Small business – Page 4

Tax on dividends rising – Changes for small business owners

Small business owners will generally be paying a little more on the dividends they extract from their corporations beginning in 2014.

In the 2013 federal budget, the government expressed its concern that individuals were being over-compensated by receiving dividends from a corporation than if the individual had earned that income personally. Changes were proposed, and now enacted, in an effort to bring the system of integrating corporate and personal taxes back into alignment.

To be more precise, these changes target corporate income that has made use of the small business deduction. Previous changes had already addressed corporate income that had been subject to the full corporate tax rates – the so-called eligible dividend regime introduced in 2006 and rolled-out over the following six years.

Ineligible dividends in 2014, and on

In our income tax system we have two main types of taxpayers: individuals and corporations. Despite that taxes are levied at the corporate level, ultimately those taxes are borne by individuals. The dividend gross-up/tax-credit procedure accounts for previously paid corporate taxes when the shareholder/individual calculates personal taxes due.

Since the introduction of the eligible dividend regime in 2006, the federal gross-up and tax credit rates on ineligible dividends had remained unchanged. Beginning in 2014, the gross-up will change from 25% to 18%, and the federal tax credit will go from 2/3 to 13/18. The provinces use the federal gross-up, so have been prompted to adjust their respective tax credit rates.

Based on enacted and announced changes (and subject to potential change in upcoming 2014 budgets), this table shows the effective tax rate shareholders face at top bracket in each province:

Top bracket rates – Ineligible dividends
(Combined federal-provincial)

Province 2013 2014

BC 33.7% 38.0%
AB 27.7% 29.4%
SK 33.3% 34.2%
MB 39.1% 40.8%
ON* 32.6% 36.5%
QC 38.5% 39.8%
NB 33.0% 36.0%
NS 36.2% 39.1%
PE 38.6% 38.7%
NL 30.0% 31.0%

The other side of the story

In fairness to the tax authorities, these changes are not arbitrary. They are designed to integrate with the actual small business rate that will have been used in calculating the original corporate income.

In theory, an individual taxpayer should be indifferent about earning income personally, or through a corporation that then distributes to the individual. This should hold true whether the distribution is in the form of salary to that person as an employee, or as a dividend to that person as shareholder/owner.

In practice though, things had gotten a bit out of kilter, leading to a preference toward dividends in most provinces in recent years. The effect of the changes will be to narrow the distinction between salary and dividends, and in some cases to slightly swing the pendulum past perfect integration and toward salary.

Bearing in mind that these are not the only considerations in deciding on the salary/dividend mix, here is the starting point those owner/managers can use for that analysis:

Tax savings or cost of using dividends
(A positive figure favours dividends)

Province 2013 2014

BC 1.0% -0.6%
AB 1.2% -0.3%
SK 2.0% 1.2%
MB 0.6% -0.9%
ON* 3.4% 0.1%
QC -0.3% -1.3%
NB 1.6% 0.9%
NS 4.2% 2.1%
PE 1.4% 1.3%
NL 1.8% 0.9%

* Ontario is expressed at the top federal bracket rate, rather than the significantly higher Ontario rate of $500,000+.

Corporate-owned life insurance – Tax keys for business needs

Most insurance advisors will have long and fulfilling careers operating almost entirely within the personal planning arena.

For many though, the capability to service the business market may be seen as a useful complement or arguably a mandatory add-on to help build a moat around clients. Still others might view that business market as their one true calling all on its own – and it certainly can be a financially rewarding calling to those who handle it well.

Whichever approach an advisor may take, informed needs analysis remains the core skill, often applied at an enhanced technical level, including a solid grounding in tax matters.

In the business context, determined needs may stand on their own, or they may be layered upon or be intertwined with personal needs. This integration of business and personal needs can present both opportunities and challenges where the business is operated through a corporation, as is the preferred mode of operation for most growing businesses.

