Accounting and Bookkeeping for Shareholder Remuneration for Small Businesses in Canada

 

 

Introduction

A corporation can remunerate an owner/shareholder in a number of different ways. Unlike an unincorporated proprietorship, a shareholder of a corporation can receive a salary from their company, net of applicable statutory withholdings. The salary is deductible to the company and taxable to the owner/shareholder. The corporation has a separate legal status and consequently, the “owner/shareholder” and the corporation are treated as separate persons for tax purposes. Remuneration to the owner/shareholder can include:

 

• A salary (with applicable deductions);
• Director fees;
• A year-end bonus based on the profitability of the company;
• Eligible dividends; and
• Dividends, other than eligible dividends.

 

The above types and forms of remuneration will be discussed below.

 

Salaries

A salary or wage generally represents compensation to an employee for services rendered. In a non-arm’s length situation, such as the case where an individual is the controlling shareholder of a company and is actively involved in the business, CRA might assess whether the salary is reasonable in the circumstances. However, where the individual receiving the salary is also the key person “driving” the business, the reasonability test is much less critical, as any level of salary or bonus paid to that individual, would probably be reasonable.

 

A base salary is an ideal method of remunerating the owner/shareholder for day to day living expenses. This is much more preferential than if the shareholder simply takes cash draws throughout the year and then, at the end of the fiscal year, clearing such draws with a large salary or bonus.

 

The best way to deal with the shareholder’s “regular draw” of cash is to set up an annual salary that will cover this cash requirement and ensure that the company makes the required source deductions on the salary. By doing so, there should be no “debit” balance in the shareholder’s account, and the tax on the shareholder’s cash draws will have been remitted to CRA. Effectively, it is best to advise the owner/manager to set up a salary payment plan at the beginning of each calendar year, and then to ensure that it is properly adhered to. Doing so will ensure that a potential payroll audit and other CRA tax problems are avoided.

 

Bonuses and the 179 Day Rule

A corporation may accrue and record a year-end bonus payable to a shareholder, based on its profitability for the particular taxation year. The purpose in accruing such a bonus may be to:

 

• Reduce the corporation’s taxable income and resulting corporate tax thereon. This may be the case, for instance, where a tax balance may otherwise be owing and where no corporate tax installments have been made;
• Reduce the corporation’s taxable income to an amount subject to the SBD Limit, thereby allowing the corporation to benefit from the lowest corporate rate of tax;
• Accelerate a deduction in the company by accruing a year-end bonus, equal to the amount of remuneration that would otherwise be paid to the shareholder in the next 6 months;
• Accrue an amount for anticipated shareholder “draws” in the next fiscal period.
• Where a bonus is accrued at the end of a corporation’s fiscal year, the following requirements must be met for the bonus to be deductible to the corporation:

• The bonus must be reasonable;
• There must be a legal obligation of the corporation to pay the bonus; and
• The bonus must be paid within 179 days of the fiscal year-end, of which it was accrued. Subsection 78(4) of the Income Tax Act (Canada) provides that where the amount “is unpaid on the day that is 180 days after the end of the taxation year in which the expense was incurred, the amount shall be deemed not to have been incurred as an expense in the year and shall be deemed to be incurred as an expense in the taxation year in which the amount is paid”.

 

This latter requirement is referred to as the “179 day rule”, and the test can be met by a company demonstrating that the bonus has effectively been paid, by ensuring that the required source deductions on the bonus have been remitted within the required time frame, and the net amount credited to the shareholder loan account. Otherwise, the accrued bonus should be paid out in cash to the employee/shareholder.

 

Payments to Family Members

A reasonable salary can be paid to a family member of the key shareholder/owner, and deducted by the corporation, provided that:

• The amount of the salary is reasonable; and
• The related family members actually worked in the business and provided services to the company. Payment of salaries to other family members can be an excellent way to income-split and provide for a tax-efficient method of withdrawing corporate surplus, provided that there is a basis to do so. Factors that are relevant in determining whether a salary can be paid to a child or spouse would be as follows:

• The age of the child;
• The child’s skill set and actual work performed in the company;
• The hours expended by the child/spouse
• Whether the child is being “groomed” as a potential successor to the business;
• The child/spouse’s knowledge and understanding of the family business;
• Whether the child/spouse is an actual shareholder of the company.

