Tax Planning for Business Owners...

Salary/Dividend Planning Many factors must be considered in determining the most beneficial combination of remunerating the owner-manager of a closely-held corporation. As with other planning, each case must be examined separately and no one "rule of thumb" can apply to all situations. Here are a few factors that should be taken into consideration: The tax rate of the corporation The marginal tax rate of the individual Exposure to Alternative Minimum Tax The ability to benefit from child care expenses and paternity/maternity benefits and to make RRSP and CPP/QPP contributions, which are all based on salary and not dividend income Wage levies applicable to salaries, such as the Ontario Employer Health Tax and Quebec's Health Services Fund and 1% Training Tax (if the payroll exceeds $1,000,000) Quebec restrictions on the deductibility of investment expenses by individuals where expenses exceed investment income Whether eligible dividends can be paid to shareholders Full or partial loss of the dividend credit if taxable income is not high enough Higher net income with a dividend than with a salary, since dividend income is grossed up by 41% in 2011 (38% in 2012) for eligible dividends or 25% for non-eligible dividends, which can have an impact on certain credits and benefits Some planning techniques include: If the corporation has Refundable Dividend Tax on Hand (RDTOH), the payment of a dividend will result in a refund of 33 1/3% of the dividend payment up to a maximum of the RDTOH balance Remuneration that is accrued and expensed by a corporation must be paid to the employee within 179 days of the corporation's year-end. When a year-end falls after July 5, the corporation can cause the owner-manager's remuneration to fall into either the current or subsequent calendar year Freeze or Refreeze? An estate freeze is used to ensure that future growth in the value of a company accumulates in the hands of a shareholder's heirs. This is accomplished by "freezing" the current fair market value of the company in the form of preferred shares. If the value of a business subsequently decreases, the benefits of freezing may not be fully realized and it may be advantageous to consider "unfreezing" and "refreezing" a company. Refreezing enables taxpayers to exchange their old preferred shares, obtained at the time of the initial freeze, for new shares with a lower redemption price. Any future gains in value will then be passed on to the holders of common shares. This type of planning helps reduce tax on the death of taxpayers by lowering the redemption price of their preferred shares and transferring more value to their heirs. Income Splitting Investment income earned by an individual who invested money borrowed at low or no interest from a related person will be attributed back to the lender. Subject to a purpose test, this rule does not apply where the loan is to a related person other than a spouse or minor child. Nor will it apply where the loan is to a spouse or minor child if interest is charged at the prescribed rate in effect at the time the loan is made (the prescribed rate for the fourth quarter of 2011 is 1%). When utilizing this exception, interest must be paid no later than 30 days after the end of the year to avoid attribution of income. For instance, the high-income spouse could lend investment funds to the low-income spouse at the current 1% rate and receive (and pay tax on) the interest income each year, for as long as the loan remains outstanding. The low-income spouse would pay tax on the income generated by the funds and deduct the interest paid to the high-income spouse. Since the attribution rules are complex, caution is advised when contemplating a transfer of property or a loan to a spouse or a child (including transfers indirectly through a corporation or a trust). Some other basic planning ideas would include: Gifting growth assets to a minor child, as the resulting capital gain is not attributed to the donor; however, certain exceptions were proposed in the 2011 federal budget Gifting property to a child who is not a minor Segregating and re-investing "attributed" income of a spouse or minor child Deposit Canada Child Tax Benefit (CCTB), Universal Child Care Benefit (UCCB) and Quebec Child assistance payments (CAP) directly into accounts opened in the children's names Use the income of the spouse with the higher income to pay all the family's expenses so that the spouse with the lower income has more capital available for investment Using a trust for the benefit of family members to hold shares of a closely-held corporation. However, there are restrictions in regard to income-splitting with minor children Spouses can choose to share their QPP and CPP retirement pensions Have your spouse as your business partner or pay reasonable salaries to your spouse or children Shareholder Loans Any loan granted by a corporation to an individual who is a shareholder or to a person with whom the shareholder does not deal at arm's length will be taxable in the year in which the loan is advanced, unless a particular exception applies. If the loan meets one of these exceptions, the shareholder will be required to pay to the corporation interest at a rate at least equal to the prescribed rate no later than January 30 each year. If a shareholder loan exists at any time during the year, a taxable benefit must be calculated based on the prescribed interest rate, less the interest actually paid. When a loan is repaid, the shareholder may claim a deduction up to the amount that had been included in income. It might be worthwhile for a corporation to make a loan to an adult child of the shareholder at a time when the child does not have much income. The loan may be repaid in a subsequent year, when the child's marginal tax rate is higher. Since shareholder loans are not deductible from a corporation's income and do not generate refunds of RDTOH it is recommended that shareholders verify whether it would be more advantageous to be paid a salary or a dividend. It is very important that any loan contract between a corporation and one of its shareholders be adequately documented. Capital Gains Exemption A capital gains exemption is available for individuals to use in relation to gains realized on qualified small business corporation shares and some other properties. The maximum lifetime capital gain exemption is $750,000. Be aware of the possible disadvantage of selling investments eligible for the $750,000 capital gains exemption and investments with losses in the same year. Capital losses realized in the year must be offset against capital gains of that year including "exempt" gains. Consider selling investments with losses the following year. Subject to certain conditions, an individual may defer capital gains on eligible small business investments to the extent that the proceeds are reinvested in another eligible small business. The reinvestment must be made at any time in the year of disposition or within the first 120 days of the following year. Acquisition of Assets Accelerate the acquisition of depreciable property used in carrying on a business otherwise planned for the beginning of the next year. This will allow additional depreciation (CCA) to be claimed in the current year. The "available-for-use rules" should be considered (generally requiring the depreciable property to be used in operations for the depreciation deduction to be allowed). Conversely, consider delaying until the subsequent year the acquisition of depreciable property in a class that would otherwise have a terminal loss in the current year. Machinery and equipment acquired after March 18, 2007 and before 2012, primarily for use in Canada for the manufacturing and processing of goods for sale or lease is currently eligible for a temporary accelerated CCA rate of 50% and subject to the half-year rule. Otherwise, a CCA rate of 30% would apply and be subject to the half-year rule. The 2011 federal budget proposed to extend this temporary incentive for two years, to eligible machinery and equipment acquired before 2014. Death Benefit A corporation can make a onetime tax free payment of up to $10,000 to the spouse or heirs of a deceased employee. This payment will not be taxable to the recipient and will be fully deductible by the corporation. * provided by BGK -Chartered Accountants - more info at www.BGK.ca

