Business Advisor: April 2012

 There are many things to consider when extracting profits from a business. Start with the nature of the income.

Recently, we received a question from a reader asking: “When is a good time to take profits from my business?” It’s a good question and an important one to get right from a tax perspective.

The best time to take income from the business is at the beginning of a new calendar year, as the income may be taxed at a lower rate.

On a high level, there is always the question of whether you should be further investing into your business or taking profits. There are many things to consider when extracting profits from a business.

The nature of the income will determine the corporate and personal tax consequences, so you need to determine that first. Typically the business will pay the owner either a salary or dividends. Accepting a salary will result in a tax deduction for the business, thus reducing its taxable income. A dividend is paid out of after-tax earnings. Because of this difference, wages are taxed at ordinary personal tax rates while dividends receive a tax credit that is intended to offset the corporate taxes paid. In fact, under the Dividend Tax Credit, a family member with no income can receive $50,000 of eligible dividends, or $38,000 of other than eligible dividends, without paying any tax at all. So if you have a family trust, you may be able to extract profits from your company with a very low tax burden. This, of course, requires planning ahead of time. 

For private companies it has been the norm for bonuses to be paid to the owners of the annual net income in excess of the small business limit. By doing this, companies avoided paying the higher general corporate tax rate. This may still be a policy for some companies including those that undertake research and development that qualifies for federal tax credits. With the introduction of eligible dividends a few years ago, larger tax credits are received by individuals who receive dividends and who were taxed at the general corporate tax rate. Many companies no longer pay large bonuses to the owners as a result. 

Planning strategies may have been implemented that will also impact the choice between wages and dividends. An income-splitting strategy may result in dividends being received by lower-income family members. This would result in a permanent tax savings. 

If you want to maximize the amount of your Registered Retirement Savings Plan Contributions, you will need to ensure that you have earned sufficient income in the year. If you do not have enough earned income, then drawing additional salary makes more sense. In 2012, the maximum allowable RRSP contribution limit is $22,970. In order to make a contribution of this size, you will need to have $127,600 of earned income. There has recently been a lot of debate over whether it is better to leave more money in a corporation than to take it out and put it into an RRSP, given the return in the stock market whether it is better. No strong conclusion has been made and personal preference will dictate. 

The timing of when wages or dividends are paid will generally depend on the level of corporate and personal income for the year, as well as the individual’s need for cash. If it is possible, wait until a new calendar year to receive income as it may be taxed at lower rates or may defer the payment of the tax. Of course, personal circumstances may require an earlier payout.

While it is important that you grasp the basic principles outlined above, in most cases this issue is complex enough that it would be wise to seek tax advice from a qualified advisor.

Gordon Jessup is the lead tax partner of Fuller Landau LLP. He works with clients from many industries who recognize him as someone they wish to consult with before making significant business decisions. He can be reached at 416-645-6508 or gjessup@fullerlandau.com.