 

There have been numerous tax cases heard in the courts on the reasonability and deductibility of salaries paid to family members. To recap, the criteria which must be met for a company to be able to deduct the payment, is not overly onerous; however, any salary or similar payment should be reasonable based on the family member’s age, skill set and involvement in the business.

 

The converse is true. A corporation should not expect to deduct an amount paid to an individual, simply because they are a family member of the business owner/shareholder.

 

In assessing client information and in preparing the corporate T2 Return, reasonable enquiries should be made to ensure that the basic criteria are met.

 

Director Fees

The payment of a Director fee to an individual by a corporation is made in the capacity of that person’s position as a Director, and not as an employee. Consequently, the test that would be required for an “employee” to provide services to the company, and for the company to make a “reasonable” payment in respect of such services, does not apply in the same manner and extent, for the payment of a Director fee.

 

To some extent, this test is much easier to meet, where payments or remuneration are being made to a related family member, because there is no requirement for an employee-employer relationship. The requirement is simply that the family member must be a Director of the corporation, and perform such services as are required by a Director including:

 

• Attendance at a meeting of the Directors;
• Signing documents; and
• Approval of minutes and resolutions.

 

A family member can be a Director of a company without necessarily being a shareholder.

 

The quantum of director fees declared and paid annually must still be reasonable based on the nature of the Director’s duties and responsibilities and the overall operations and complexity of the business. Director fees paid to an individual are deductible to the company and taxable to the recipient individual. A T4 slip is required to be issued and normal tax withholdings will apply.

 

Remittance and Filing Requirements

As explained above, the payment of salaries, bonuses and director fees are all subject to statutory withholdings, which can include income tax, CPP and EI.

 

Remittance requirements will apply to the payor corporation in respect of such withholdings and the remittance periods will depend on whether the employer is subject to accelerated remittances as a level 1 or 2 remitter or not. If the corporation is not an accelerated remitter, source deductions are due on the 15th of the month following the month that such remuneration was paid.

 

Failure to make the remittance on time is subject to a penalty by CRA.

 

The corporation will also have a requirement to prepare and file a T4 summary and related supplementaries with CRA, on or before February 28th of the year following the calendar year, for which the payroll year relates. Penalties apply for a late filed T4 summary and supplementary.

 

CPP (Exempt or not exempt)

Tax laws, recently changed, now require individuals who are receiving CPP benefits to contribute to CPP if they are still working and receiving a salary, unless they attain the age of 65 and elect in prescribed form on CPT30, to elect out of contributing to CPP.

 

Effectively, this means that many owner/manager shareholders who have opted to start receiving CPP benefits at age 60, and who are still actively involved in the family business and receiving a salary, will have to continue to contribute to CPP. If the shareholder has attained the age of 65, the individual can complete and file FORM CPT30 with the employer and CRA, and elect to STOP contributing to the CPP.

 

Interest and penalties will be levied if the corporation has incorrectly or not withheld and remitted the CPP (ineligible to elect out) at all, or if the FORM CPT30 was not filed.

 

Where the shareholder has already started to receive CPP benefits and is between ages 60-65 there is no opportunity to elect out of paying CPP, if the company continues to pay the shareholder a salary.

 

Where this is the case, consideration should be given to re-structure the shareholder’s remuneration in the form of a dividend. A dividend is not the payment of a salary, and is not subject to the CPP.

 

EI (Exempt or not Exempt)

Where salaries are paid to the owner/manager and to related family members, there may be the requirement for the company to withhold and remit EI on the employee’s insurable earnings.

 

A shareholder/employee who controls the corporation, or owns 40% or more of the voting common shares of the corporation will be considered to be EI exempt.

 

The EI status of related family member employees is not always as “clear-cut”. If the family member is employed in a manner and is subject to the same or similar terms of an “arm’s length” employee, then the employee of the related person will be considered to be insurable and subject to the EI withholdings.

 

If on the other hand, the terms of employment are such that they would differ significantly from that of an arm’s length employee, the related/family member employee might be considered to be EI exempt. An employee can apply to CRA/EI for a ruling with respect to a particular employee, in order to determine whether the employment is EI insurable or not.