Business needs framework

Though not exhaustive, these are the most common life insurance needs associated with a business:

Buy-sell funding … provides the financial means for a buy-out of a business on an unexpected death. This paves the way for the timely payout to the deceased’s survivors, and smooth continuity of the enterprise for the continuing owners. In the case of a corporation, it is most prudently documented in a binding shareholders’ agreement

Key person protection … contributes capital to maintain the going concern value of the business on the loss of a key contributor. Whether or not the deceased was an owner, the cash acts as a financial bridge until a suitable replacement can be found, or at least until operations can be stabilized. It may also include an estimate of direct lost revenue and extraordinary expenses.

Estate tax liabilities … arise on deemed disposition of capital assets. This applies to business interests generally, though qualifying small business corporation shares are entitled to make use of the $750,000 lifetime capital gains exemption (going up to $800,000 next year). As well, the disposition related tax can be deferred if those capital assets are rolled to a surviving spouse.

Income replacement … is a proxy for the lost income-earning capacity of a breadwinner to a household. In effect, the insurance proceeds create a pool of wealth that can be drawn down over the time that the deceased would have otherwise contributed to the household. Though unfortunately not physically present, the person is still there in financial spirit.

The first three of these needs are clearly commercial in nature, whereas income replacement is a personal need irrespective of the existence of any business. The reason why this latter personal need is addressed here is that it is not uncommon for a business owner – and particularly a shareholder running a corporation – to wish to combine multiple insurance needs into a single contract, or at least to fund coverage at the corporate level.

A careful review of the personal and business particulars is crucial to assure that such an approach does not compromise the availability of funds for each respective purpose at the appropriate time. Assuming this passes muster, attention may turn to the tax implications of funding and receiving insurance through a corporation.

Corporate economics examined

To deal with a common misconception first, except in very isolated circumstances (none of which apply here), life insurance premiums are not tax-deductible for a corporation, no more than they would be for personally-owned life insurance.

Even so, corporately-paid premiums are generally less costly than personally-paid premiums. This is because the corporation can pay the premiums itself, or issue a dividend to the shareholder to pay the premiums personally. Of course the shareholder will be taxed on the dividend, meaning less cash would be available for the purpose in those personal hands, thus requiring a larger dividend in order to net down to the required dollars for the premium cost.

In turn, life insurance proceeds are a tax-free receipt to a beneficiary, whether that beneficiary is a corporation or an individual. For a policy owned in a corporation, the corporation itself or a subsidiary corporation would be named as beneficiary; if not, the payment of the death benefit could give rise to a taxable shareholder benefit. (Similarly, a shareholder benefit would apply if a corporation pays the premium on a policy owned by a shareholder.)

Comforting though it is to know that a corporation receives insurance proceeds tax-free, even these business-based needs (except key person) still ultimately require the insurance proceeds to make it into personal hands to be most effective. Fortunately, there is a mechanism that allows for the transfer of tax-free amounts received at the corporate level to make their way into shareholder hands, intact as tax-free amounts.

A corporation’s capital dividend account or CDA keeps track of items such as life insurance proceeds and the non-taxable portion of capital gains. Declared dividends to a shareholder will not be taxable if they are elected to come from the CDA, which consequently is reduced by the amount of such dividends. This election may also apply to deemed dividends that occur when shares are redeemed, for example when a surviving spouse decides to wind up the corporation after the death of a business owner spouse.

Appreciating the limits

Bear in mind that these are the fundamental tax issues underlying the corporate ownership of life insurance. As one might expect, things can get much more complicated in practice, which is why conscientious due diligence is critical – both in terms of building ongoing technical expertise, and in clearly understanding the needs of the business and the individuals behind it.

Ten lost tax and estate planning opportunities for entrepreneurs – Part TWO

Entrepreneurs are often so focused on their expertise and wares that they fail to adequately plan how to structure the business itself. In particular, a failure to make use of a corporation and to careful monitor its operation can lead to significant forgone benefits and potential liabilities.