How an honest mistake beat a $6-million tax bill **

Some mistakes can be costly. Consider the story of Andrew Espey from Jackson, Minn. According to KEYC-TV, Mr. Espey was fined $2,000 (U.S.) and sentenced to 90 days in jail for improperly shingling his house (he affixed the new shingles without first removing the old ones). I just hope that same building inspector doesn’t show up at my place to examine the poor job I did of hanging our new screen door. While a home improvement faux pas can be bad enough, other mistakes – particularly tax mistakes – can cost even more. How about $6-million more? Today I want to share the story of siblings who found that they owed the taxman that much. The good news? The tax bill was the result of a mistake made by these siblings, and the court was sympathetic to them. This could be good news for other taxpayers. The story Ashok and Saroj Arora are siblings who owned and operated a business by the name of Stone’s Jewellery Ltd. In 1996, Stone’s entered into an agreement to purchase a parcel of land in Springbank, Alta., for $500,000. The closing date was delayed until 2004 at which time the property was worth about $4-million. The Aroras were advised at the time of closing to register the property in their personal names rather than in the name of Stone’s in order to protect the property from potential creditors of the business. The advice they received was that this transaction would be tax-free. Then, in 2006, the Aroras transferred the property to a wholly owned corporation on the advice of their advisers. The property was worth about $6-million at the time of this transfer, and the transfer was to be treated as a tax-free transfer (by taking advantage of section 85 of our Income Tax Act which allows certain transfers to a corporation to be made tax-free). Here’s the problem: The Canada Revenue Agency argued that there were two taxable transfers here: the one in 2004 when the Aroras took possession of the property personally (CRA called this a taxable transfer by Stone’s to the Aroras), and again in 2006 when the property was transferred to the new corporation (CRA argued that section 85 was not applicable to the transfer since this was “land inventory,” or land held for resale). CRA also argued there was a taxable shareholder benefit that arose when the land was placed in the names of the Aroras. The total tax bill owing by Stone’s and the Aroras was about $6-million. This issue ended up in court (Stone’s Jewellery Ltd. v. Arora, 2009 ABQB 656) and the Court of Queen’s Bench of Alberta rendered a decision that may help other taxpayers. The decision In their application, the taxpayers argued that they were entitled to relief based on three different principles. One of these was the principle, or doctrine, of mistake. The court summarized the doctrine of common law mistake by saying that a mistake must be fundamental, going to the identity of the contract, where the contracting party obtained something other than what was intended. This should be distinguished from a situation where the contracting party did receive what was intended but it turned out to be less valuable than expected. In this latter case, the mistake is not considered to be fundamental. In a case where a mistake is fundamental, the contract can be rendered by the court to be void from the very beginning. It shouldn’t be surprising that CRA opposed the taxpayers’ application, arguing that (1) other legal remedies were available and (2) the parties should not be allowed to undertake retroactive tax planning. The court dealt with the 2006 transfer first. Although the court acknowledged that it didn’t have the power to order that the transfer take place under section 85 of the Income Tax Act, it did say that all of the parties held the mistaken belief that the transaction could be done on a tax-free basis – a fundamental mistake that went to the root of the contract. The court said the transfer was therefore void from the beginning. As for the 2004 transfer, the court said that there was a common mistaken belief by the parties, based on the advice of their advisers, that there would be no negative tax consequences to registering the property in their personal names. This too was a fundamental mistake that went to the essence of the agreement, and the transaction was rendered void from the outset. This is, of course, good news for taxpayers who may be in a similar situation where an honest and fundamental mistake results in taxes owing. * written by Tim Cesnick and published in the Globe and Mail.