In Part 1 of our Incorporation series, we introduced the corporation basic definitions and explained its lower effective tax rate. Many readers would notice that a single person needs to make a significant income more than their yearly living costs to benefit from the lower effective corporate tax rate/ tax deferral advantage. Nothing in personal finance beats the advantage of living within your means and a high savings rate. I have discussed saving techniques in earlier blog posts. Another significant advantage of a corporation currently is income splitting that leads to absolute tax savings. As mentioned, I will discuss how income splitting currently works and then how proposed tax changes might affect it.
Tax Deferral vs. Tax Savings
Tax deferral is paying less tax today to have more money available now. The fancy term for the extra after-tax money in a corporation is retained earnings. In the future, tax will still need to be paid on this extra available money. The main benefit can be to do something useful with those retained earnings that can work on your behalf to grow that deferred money.
In RRSP’s, you receive a tax deferral by reducing your taxable income by the amount you have deposited for your retirement. When you draw those RRSP funds in retirement, you will pay full tax at your marginal tax rate on both the contributions you made as well as the capital gains in portfolio value.
In a corporation, the same concept applies. If you only wait one year and then draw your retained earnings from the previous year, there has likely been little benefit to paying less corporate tax. If you allow the retained earnings to grow over 30 years, the compound interest post will show the degree that tax deferred growth can achieve.
The holy grail of accountants is absolute tax savings. This is different than tax deferral because it leads to more money in your pocket with no future tax to pay. Clearly this is better than a tax deferral and is why absolute tax savings are hard to come by.
Enter income splitting – one of the main reasons why professionals have found benefit to incorporation over the last several decades. Canadian controlled private corporations (CCPC) can have more shareholders than just the primary individual who operates the business. Typically, shareholder status for individuals is reserved to immediate family such as a spouse, parents and children.
A shareholder other than the individual professional/business operator can only receive salary income if they perform a real task for the business that would cost a similar amount to hire out externally. For example, a spouse may work as a receptionist, do book-keeping or perform other tasks within their individual skill set. If the CCPC attempted to pay a family member book keeper a $100K/year salary, this would not pass a reasonability test in the eyes of the CRA. This would likely lead to an audit and back taxes owing.
A shareholder not eligible for salary can however receive a share of the after tax retained earnings of a CCPC. This is like how a major Canadian corporation like Bell can take after tax profits and distribute a portion of them to its shareholders (formally known as eligible dividends in our tax code).
A CCPC can also pay a dividend (formally known as an ineligible dividend in our tax code – more on this later) from after corporate tax retained earnings to its shareholders. An example will show why a CCPC may choose a dividend to an additional shareholder.
Income Splitting Example
The previous post discussed thoroughly the progressive personal marginal tax system in Canada. I will use again the example of the Ontario professional who:
earns $250K/year in their CCPC after corporate expenses
Assume they need all this income to live and take it as salary. They will pay an effective tax rate of 38.88% with taxes due of $97,190* leaving ~$153K after tax income to spend as a family.
*Note this number ignores CPP/EI contributions when income is taken a salary
Earns same $250K/year in the CCPC after corporate expenses.
Pays $100K salary to professional – tax paid ~$25K leaving $75K* after tax
*note this ignores CPP/EI contributions
$150K/year retained in corporation with tax of 15% costs $22.5K leaving $127.5K of after tax retained earnings.
The $127.5K is distributed as an ineligible dividend to the spouse. This dividend needs to be taxed a second time (first was the 15% in the corp) in the personal hands of the spouse
The spouse pays almost $25K in personal tax leaving $102.5K in after tax income.
Tax paid to distribute money to spouse = $22.5K corporate tax + $25K personal tax = $47.5 total tax.
The family unit has $75K (professional) + $102.5K (spouse) = $177.5K after tax family income.
Scenario #2 has $24.5K in absolute tax savings for the family unit compared to Scenario #1!
Theory of Integration
An important point in the above example is that there wasn’t any magical tax savings from the dividend/corporate tax per se, it was purely the ability to split the income into the hands of two individuals instead of one. This is secondary to the progressively higher personal tax rates I discussed in Part 1.
If the spouse had received the original $150K personally as salary, the corporation would have no tax to pay within it (salaries are treated as a deduction/expense to the corporation) and would also have no retained earnings to pay out.
$150K paid as direct salary to the spouse would trigger ~$47K tax leaving $103K after tax in spouse’s hands.
