“You must pay taxes. But there’s no law that says you gotta leave a tip.”
–Morgan Stanley advertisement
Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.
Understanding how different types of income are taxed is the starting point to learning how to manage tax on your income and reduce overall family taxes. In this article we’re going to look at personal and corporate income tax rates and then make some observations which you might discuss with your tax accountant to see if there are opportunities to improve your tax planning.
Income Earned Personally
Generally speaking, as an individual, your income and dividends from a private corporation are taxed in one of the four categories below:
- Dividends from public corporations (such income is considered as Eligible Income for the preferred dividend gross-up and tax credit),
- Dividends from a Canadian private corporation (such income is considered as Non-Eligible Income subject to a different gross-up and dividend tax credit resulting in a higher amount of taxes),
- Ordinary income (this includes wages net of CPP and EI, interest income and foreign dividends although any tax withheld may be partially offset by a foreign tax credit), and
- Capital Gains (where only one-half the gain is included in your income which is taxed as Ordinary Income; the other half is a tax-free gain)
Income Earned through a Canadian Private Corporation (a “CCPC”)
Income earned in a private corporate is typically classified as being either: (i) Active Income, or (ii) Passive Income – this generally being your portfolio income.
Active Income is then characterized based on whether it qualifies for the Small Business Deduction (the first $500,000 of taxable income) or not.
Passive income is divided into:
- dividends from Canadian corporations,
- interest income, and
- capital gains (where only one-half the gain is included in your income; the other half is added to your Capital Dividend Account where an election can be made to pay out to your personally a non-taxed capital dividend)
Number 1: For all passive income, the corporate tax rates are higher than the highest personal tax rate for each type of income.
This higher tax on passive income is punitive, so we need to either:
- find a deduction against such income and avoid that high tax, or
- pay out a dividend of the after-tax income assuming that the company tax less any dividend tax refund plus personal tax becomes competitive to the personal tax rates.
Number 2: Active Business Income that qualifies for the Small Business Deduction is taxed at a lower rate than all personal marginal rates of income if earned personally (see Exhibit 3 below as to the Ordinary Income compared to the 13% corporate tax rate on Active Income).
The difference in tax ranges from 7.06% to 34.7% (see Exhibit 2 as to the 13% tax rate on active income qualifying for the Small Business Deduction and Exhibit 3 as to the tax rate on Ordinary Income – which includes business income earned personally). This is a tax deferral as we have to pay tax when we take that after-tax income out of the company.
Company Active Income is taxed preferentially to incentivize people to create and grow small businesses which are responsible for most of our country’s jobs.
Once we take out this income, the tax deferral ends. If we pay a dividend out equal to the after-tax income, our total income tax burden (personal tax plus corporate tax) is slightly more than if we had earned the income personally (see Exhibit 4 and compare to Exhibit 3).
If a company earns both passive income and active income, any bonuses or employment income taken goes first to offset active income. Once our active income is used up, then the remaining salary is offset against our passive income. This is exactly the opposite of what we desire. So, if we have both active and passive income in the same company, a bonus doesn’t achieve our goal to minimize tax.
But what if we dividended out the after-tax passive income? Exhibit 5 shows that the result is a marginal tax rate ranging from 12.70% to 47.79%. In effect, the marginal tax rate difference varies with taxable income. In the lower tax rates, dividending out passive income results in lower tax (eg. 12.70% versus 20.06% for taxable income to $38210) and at the high tax rate results in slightly higher tax (48.33% versus 47.70% for income over $200,000). So one corporation can serve your needs.
Having two corporations – one for active income and one for passive
An alternative way of doing things is where all after-tax passive income is dividended out to an investment holding company.
The key reasons for this include:
- To segregate your investment assets and any insurance from potential creditors of your business;
- To maintain your corporation as a Qualifying Small Business Corporation. The principal advantage of this is access to the Small Business Capital Gains Exemption through time.
- It makes it easier for a banker or investor to gauge the performance of the active business through time (and you then have financial statements and tax returns to back this up). And if you take on a partner in your active business, they don’t inadvertently become partners in your other assets.
This article has explored the tax rates of various types of income to help give you some insight to how you might manage income and whether to incorporate an investment holding company. Your next step might be to talk with your tax accountant to see if you are managing your company income tax efficiently. It also makes sense to review with your financial planner and portfolio manager so that they understand the tax planning in place, tax carryforward info (unusued contribution room, capital losses carryforward), and taxation of your income (like your marginal tax rates) so they can help you create a tax efficient portfolio.
If you are interested in having an investment adviser knowledgeable about taxes, then please call Steve Nyvik at (604) 288-2083 Extension 2 or email him at: Steve@lycosasset.com.