For many years, accountants for Canadian-controlled private corporations (“CCPCs”) have followed the old adage of advising their clients to “bonus down” to the Small Business Limit (the amount of active business income earned in Canada that is subject to the lowest corporate tax rate), as it generally provided the owner-manager/shareholder with higher after-tax cash than the alternative of paying tax in the corporation, and then ultimately paying dividends to the owner-manager/shareholder. This is because corporate income subject to the general tax rate was poorly integrated when such income was eventually paid as a dividend to the owner-manager/shareholder. Table 1 roughly displays the lack of integration for a corporation earning $1,000,000 of taxable income in the late 1990’s.
Table 1 – Approximate 1990’s Example
|Note: tax rates are approximate.|
|Small business tax – 23%||–||46,000|
|up to $200,000 Limit|
|Corporate tax – 40%||–||320,000|
|After tax corporate cash||–||634,000|
|Personal tax – 42% / 25%||420,000||158,500|
|Total after tax cash||580,000||475,500|
With the introduction of the eligible dividend regime effective January 1, 2006, tax integration for high rate corporate income has greatly improved. Table 2 provides an illustration of tax integration for an Alberta based CCPC with $1,000,000 of taxable income. The first option in each year displayed is to pay a bonus of $500,000 down to the Small Business Limit (which is now $500,000 effective January 1, 2009) and extract the remaining surplus out as a non-eligible dividend. The second option in each year displayed is not to pay a bonus, but rather subject the corporate income to the lower rate of tax on the first $500,000 of corporate profits and the high rate of corporate tax on the next $500,000. The after-tax corporate surplus would then be extracted using a combination of non-eligible dividends and eligible dividends. As illustrated, the total after tax cash is only $3,600 to $4,100 higher between 2009 and 2012 for the Bonus option versus the No Bonus option. Accordingly, one could say that for Alberta based CCPCs, the tax system is now essentially integrated. (Note that the general corporate tax rate for Alberta corporations is declining for every year from 2009 to settle at 25% in 2012. Similarly, the personal tax rate for Alberta resident individuals on eligible dividends is increasing every year from 2010 to settle at 19.29% in 2012).
What if the owner-manager/shareholder has no immediate need for funds? Some practitioners have suggested to us that bonusing down to the Small Business Limit still provides higher after-tax cash than retaining such cash in the corporation. We decided to test this strategy in the following example illustrated in Table 3. Again, suppose a CCPC has $1,000,000 of taxable income, and the owner-manager/shareholder has no immediate need for funds. In this case, the two options are as follows:
- Pay a bonus of $500,000 down to the Small Business Limit and retain the remaining after-tax corporate income within the corporation. In this case, the owner-manager/shareholder will have some after-tax cash in their hands personally.
- The second option is to retain the income in the corporation, i.e. not to pay a bonus or a dividend.
In order to compare apples to apples, let’s further assume that the corporate retained earnings in both options above are paid out in 2012 by way of a dividend (2012 was purposely selected as the year to withdraw the corporate surplus since this will be the year, as mentioned above, that the eligible dividend rate is settling at its highest rate of 19.29% – an increase of approximately 5% from the 2009 rate of 14.55%).
As Table 3 illustrates, the cumulative after-tax cash is approximately $50,000 higher in the bonus option, or about 2%. In addition, under option 2, the lower eligible dividend rates from 2009 to 2011 are foregone in favor of retaining funds within the corporation.
However, under option 1, the bonus payment in 2009 to 2012 results in a “prepayment” of tax. In other words, under option 1, the owner-manager/shareholder is prepaying taxes of about $50,000 to $70,000 in each of 2009 to 2012, in order to save $50,000 in taxes in 2012 when the accumulated surplus is paid out.
To elaborate, the first $500,000 of taxable income is subject to the small business tax rate under both option 1 and 2. If the next $500,000 is paid out as a bonus in 2009, it would be subject to a 39% personal tax rate in Alberta. However, if this $500,000 is retained (and therefore taxed) in the corporation, it would be subject to a 29% general corporate tax rate in 2009. Therefore, there is a $50,000 “prepayment” of tax in the bonus option, or 10% of $500,000.
To put it another way, if the $500,000 is retained in the corporation, there is a tax deferral of 10% until such funds are eventually paid to the owner-manager/shareholder (by way of a dividend). This tax deferral increases steadily to 14% by 2012 when the general corporate tax rate declines to 25%. This deferral of tax is significant and our analysis, of course, ignores the time value of money and the rate of return that could be earned on the deferred tax.
The decision to bonus or not will ultimately depend on whether the owner-manager/shareholder needs funds personally. If the answer is “no” then there is a very compelling argument to not bonus. Of course, not bonusing will come with some cons (such as increased corporate income tax installments and increased cash in the company) but such cons can be easily dealt with by way of good cash management and additional planning. CCPCs that also rely on refundable SR&ED tax credits should be careful about paying high rate corporate tax since this may reduce their refundable tax credits. In addition, Alternative Minimum Tax (“AMT”) should always be considered when paying out dividends. With regards to both Option 1 and 2 in Table 3, there is no AMT payable in 2012 when the accumulated earnings are paid out.