This is the continuation of the list of the most important tax and estate issues most entrepreneurs may face. Here are the first five items addressed in the prior column, and the list continues below:

Failure to incorporate – Slowing business growth
Failure to incorporate – Losing tax-free capital gains value
Failure to incorporate – Exposure to creditors
Holding investment money in a small business corporation
Paying personal expenses out of a corporation

Continuing on …

6. Not protecting wealth using one’s spouse

While a couple may consider themselves as one family unit, every person is a separate legal entity. This is particularly important when one considers exposure to creditors

Entrepreneurs can take the simple step of transferring assets into the name of a spouse in order to distance those assets from creditors. As long as this is not done in an attempt to defraud creditors or as they are otherwise standing at the door, the exercise will have its intended effect.

Should there be a later marriage breakdown, the fact of the assets being in one or the other spouse’s name does not affect one’s entitlement to the value of those assets, at least in principle. Not surprisingly those going through such a breakdown are not always so co-operative, meaning that these steps should only be taken with the benefit of informed professional guidance.

7. Failure to protect against the loss of a business to taxes at an owner’s death

The shares of a corporation are capital property to a shareholder, and at that shareholder’s death those shares will be deemed disposed for tax purposes. If the shareholder’s children are the beneficiaries of the shares, the tax liability may be sufficiently onerous that the business itself will have to be sold or mortgaged to pay the taxes.

Where there is a spouse, those shares can be rolled over to defer taxation. As a practical matter however, the spouse is often unable to continue the business, and therefore it may have to be sold anyway, then giving rise to the taxation. The problem is exacerbated where the spouse may need to sell quickly and therefore may not get the best price for the business.

The simplest strategy to assure that the tax liability does not either force sale or impose a heavy debt burden is for insurance to be carried on the life of the shareholder.

8. Having no exit strategy from a business

Few people build a business for the sake of the business itself – generally it is a means for building and holding wealth to benefit oneself and one’s family.

Where there are multiple owners of a corporation, the usual expectation is that when an owner departs or dies, one or more of the others will buyout that interest. To be assured that this will be carried out, the owners would be well advised to execute a buy-sell agreement detailing what is to occur

Beyond the execution of the agreement, it is critical that there be sufficient funding to carry out the commitments at the appropriate time, especially for the sake of the spouse & family of a deceased shareholder. In that respect, life insurance is the simplest and generally the most cost-effective means to put the funding in place in the exact amount and at the exact time when it is needed.

9. Paying for business needs insurance personally rather than corporately

Where insurance is needed to pay for taxes at a shareholder’s death and/or to fund the transfer of the shares of that deceased shareholder, such insurance may be held personally or corporately.

While there may be factors encouraging one to own insurance personally, for premium cost reasons the insurance is often held corporately.

A corporation cannot deduct the cost of insurance premiums so it is using its own after-tax dollars to pay premiums. Alternatively, shareholders could receive taxable dividends out of the corporation in order to pay the premiums personally. Thus no matter how small the dividend tax (which can be over 30%), less insurance would be able to purchased personally than corporately.

Of course the difference in cost would be for naught if the eventual insurance proceeds were worth different value. In fact there is a corporation mechanism called the capital dividend account which can be used to preserve the tax-free status of insurance proceeds to flow out to a spouse and other estate beneficiaries.

10. Double taxation of capital assets

The shares of a corporation are capital property to a shareholder. In turn, the corporation may itself own capital property, and the value of the shares held by the shareholder will in part relate to the value of those underlying assets. Tax will be payable on the capital gain on share value when the shareholder disposes of the shares or when there is a deemed disposition such as at death.

At death then, the shares will flow to the deceased shareholder’s estate. When the estate later causes the corporation to sell the underlying capital assets (to wind up the business and distribute the estate), the corporation will pay tax on those same capital gains that the deceased paid indirectly on the share value increase.

All is not lost here – Steps can be taken in advance to plan against this result, and estate elections may also be possible post-mortem to minimize the damage.