Building a profitable and sustainable business requires time, patience and hard work. During the startup years, owners of Canadian-controlled private corporations often forgo payment of salary, dividends or other remuneration in favour of reinvesting in the business. At some point, however, personal living costs require cash flow from the corporation.
Business owners have various options for extracting cash flow from a corporation, each with pros and cons depending on the circumstances. Tax-free payments may be the primary objective, or, perhaps, the creation of RRSP contribution room. Maybe the payment is being made to reduce taxation at higher general corporate tax rates, or maybe a loan to a shareholder makes sense.
Whatever the reason, simply withdrawing money from a corporation’s bank account for personal use without properly characterizing the payment can lead to unexpected tax results.
The table below lists common options for extracting cash flow from a corporation and some key considerations.
Table: Options to extract cash from a corporation
|Type of payment||Considerations|
|Salary and bonus payments||
|Return of capital (ROC)||
|Repayment of shareholder loan||
|Loan to shareholder||
Determining an appropriate cash flow mix
Determining an appropriate cash flow mix can be complex. Owners should consult with their tax advisors to review the corporation’s structure and tax attributes, as the best approach can differ from corporation to corporation. When determining a strategy, shareholders should consider the following questions:
- Is one form of cash flow more costly than another when all taxes (corporate and personal) are considered?
- Is a corporate tax deduction required to reduce or avoid taxation at general corporate tax rates (as opposed to the small business rate)?
- Are tax-free payment options available?
- Who is receiving the payment, and can/should capital dividends be reserved for the owner-manager?
- Is there a desire for RRSP contribution room and/or CPP or QPP benefits?
- Will the payment trigger payroll taxes and/or onerous remittance or tax-filing obligations?
- Is there a plan to establish an IPP or RCA at some point?
- What impact will the payment have on income-sensitive benefits (e.g., OAS)?
- If the payment is for income-splitting purposes, will punitive TOSI or attribution rules apply?
Can your client take a payment without formalizing it?
When personal cash flow needs arise, a business owner may be tempted to withdraw money from the corporation’s bank account without formalizing the payment as indicated above. With a solely owned business, no one would prevent the owner-manager from doing so.
However, the Income Tax Act (ITA) discourages such activity, as amounts withdrawn from a corporation are normally subject to personal taxation, with the exception of defined options for extracting tax-free cash flow.
Specifically, section 15(1) of the ITA indicates that where a benefit, including cash, is conferred on a shareholder by a corporation, the benefit is included in the shareholder’s income for that year. If the benefit isn’t reported as income, the CRA can reassess, resulting in double taxation and potential gross negligence penalties payable by the shareholder.
Consider the following example.
Earlier this year, Angela, owner-manager of ABC Inc., withdrew $10,000 from her corporation’s bank account for a personal trip. No formal declaration of payment was made, and Angela has no intention to repay the amount to the corporation.
As per the ITA, Angela is required to include the $10,000 withdrawal in her income for the year. Failure to do so can result in a gross negligence penalty of 50% of the understated tax payable. Making matters worse, the $10,000 withdrawal isn’t deductible to the corporation, resulting in double taxation.
While “benefit” isn’t defined in the ITA, it normally includes any type of payment or advantage to a shareholder not in the normal course of business and can include personal use of company assets, such as equipment or vehicles. Given the punitive penalties that can result from shareholder benefits and appropriations, these situations should be avoided.
Wilmot George, CFP, TEP, CLU, CHS, is vice-president, Tax, Retirement and Estate Planning at CI Investments. Wilmot can be contacted at firstname.lastname@example.org.
1 A corporation can normally deduct unlimited salary paid to its owner-manager on the principle that its profits are due to the owner’s work
2 Provided amounts paid align with services provided
3 Employment insurance premiums don’t apply to salaries paid to owner-managers who own 40% or more of the voting shares of the corporation
4 Contributions to individual pension plans and retirement compensation arrangements are normally based on T4 income
5 No CPP/QPP contributions mean no related retirement benefit
6 To purchase a home, shares of the corporation or a motor vehicle for employment purposes
7 Equal to the difference between the CRA’s prescribed rate and the rate paid