 

Frequently, owner/manager employees and their related family members mistakenly contribute to EI, where their employment would be considered not insurable, and therefore EI exempt. Where this is the case, it is possible to amend T4 filings and returns and apply for a refund of EI premiums.

 

Dividends and “Income-Splitting”

A dividend is a distribution of tax-paid corporate surplus and, unlike the payment of a salary, bonus, or director fee, a dividend is not deductible from the income of a corporation for tax purposes. A dividend is, instead, paid from the tax-paid retained earnings of the corporation.

 

The other distinct difference in tax treatment between salary and dividend payments, is that there is no “reasonability” test associated with the payment of a dividend. A shareholder who receives a dividend paid on their particular class of shares, receives the divided by right of ownership. It does not matter whether the particular shareholder is actively engaged or employed in the business. If an individual owns shares, they have a legal right to the dividend.

 

In some respects, income-splitting with other family members, in a private family owned corporation, is easier and requires a lower risk threshold, then the payment of a salary. Of course, to “income-split” with other family members, by sprinkling dividends paid from the corporation, requires that such family members either hold shares directly in the company or have an indirect interest through a trust or another holding corporation. The income-splitting opportunities with other family members is an attractive opportunity; however, there can be other non-tax risks in having other family members as direct or indirect shareholders in the family business (including claims of other creditors, claims through other common-law relationships or marriages of children).

 

Dividends are taxed differently to an individual than a salary, bonus or director fee. Because a dividend represents a distribution of tax-paid corporate surplus, an individual is entitled to claim a dividend tax credit against federal and provincial taxes, otherwise payable on the dividend income. The dividend tax credit (DTC), is the mechanism which ensures that “double tax” does not result by having the income taxed first in the corporation, and then again in the hands of the shareholder.

 

To accomplish this “tax integration”, the taxable dividend paid to the shareholder is “grossed up” by a defined factor, so as to arrive at an average pre-tax corporate amount, and then a dividend tax credit (DTC) is given to the individual taxpayer, to offset the taxes already paid by the corporation. The effect of this calculation is that dividends are generally taxed at a lower rate than salaries, bonuses or director fees.

 

Overall, the total taxes paid by the corporation and the individual integrate, so that there should be no significant difference in tax, had the income been earned directly by the individual. This concept is called “corporate tax integration”, and it is discussed in more detail in our GreenLearning article “Corporate Tax Integration”.

 

The payment of a dividend to a shareholder of a corporation can be utilized as a strategy to:

• Fund all or part of the shareholder’s annual remuneration;
• Income split with other family members, where the payment of a salary might be problematic, because of the reasonability test; and
• Clear a year end “debit” in the shareholder’s account. Unlike a salary, bonus or a director fee, tax withholdings are not required on a year-end dividend.
• The corporation has a requirement to report all taxable dividends paid in the calendar year, by filing a T5 Summary and related T5 slips with CRA on or before February 28th of the year, following the calendar year for which such dividends were paid.

 

Penalties apply for a late-filed T5 summary or supplementary slip.

 

Eligible vs. Non-eligible Dividends

A corporation which earns active business income (ABI), subject to the Small Business Deduction (SBD) pays tax at the low corporate tax rate. This rate is 11% in Manitoba in 2015 and 15.5% in Ontario for instance. Dividends paid to a shareholder from this type of surplus are classified as “non-eligible” dividends.

 

In contrast, where a corporation earns active business income (ABI), which is not subject to the Small Business Deduction (SBD) the corporation, will pay tax at a higher corporate tax rate. Rates vary from province to province. In 2015 in Manitoba, the rate is 27%. In Ontario, the tax rate is 26.5%. Of this amount, a specified percentage of a corporation’s taxable income subject to the general rate, is then added to a notional pool called the General Rate Index Pool (“GRIP”), and accounted for on Schedule 53 of the T2 Corporate Return.

 

Dividends paid from GRIP can be designated as an “eligible” dividend and such dividends are accorded a higher dividend tax credit to the individual receiving the dividend. This is in order to compensate for the higher corporate tax rate levied on the corporate income. An eligible dividend designated by a corporation is reported on Schedule 53 of the Corporate T2 Return. If a corporation designates an amount in excess of its GRIP balance at the end of a particular taxation year, the excess dividend election is subject to a special Part III.1 tax equal to 20% of the Excessive Dividend Designation. See Schedule 55 of the Corporate T2 Return.