Scenario #2 showed $47.5K total tax and ~$102.5K after tax for the spouse which is the same as above with the $0.5K mostly being a difference from my rounding of the numbers.
This is known as the theory of integration. Integration in our tax code attempts to ensure that there is no advantage or disadvantage between having income flow through a corporate tax and then all be paid out via dividends to an individual compared to taking all the income via personal salary. Integration works well, but there are some discrepancies that allows some potential savings which I will discuss in the corporate dividends vs salary post.
The above example assumes a spouse makes no income, but income splitting still has a benefit even if the spouse works. If the spouse makes less than the top marginal tax rate, an ineligible dividend can be paid to “top up” a total spouse income. If the total income doesn’t exceed the top marginal tax trigger, there is likely an absolute tax savings than if the professional took that income themselves in the highest tax bracket range.
You can also imagine the benefit to having multiple shareholders within the family to income split. If the $250K income from our original example was split between 5 shareholders, this would be over $40K/person in after tax retained earnings available to distribute and total tax would be very, very low – try the calculation for yourself with the calculators from part 1. This scenario is only likely to occur when children shareholders reach the age of 18 and can start receiving dividends.
Proposed Tax Changes
Income splitting has been an essential tool to allow most CCPC’s to overcome my suggested $10K/year incorporation/maintenance hurdle cost to ensure the hassle of incorporation is a worthwhile endeavor. As you can see, the family in our example did not have any benefit to tax deferral in the CCPC as they used all the earned income. Many incorporated professionals fall into this category and may have little benefit to incorporation if the proposed tax changes to income splitting move forward.
The government has examined income splitting and determined changes that can lead to $250 million of additional yearly tax revenue. Many people feel the changes are likely to go through because it is easy for the government to implement and enforce. The changes are easiest to understand in the context of what happened briefly when incorporation for doctors and other professionals first was allowed.
Prior to the “kiddie tax”, a professional with a CCPC could dividend income out to any children including below 18 years of age. This allowed a family with children to pay a substantial amount of dividends to a child TAX FREE. This would be because of personal tax credits and dividend tax credits available to a low income earning individual. A family could have tens of thousands of dollars in tax free money taken out of the CCPC before any draws from the income earner or their spouse. The minor children were clearly not contributing to the family business. Using minority children was pervasive in the 90’s and clearly was not what the small business tax act was contemplating. In 1999/2000 the kiddie tax was implemented where if a minor child received dividends they would be taxed at the highest marginal tax rate. This amendment was labelled Tax On Split Income or TOSI.
I don’t know for certain, but I assume TOSI wasn’t applied to spouses or children over 18 because of the assumption it was more plausible they could participate in the small business. The expansion of CCPC’s which are primarily services based corps for dentists, doctors, lawyers, real estate agents etc. has led to significant expansion of total small business corporations. The Finance department document notes evidence of increasing use over time of significant tax saving strategies by paying dividends to children typically between age 18-24 like in our example of 5 shareholders above.
The government asserts that income splitting was meant for true family businesses where multiple members were participating actively in the business. The personal service corporations mentioned above often do not have legitimate roles for family members to participate in to receive significant income.
Hence, the tax change proposal is to extend the original TOSI amendment to spouses and all children regardless of age. This would imply all dividends not to the primary income earner would be required to pass a “reasonability test” for providing a service to the business that is fair market value based on time spent and reasonable 3rd party wage equivalent if that service was outsourced outside of a corporation shareholder. This is like the test applied to a shareholder receiving salary as discussed above. If you are curious, the document gives examples of what would and would not pass the reasonability test.
You can imagine why this significantly alters the typical tax planning of many professionals that have a spouse at home who does not work. It essentially eliminates income splitting entirely for CCPC’s as currently practiced today. My personal feeling is this is highly likely to move forward as it is just an extension of the current Kiddie tax. It should be easy to implement and easy to enforce with minimal legislative change and regulatory burden.
If you are a professional who does not have a high income earning spouse, this proposed change will certainly skew the cost/benefit analysis of your current or proposed CCPC. It certainly makes sense to maximize any income splitting in this current corporate year assuming the changes become effective by Jan. 1st, 2018. If both spouses are high income earners, the income splitting proposed change likely has minimal to no effect for you. There still may be benefits that make it worthwhile which will be discussed in the next 2 posts. I would still strongly suggest waiting for the official changes to be decided before making any formal changes to your CCPC.
If you feel strongly about the changes to income splitting, I suggest you contact your MP and track down the multiple online petitions that discuss the value of the family unit in relation to small businesses across our country.