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FROM: SEP-OCT 2009 ISSUE | BY J. THOMAS McCALLUM
This past tax season I was reading an accountants’ discussion board, and one posting in particular struck me. In advising a client on charitable donations the accountant offered that these should be made by the client personally and not by the corporation he solely controlled. The logic was that a $1,000 donation resulted in a tax credit of about $365 whereas the corporation’s tax reduction would only be about $155.
The analysis isn’t complete because the individual needs to draw the $1,000 from the corporation to make the donation personally, and that will be taxable income to the individual. The $1,000 will attract about $450 in personal income taxes, and after allowing for the $365 tax credit, the net realizable amount is $915 – not enough to make the $1,000 donation. The accountant’s analysis was incomplete because there isn’t a $210 advantage but rather, a disadvantage of $85. (In actual fact the disadvantage is greater than that as it’ll take another $155 in pre-tax personal income to raise the $915 to $1,000.)
From a tax perspective, the corporation is indifferent as to whether it pays $1,000 to charity or as salary; the tax reduction is the same in either case. Given the analysis of the two alternatives on a net basis, the corporate donation is the superior choice. But the mistake of analysing too superficially is an all too common error and I’ve fallen victim to it myself. It most likely happens because we tend to look at problems without considering the issue as a whole. Very often the solution is to take the time and track the money under each of the available alternatives.
Here’s another example drawn from my experience. In most provinces, dividends are more tax effective than salary (assuming a reasonable remuneration) for the shareholder-manager of a Canadian-controlled private corporation carrying on an active business. This is easily proven, yet I’ve been challenged by accountants who, once shown, discover they are actually comparing apples and oranges. You simply can’t compare a $100,000 dividend with a $100,000 salary.
A dividend of $100,000 requires a pre-tax corporate profit of $118,350 because dividends are paid in after-tax corporate dollars. The correct comparison – apples to apples – is to a $118,350 salary, not a $100,000 salary. The personal tax on that salary is $53,250 whereas the total personal and corporate tax involved on the $100,000 dividend is about $50,000. Clearly, the dividend approach provides the shareholder-manager with more money. It’s really just a matter of going back to the originating source and tracking the alternative cash flows.
One last example: a daughter wants to acquire her mom’s qualified small business corporation shares at a purchase price of $350,000. Naturally, the mom wants to receive her proceeds tax-free via the use of her capital gains deduction. To pay $350,000, the daughter has to draw the money from the corporation and pay her mom in personal after-tax dollars. To net $350,000, the daughter has to draw about $635,000 from the corporation, although she could lower that to about $607,000 if she uses dividends instead of salary. The daughter doesn’t have the option of creating a holding company to purchase mom’s shares (because of Section 84.1 of the Income Tax Act) and servicing the debt in pre-tax corporate dollars. For mom to receive $350,000 tax-free, the daughter has to incur more than $250,000 in income taxes.
The only other option is to redeem mom’s shares at fair market value, allowing the daughter to buy-in for a nominal amount; however, mom will then have dividend income and the tax bill will be around $100,000. But that’s about $150,000 less tax overall than the daughter-purchase approach. And there’s a business advantage to the redemption option in that less money is stripped from the corporation and the company isn’t as inhibited in its operations and growth capacity.
Tax analysis is real problem solving and like any problem, it’s essential to get to the roots and not just address the symptoms.
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