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Linda is approaching retirement with cash in her corporation. She wonders how to withdraw it before or after retirement.
I work as a self-employed IT contractor. I am incorporated. Over the years I have accumulated about $100,000 in my business account, over and above what I need to carry operating expenses. I am about five years out of retirement, maybe less than that if I go for a semi-retired approach. I would like to know the best strategy for withdrawing the money from my business.
I am aware I can pay myself a dividend, but I thought a business had to have earnings in order to declare a dividend. Is that the case? As I am a one-person operation, am I even allowed to declare dividends anymore? I heard the tax laws changed recently.
–Linda
Linda, you have a corporation and $100,000 of cash you have saved. A common mistake by business owners is thinking they cannot invest this money. A corporation can buy guaranteed investment certificates, stocks, bonds, mutual funds, and exchange traded funds. It can work with an investment advisor or open a self-directed brokerage account. A corporation can even buy a rental property or invest in another business.
But let’s go over some notes on incorporating, first.
One of the benefits of incorporation is the ability to leave savings in the corporation, when it’s not needed for personal use. An incorporated business owner who does this can defer over 40% tax on their earnings.
There are other reasons to incorporate. One is to limit your personal liability, but liability can also be mitigated by purchasing insurance. Some people feel a corporation conveys a more professional business appearance, which may not matter if the business is essentially you. Another reason is when you have business partners.
Incorporation costs money up front and ongoing. There are legal fees and accounting fees. Bank fees are higher as well. So, unless there is a benefit to incorporation, a business owner should consider operating as an unincorporated sole proprietor, reporting their earnings on their personal tax return. A business does not need to be incorporated.
An owner manager who owns shares of their corporation, and is also an employee, can pay themselves in different ways: An employee can be paid a salary. A shareholder can be paid a dividend on their shares.
Since both apply to you, Linda, that means you can choose either option.
When a corporation pays a salary, it deducts that salary from its business income. So, say your corporation earns $100,000 per year, and you pay $75,000 out as a salary. The salary would reduce the corporation’s taxable income to $25,000 (ignoring other business expenses).
Say you live in Saskatchewan, Linda. Your corporation, assuming it qualified for the small business deduction, would pay 11% corporate tax on that $25,000 of income, leaving $22,250 in cash. I suspect over time this is how the $100,000 of cash you have currently has been accumulated.
A dividend is a payment of after-tax corporate savings to a shareholder. Dividends are taxed personally at lower tax rates than salary to account for the fact that corporate tax was already paid on the earnings. In an ideal world, the dividend would be taxed at 11% less when paid to you and result in perfect integration in my example but the actual difference can vary. The tax rate is always lower on dividends than salary.
In any event, Linda, you could pay out your $100,000 in cash as dividends now, over the next few years, or in retirement.
If you did it now, you would pay a lot of tax as the dividends would be in addition to your salary for the year. But if you have room to contribute to a registered retirement savings plan (RRSP), you could use the money to be invested and growth tax deferred. A RRSP contribution could more than offset the tax on the dividend.
For example, if you have a $75,000 salary, pay a $100,000 dividend, and have $100,000 of RRSP room to make a RRSP contribution, the net result could be a $7,000 tax refund, fully offsetting the tax on the dividend (assuming Saskatchewan residency and ignoring other deductions or credits).
If you paid the dividends over the next few years, you could do this to top up your salary assuming you are going to semi-retire, as you alluded to doing. As an example, if your business income went from $100,000 to $50,000, you might reduce your salary to $50,000 and take some dividends to top up your personal cash flow needs.
Alternatively, when you retire, you can withdraw the accumulated savings for the first few years of retirement and consider deferring withdrawals from your RRSP and other personal investments, combined with potentially deferring your CPP and OAS pensions. In this way, you could split the tax on the corporate withdrawals over a few years and be able to wind up the corporation early in retirement.
Since you asked, Linda, a dividend is a payment to a shareholder of a corporation’s after-tax earnings, the business does not need to have earnings.
You also asked about tax law changes and whether you are allowed to declare a dividend. You may be referring to the Tax on Split Income (TOSI) rules introduced a few years ago. These rules apply to shareholders who are not very active or not at all active in a business, so do not apply to owner-managers like you. The rules could apply to a spouse or child who is a shareholder of your corporation and cause dividends to them to be taxed at a high rate.
If a business owner has a lot of corporate savings, they might always keep their corporation to defer personal tax, long after they retire. Some owner managers keep their cash and investments in their primary company, which then notionally becomes an investment holding company upon retirement when it is no longer active.
Others set up a separate investment holding company to move cash out of their operating company for various reasons (creditor protection, multiple owners of the operating company, plans to sell the operating business, etc.).
There are a bunch of other considerations, Linda, but I wanted to try to summarize some of the key items for you and other readers. The starting point for any business owner is whether to incorporate in the first place. If you are accumulating cash in your business, you should consider whether to take extra withdrawals to make RRSP or tax-free savings account (TFSA) contributions. Sometimes, setting up an investment holding company makes sense.
In your case, Linda, you can consider paying out your after-tax corporate cash as tax-efficient dividends to top up your RRSP, supplement your salary as your business income decreases in semi-retirement, or to wind up the corporation in the early years of retirement.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
If you have a question for Jason, please send it to [email protected].
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Hello, If one has a corporation with say $200,000 cash in it and they are starting to wind down the business – can they still pay themselves a salary if they don’t bring in enough sales to cover the salary per say? It would be covered by the cash in the corporation. I understand you can take the shareholder dividends from the corporations cash. Thank you.
There also financial products and services and strategies besides all that was mentioned above to grow money tax free beside the TFSA account offcourse. Only Financial licensed professionals have access to those strategies which accountant don’t have the license for.
Great article. The problem I see the most with small single operator incorporated businesses is they have a hard time wrapping their heads around the fact that the money earned by the corporation is not theirs, it belongs to the company. So money earned from their business goes into a corporate bank account and they use this bank account to purchase personal items such as beer, pop, electronics, groceries for the family etc and even though I explain they can’t do that they still do? I explain that they are taking small loans out the business that need to be paid back! They ignore it and keep using it as a personal account to purchase things? So what I do is group these purchases and record as dividends taken. I don’t know how the federal government looks at this type of activity within a corporation but seems to me a type of embezzlement and even though I try to explain they must take monthly dividends and move to a personal bank account they don’t? The other fact is some don’t even make a profit (as they should) before purchasing items or moving money out the company? And again even though I try to explain dividends are taken from profits only they still do it? Your thoughts and feed back would be appreciated. And also this would you say this is a type of embezzling funds by making personal purchases?
Thanks