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How is money taxed when you take it out of your corporation?

finding tax breaksThree examples to show you how

Have you ever had that feeling where something seems too good to be true? The other day I was reminded of such a time when listening to one of my favourite podcasts. The guest on the show was a fitness guru, who mentioned how many of the bodybuilders of the ’80s and ’90s are starting to die of heart failure in their 50s.

Just hearing some of the names of the bodybuilders immediately took me back to my teenage years when I was mildly obsessed with working out and getting “big”. These “athletes”, as I considered them, were the pinnacle of health in my eyes. I wanted to be like them. On one family Thanksgiving road trip to New York City, I devoured the entire 700-page copy of “Arnold Schwarzenegger’s Encyclopedia of Modern Bodybuilding”. I was hooked and started following the sport closely.

But as I started learning more about it, I realized that there was something odd about this seemingly “healthy” lifestyle. As it turned out, every bodybuilder was likely not only on steroids, but probably a cocktail of other chemicals that they were experimenting with to get an edge. They were doing everything they could to get ahead in the present, but gave little thought to how treating themselves as human lab rats would affect their bodies in the future.

So what does this have to do with the price of tea in China?

Often in the finance world “experts” give advice that focuses on how to improve a client’s financial situation today, without much thought about the future. Years ago, I would come across investors who mindlessly put as much money as they could into their RRSPs to minimize their current tax bill. If people did this for their entire working life, they could end up with huge – but fully taxable – sums of money.

If you’ve been reading this blog for the past while, you are likely familiar with the potentially huge tax advantages of business owners taking a lower salary and keeping the profits in the company. However, you may be less familiar with how the money is taxed once you take it out of the company.

First off, let me assure you that the repercussions should not lead to heart failure!

The following three examples can be executed while you are still working, during retirement, to fund a sabbatical or whenever you feel is advantageous to your situation:

1) The easiest and most straight forward way to take funds out of your corporation is to pay yourself a salary. This is treated as earned “income”. It’s taxed in the same manner and in the year you take it. This is often used to supplement lifestyle expenses or even out income should your business have a slow year from time to time.

2) Another way you can withdraw funds from your corporation is to take it as a dividend. There are some complicated calculations that go into figuring out the tax rate on dividends; however they are generally taxed at a lower rate than salary. One thing to consider is that if you opt to take all of your compensation as dividends, it can diminish the amount of CPP you receive.

3) If you’ve set up a holding company to own the shares of your operating company, you can have multiple shareholders own the shares of the holding company. This could likely include yourself, your spouse and your children. When a shareholder is 18 or older, you can pay them a dividend as one of the owners. If they have very little or no income at that time, they could receive up to $40,000, potentially tax-free if they have tax credits from school.

As it may be advantageous to pay some shareholders a dividend in one year and not others, each shareholder can own their own class of shares (e.g.,. Wife – Class A, Husband – Class B, Eldest Child – Class C, Second Eldest Child – Class D, etc.) This way when the eldest child turns 18, you can declare a special dividend of $25,000 to owners of Class C shares and only the eldest child will receive the dividend. If they don’t have any income that year, it’s possible they won’t have to pay any taxes on it.

Odds are that you won’t be able to remove all the funds from the corporation tax free. However, when combined with the tax savings you get at the beginning of the process, it is likely that using your corporation in a wise manner may provide you valuable tax savings.