 

 

GREENLEARNING PRACTICAL APPLICATION

One of the most requested consulting services from small to medium business clients is to provide tax planning opportunities that minimize taxes payable, but also minimize the potential for tax risk. A corporation provides you with a multitude of tax options when it comes to planning the shareholders’ remuneration. You should become well versed in the pros and cons of each method of remuneration as there is never one perfect method, but usually a combination to achieve the best tax planning solution. To obtain this tax planning solution you will need to ask the right questions of your clientele and listen carefully to the answers provided. The solution will then be driven by the answers they provide.

 

Salaries-T4

Salaries are the primary method to provide a base wage to an owner on a regular basis. There are many advantages to a wage or salary and some are described here:

 

• Salaries and wages provide the Owner-Manager Shareholder with a T4 slip showing employment income. This is often required for personal bank financing and disability insurance applications. In general, many financial institutions are more comfortable lending money to an “employee” than a self-employed person, simply because there is an element of consistency and expectation with employment income. Salaries are exactly that, and the shareholder is required to contribute to CPP. The corporation would be required to pay the employer’s portion. . This is not a bad thing since CPP does provide for some retirement income as well as the income protection for survivor benefits and disability income. CPP earnings used for calculating contributions are subject to an annual maximum. Therefore you take this into consideration when planning how much the base wage should be. An example might be that an owner wishes to receive $85,000 in total remuneration. The solution could be to provide a base wage of $53,600 and then issue a dividend of $31,400. This allows the owner to maximize their CPP contribution (2015 maximum) and then focus on the available tax savings from a declared dividend. Management Fees are considered salary by CRA and are reportable on a T4 slip.

 

Points to consider:

• Because employment wages are exactly that, employment wages, payroll deductions are required for CPP and income tax and remitted to CRA with the regular payroll remittance. This could be considered an advantage or disadvantage, depending on the cash flow availability of the corporation. It’s much easier to pay remittances in monthly chunks, but the owner-manager may want to consider an annual payroll frequency for themselves in order to delay remitting the payroll deduction amounts as long as possible. The danger with this is being certain the funds are available to remit when required.

• Owner-Manager Shareholders on payroll also will allow for more efficient cash flow management within the corporation, and potentially within the owner-manager’s personal finances as well.
• Employment income is earned income and will qualify towards earning RRSP contribution room at the rate of 18% of earned income, subject to an annual maximum. Note that “dividends” outlined below, do not create RRSP room.
• “Earned income” also will allow the owner-manager to investigate other forms of retirement income planning such as Individual Pension Plans (IPP) or participate in corporate sponsored Registered Pension Plans (RPP) or Pooled Registered Pension Plans (PRPP) which are on the horizon.

 

Depending on the needs, wants and answers from the client, the advantages of a salary may become a disadvantage. Your questions must be structured in a way to get the proper answers to address whether these items are advantages or disadvantages as no two clients are exactly alike.

 

Bonuses-T4

A year-end bonus is one of the quickest and best tools in your arsenal to deal with a corporate profit at year-end. Most small corporations are required to pay their corporate tax balance due 3 months after the fiscal year-end. If a client comes to see you after the 3 month deadline or simply does not have the cash flow to pay their corporate taxes, a bonus being expensed can defer the payment of corporate income taxes; but this also shifts the income tax burden to the individual on their personal tax return. You must do careful tax planning to ensure you are not putting the owner into a worse tax situation on their personal tax return.

 

A year-end bonus is also widely used to help eliminate shareholders drawings that are in a debit balance.

