Tax implications of salary and dividend payments for business owners

Taxation

Impact of taxes on business owners

Tax Implications on Salary and Dividend Payments

The amount of money that a business takes out has important implication of tax amount that the business will be liable to pay. But for the case of sole proprietorships and partnerships, it makes no difference how much or when the money is taken out of the business. After all, owners of both partnerships and sole proprietorships pay personal taxes on their full share of their company's incomes every year. These business structures do not allow for owner salaries but withdrawals which have no tax impact at all (Ross, 2007).

For the case of corporate businesses, owners can get money out of their businesses in just a number of different ways each of which has different tax implications. In this case, the business owner and the tax authorities are at cross purposes; the business owner wants to minimize tax bills while the tax authorities want to maximize it. To achieve their objectives, tax authorities will have created some guidelines for reducing the income shifting capacities available to corporations. But with little planning and flexibility, the corporations can abide by the rules of the state regulatory bodies and still apply the rules to pay own tax advantages.

Most tax rules for corporations and unincorporated businesses are very rigid as far as taxes, salaries and dividends are concerned and getting any of them wrong can plunge a business into troubles (Parkin, 2006). To avoid unnecessary legal repercussions, most business hire qualified tax preparers with business experience to advise them, on how to go about factoring for taxes on salaries and dividends received. In any corporation, there are three basic ways of getting money out of a business namely loans, dividends and salaries. The type of business structure is however a major factor in this mixture. Since the aim of business owners is to cut down on income tax, they will always want to shift most of the income into whichever direction that affords the minimum tax rate. When a business owner consider themselves and the company as a single tax payer, any initiative that cuts down the absolute level of tax leads to extra cash in the owner's hand.

i. Effect on Salary

In matters of tax management, salary entails more than just a regular pay check. It may encompass such things as bonuses, deferred payments, and fringe benefits among others. Essentially, salary is the owner's total pay package. To avoid heavy tax implications business owners may want to increase their total pay packages as much as possible. In S corporations, shareholders may not have to deal with the problem of double taxation on dividends as they personally pay taxes on the total incomes of the business whether they take the dividends or not. On the other hand salary is taxed at a relatively higher rate than is the case with dividend income since it is subject to employment taxes. Therefore, looking at the shareholders and S corporation together, more taxes have to be paid on salaries than on dividends making it more beneficial for such corporations' shareholders to shift the game towards lower salaries and higher dividends (Ross, 2007).

In some cases, small corporations' owners may want to do the opposite and put more money into salaries and avoid paying themselves dividends. In this case, the double taxation on dividends does not arise in which the corporation pays taxes on profits and the shareholders pay taxes again on profit distribution. Salaries in most cases are completely deductible and this reduces the taxable income as only the shareholders pay income taxes on the money.

ii. Effect on Dividend

Dividends which are a form of distribution of company profits are only available to shareholders of corporate businesses. The type of business that an owner has determines how the pay-outs are treated. For instance, under C corporations, dividends require double taxation and this makes small business owners to avoid using the method as a way of getting money out of their businesses. With's corporations on the other hand, owners have an obligation to pay same amount of tax whether they take money out of their business or not. In this case, it will be their advantage to maximize dividend payouts.

In S corporation businesses, the situation is somehow opposite. Here, salaries call for higher taxes than do dividends, the main reason being taxes are subject to employment taxes whereas dividends are not (Hoffman, 2004). Nevertheless, both forms of income show up on the business owner's income tax return which is the only variable factor in the two cases. While the business owner's salaries as well as related employment taxes are classified as deductible to the corporation, the corporation will nevertheless have to pay them in the first place. But taxation agencies are aware that business owners may want to avoid the double taxation issue on dividends and therefore put special mechanisms in place which in certain cases penalize business owners for retaining profits instead of distributing them, to shareholders and paying extra tax to the government.

iii. Loans between the Business Owner and The Corporation

Loans provide a method of taking money out of the business without necessarily creating big tax situations. Although there might be some taxes attached to a loan, they are usually less costly than are double taxations and employment taxes. The part of the loan that is most taxable is the interest part even though it must be paid. Therefore, if there is no reasonable amount of interest attached to a loan, tax authorities may decide to treat it as a dividend or some kind of capital contribution in which case the business owner will not gain any benefit. For fair taxation purposes, loans between a business owner and the corporation should be treated just like any other business loans which require drawing up of official document loans which specify not only payment amounts but also interest rates on the loan as well as due dates.

