividends Received Tax-Free

Because of the dividend tax credit, a considerable sum of dividends can be received without paying personal tax. Using current federal tax rates and without considering refundable provincial tax credits, actual dividends of $24,884 can be paid without triggering any tax (except in Québec), assuming the shareholder-manager has no other income. For a married taxpayer whose spouse has no income, this figure becomes $32,045 (except in Québec). Refer to Figure 3 for the actual calculations.

Figure 3: Dividends that can be Received Tax-Free

Assumption: Spouse has no income Single Married Dividends received $24,884 $32,045 Dividend gross-up (25% of dividend) 6,221 8,011 Taxable amount of dividends $31,105 $40,056 Federal tax on dividends (17% on first $30,004 + 25% on remainder) $5,375 $7,613 Less: basic personal tax credit ($17% of 7,231) (1,229) (1,229) Less: spousal tax credit (17% of $6,140) 0 (1,044) Less: dividend tax credit (13 1/3% of taxable amount of dividends) (4,146) ($5,340) Total federal tax $ 0 $ 0 Total provincial tax (calculated as a percentage of federal tax, except in Québec) 0 0 Total tax $ 0 $ 0

Although all shareholders can take advantage of this strategy, it may be most beneficial in the case of retired individuals or couples over 69 years old. Such individuals are not concerned about receiving "earned income," since they can no longer contribute to RRSPs. If each spouse earns only dividend income derived from his or her shares in an operating company, the couple can receive up to $49,768 in dividends (2 x $24,884) without paying any personal tax.

Summary