Ways to smooth income over a number of years to ensure an individual is maximizing access to the lowest marginal tax rates
Higher levels of personal income are taxed at higher personal rates, while lower levels are taxed at lower rates. Therefore, individuals may want to, where possible, adjust income out of high-income years and into low-income years. This is particularly useful if the taxpayer is expecting a large fluctuation in income.
A taxpayer may expect a large fluctuation in income, due to, for example, an impending
- maternity/paternity leave;
- large bonus/dividend; or
- sale of a company or investment assets.
In addition to increases in marginal tax rates, individuals should consider other costs of additional income. For example, an individual with a child may receive reduced Canada Child Benefit (CCB) payments. Likewise, excessive personal income may reduce receipts of OAS, GIS, GST/HST credit and other provincial/ territorial programs.
There are a variety of ways to smooth income over a number of years to ensure an individual is maximizing access to the lowest marginal tax rates. For example,
- Taking more, or less, earnings out of the company (in respect of owner-managed companies).
- Realizing investments with a capital gain/loss.
- Deciding whether to claim RRSP contributions made in the current year or carry-forward the contributions.
- Withdrawing funds from an RRSP to increase income. Care should be given, however, to the loss in RRSP room based on the withdrawal.
- Deciding on whether or not to claim CCA on assets used to earn rental/business income.
Dividends paid out to shareholders of a corporation that do not “meaningfully contribute” to the business may result in higher taxes due to the “tax on split income” rules.
Year-end planning considerations not specifically related to changes in income levels and marginal tax rates include:
Corporate earnings in excess of personal requirements could be left in the company to obtain a tax deferral (the personal tax is paid when cash is withdrawn from the company).
The effect on the “Qualified Small Business Corporation” status should be reviewed before selling the shares where large amounts of capital have accumulated. In addition, changes which may limit access to the small business deduction where significant corporate passive investment income is earned should be reviewed.
If dividends are paid out of a struggling business with a tax debt that cannot be paid, the recipient could be held liable for a portion of the corporation’s tax debt, not exceeding the value of the dividend (Section 160 assessments).
Year-end bonuses can affect the business’ Canada Emergency Wage Subsidy (CEWS) and the recipient’s Canada Emergency Response Benefit (CERB). If the bonus partially relates to a claim period, it could increase entitlement to CEWS. On the other hand, it could eliminate entitlement to a CERB claim if it pushes the individual’s earnings for the period above $1,000.
Individuals that wish to contribute to the CPP or a RRSP may require a salary to generate “earned income”. RRSP contribution room increases by 18% of the previous years’ “earned income” up to a yearly prescribed maximum ($27,230 for 2020; $27,830 for 2021).
Dividend income, as opposed to a salary, will reduce an individual’s cumulative net investment loss balance thereby potentially providing greater access to the capital gain exemption.
Consider paying taxable dividends to obtain a refund from the “Refundable Dividend Tax on Hand” account in the corporation. The amount of refund may be restricted if “eligible” dividends are paid. Eligible dividends are subject to lower personal tax rates.
It is costlier, from a tax perspective, to earn income in a corporation from sales to other private corporations in which the seller or a non-arm’s length person has an interest. As such, consideration may be given to paying a bonus to the shareholder and specifically tracking it to those higher-taxed sales. Such a payment may reduce the total income taxed at higher rates.
Recent changes to the tax regime will likely require more careful tracking of an individual shareholder’s labour and capital contribution to the business, as well as risk assumed in respect of the business. Inputs should be tracked in a permanent file. Dividends paid that are not reasonable in respect of those contributions may be considered “split income” and taxed at the highest tax rate. Several other exceptions may also apply.
Recent changes will restrict access to the corporate small business deduction where more than $50,000 of passive income is earned in the corporation. Consider whether it is appropriate to remove passive income generating assets from the corporation and whether a shift in the types of passive assets held is appropriate. In some provinces it may actually be beneficial to have access to the small business deduction restricted. As many variables affect these decisions, consultation with a professional advisor is suggested.
If you are providing services to a small number of clients through a corporation (which would otherwise be considered your employer), CRA could classify the business as a Personal Services Business. There are significant negative tax implications of such a classification. In such scenarios, consider discussing risk and exposure minimization strategies (such as paying a salary to the incorporated employee) with your professional advisor.