The Canadian Tax Integration System and Its Effect on Active Business Income and Taxable Dividends Received By Private Corporations

According to Canada's system of taxation, corporate income is subject to corporate income tax and upon distribution to shareholders as dividends; it is subject to personal income tax. Actually, Canada's personal income tax system through the dividend tax credit and the gross-up mechanism provides for recognition of corporate taxes based on a certain percentage of notional federal tax rates to all taxable individuals resident in the country.

Because of the country's taxation policies and related issues such as proliferation of publicly-traded income trusts, the federal government of Canada has proposed that it shall introduce an enhancement to the current dividend tax credit and gross-up for all eligible dividends received by shareholders. In these new arrangements, all eligible dividend allocations will be grossed up by up to forty five per cent. This means that shareholders will have to include 145 per cent of their dividend amounts in personal income. On the other hand, the dividend tax credit for eligible dividends will be 19 per cent but this will depend on the federal corporate tax rates foe each year. Both the gross-up and dividend tax credit will continue to be in effect in respect of other dividends.

The tax integration system will have important ramifications on business incomes and taxable dividends to be received by private corporations operating in Canada. These ramifications will be more complex for incorporated businesses than in the case of proprietorships and partnerships but the complexity will be merely a trade-off for the limited status obtained with the incorporation of businesses. According to Hoffman, 92004), the tax consequences of Canada integrated tax system on businesses will be of fewer disadvantages than having total liability or no liability for businesses.

Some categories of businesses in Canada are not technically incorporated and therefore have no authority to issue stock. The business structure of the new integrated tax system is relatively new compared to tax systems in other countries and therefore some business owners are making decisions on the kind of business structures they should adopt to avoid paying heavy taxes under the integrated tax system. There are however a few constraints that can be counted on with respect the impact of the new tax system on salaries and dividends.

The first one is that under the integrated tax system, company owners and the company itself are seen as two different entities and therefore taxes will have to be filled for each entity giving rise to the problem of double taxation. The second constraint is that both unincorporated and incorporated businesses have a flow-through taxation type meaning that the entities do not pay taxes on their incomes. In its place, the owners of the companies pay taxes on their distributive shares in the business entity's taxable income. The integrated tax system permits owners of business entities to decide how the income of the company should be allocated between the government and the owners (Hoffman, 2004).

Effect of Salary-Dividend Mix on Dividend Tax Credit

The actual tax amount that a business owner pays in dividends is normally lower than the headline rates as dividends automatically receive certain specified tax credits such as 10%. This dividend tax credit takes into account the fact that a business owner will have already paid corporation taxes on their company profits. Thus for lower rate tax payers, they have no further tax requirements to comply to as the tax credit balances the dividend ordinary rate. However, for higher rate tax-payers, their dividend tax liability rates will be higher. It is thus not surprising that for a number of business owners in countries like Canada, they will receive their incomes in terms of deemed salary instead of dividends (Atkinson, 2007)

It is however important that company directors take reasonable steps to ensure that they do not declare dividends illegally in light of tax and other statutory requirements. If a company and a limited one for that matter declare interim dividend rates, the directors must ensure that the company has got sufficient post-tax profits to cover for the dividends. Failure to factor this may result in borrowing of money from the company resulting in overdrawn loan accounts. The obvious consequence of this misjudgement is that it runs risk of possible questioning and scrutiny from stakeholders and may as well lead to extra tax in case the dividends are reassessed as salary.

Tax Consequences of Incorporation Businesses

The decision to incorporate a business can be based on a number of factors one of which is the need to reduce personal liability. Business owners regardless of the structure of their businesses always want to make sure that their personal assets are protected even if the future of their business is under threat of running insolvent. Another important consideration that motivates incorporations is the tax consequences and implications of those business structures. Majority of business owners base their business decisions on how they can best reduce the negative aspects of taxation and keep as much cash as possible in their personal accounts and reinvest it in the business.

But as Atkinson, (2007) explains, the choice of a business structure would be quite easy if taxation requirements are consistent with the wishes of the business owners. But the reality is that they can vary considerably depending not only on the kind of business structure adopted but also what state the business in as well as the number of shareholders the business has.

Reference

Atkinson, B. (2007), Optimal Taxation and the Direct vs. Indirect Tax Controversy, Ottawa

Hoffman, N, (2004), Fiscal Crises, Liberty, and Representative Government, Vintage Books, Boston

McCluskey, W., (2005) Land Value Taxation: An Applied Analysis, William J. McCluskey Books

Parkin, M., (2006), Principles of Microeconomics, Moss Publishers, New York

Ross, L. (2007). "Does Taxation Lead to Representation?." UCLA Department of Political Science