 

Since a year-end bonus is governed by the 179 day rule, if the corporation year-end falls between July 6 and December 31, this will give you control over what calendar year a bonus is received and reported on the T4 slip which can result in a deferral of taxes between the corporation and the individual by over a year. A Bonus does not have to be paid in one single lump sum. It can be paid out in pieces of any size over the 179 days

 

 

​Example - Dividend Tax Planning

​ The corporation has a year end of July 31 and a profit of $25,000. You decide through careful planning to declare a year-end bonus of $25,000 to the owner of the company. The corporation now owes zero tax on the T2 as the Bonus is immediately accrued as an expense to the year-end and reduces the profit to zero. You now have the option of allocating the bonuses between the current calendar year and the next calendar year as you have until January to pay out the bonus in full. ​Corporate Year-endCorporation Expense​(July 31)Current Fiscal Year​TaxpayerOwner Manager Income​T1 Y/E December 31    Current Calendar Year-or-Next Calendar Year-or-Combination of the two 

 

 

 

*Audit Trap*

Remember: A bonus is payable through payroll and will therefore will trigger personal tax deductions and CPP payable on the 15th of the following month. You must work closely with your client to ensure they have the cash flow to meet these obligations for large bonus amounts.

 

Dividends-T5

Dividends offer flexibility in both personal income and tax planning, but as with salaries their advantages could turn to disadvantages based on your client’s needs and the needs of the corporation. As previously outlined, Dividends are subject to, in most cases, provincial legislation and the structure of the share capital of the corporation determines what classification of dividends are paid. Structure is everything.

 

Dividends, just like bonuses, can be used to help eliminate shareholders’ loans that are in a debit position. This can be a very tax efficient way of disbursing funds on paper to a shareholder.

 

 

​Example - Dividends and Debit-Balance Shareholder Account

​ Shareholder has a debit balance in their shareholder loan account of $10,000. In order to clear this balance using a dividend a dividend would be declared and an accounting journal entry would be completed as of the fiscal year-end as follows: ​DATEGL ACCOUNTDEBITCREDIT​December 31, 20XXDividend Paid$10,000 ​December 31, 20XXShareholder Loan $10,000To record and pay out dividend declared at December 31, 20XX  Dividends paid to shareholder are not subject to withholding taxes and as a result, can be used to maximize the cash to be paid to a shareholder, but make your client well aware of the tax bill that will be due when their personal taxes are filed in April. As mentioned earlier, structure is everything. A proper corporate share structure will allow for income splitting and wealth distribution among adult family members simply by issuing a class of shares to that individual  

 

 

 

​Real Life Example - Dividends

​ 1. Tim owns 100% of the common shares of the corporation. In this case, Tim will record and receive 100% of any declared dividend and it will be taxed on his personal return. 2. Tim owns 50% of the common shares and his spouse, Terri, owns the other 50%. Any dividend declared will be taxed on each of their personal tax returns in relation to the dividend paid. 3. Tim owns 100% of the common shares and Terri owns 100% of Class A special shares. Tim will report 100% of any dividends declared on the common shares while Terri will record 100% of any dividends declared on the Class A special shares. The declared dividends, depending on the structure, are not related and do not need to be the same amounts  

 

Dividends are also a tax preferred source of income. Because a dividend represents a distribution of tax-paid corporate surplus, an individual is entitled to claim a dividend tax credit against federal and provincial taxes, otherwise payable on the dividend income. Typically this means you can receive remuneration in the form of a dividend and lower your effective tax rate on your personal tax return. Dividends should always be considered in combination with salaries and bonuses. This blended approach usually yields the best solution.

 

Schedule 53

Schedule 53 calculates the General Rate Income Pool (GRIP). Enter the previous year’s GRIP on Line 100. Eligible dividends received, other than eligible dividends received, eligible dividends paid and dividends deductible under section 113 (received from foreign affiliates) are entered as part of the calculations on this form to arrive at the GRIP amount as at the end of the fiscal year.

 

Conclusion

To summarize, ask the right questions of the client. By doing so, you will be able to balance the need for retirement planning; tax savings; building their real wealth over their remaining working life and satisfying the current needs and wants. This will determine the best owner-manager shareholder compensation method and plan.

 

 

We can assist you with advice and reporting as it relates to Shareholder Remuneration. Here at Green Quarter Consulting - Accounting and Bookkeeping Services for Small Businesses  in White Rock South Surrey, Vancouver, Langley and Surrey BC, we assist Small Business Owners with analyzing transactions, sources of income and your tax risks and how they relate to your specific business strategy. Learn more about our Greenstamp CFO Services here.

 

Contact us today at 778-791-2864 or 604-970-0658, let’s talk, or send us an email here and we will be in touch very shortly.

 

 

 

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