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Corporate Taxation: Tax Integration of Active Business Income

June 19, 2017 - 4 comments

In my last blog post, I introduced the wild world of corporate taxes, illustrating how an Ontario business owner could end up paying only 15% in combined federal and provincial corporate taxes. If this amount seems low to you, fear not. The government has a way of making sure everyone pays their relative due by having corporate shareholders perform personal and corporate tax integration.

Big picture, here’s the end goal: Once a corporation’s after-tax business income is distributed to its shareholders and personal taxes are paid on the proceeds, each taxpayer’s combined corporate and personal taxes should come out about the same as if he or she were a “regular” taxpayer. Admittedly, the results ain’t always perfect, but they usually come pretty close.

Would you like to see how this sausage gets made? Let’s grind out the calculations.

We’ll begin by assuming that our sample taxpayers are in Ontario’s highest marginal 2016 tax bracket. That is, they’ve already exceeded $220,000 in other income, so the dollars illustrated here are in addition to that. This makes the math a little easier. In this context, let’s compare an individual earning an additional $100,000 of personal income, versus someone who’s received an extra $85,000 through a non-eligible corporate dividend. (I’ll explain in a moment why, tax-wise, these are comparable figures.)

Scenario 1: Income earned personally

In Ontario, a taxpayer in the top 2016 tax bracket would pay 53.53% in taxes on any additional income. In our example, the $100,000 of income earned personally by an individual would incur $53,530 of taxes, leaving the taxpayer with $46,470 of after-tax cash. Pretty simple.
Income earned personally

Income earned personally

General Formula Amount Calculation
Personal income $100,000  
Deduct:
Personal tax payable
($53,530) $100,000 × 53.53% (Ontario)
Equals:
After-tax cash
$46,470 $100,000 - $53,530

Source:  KPMG 2016 Personal Tax Rates

 

Scenario 2: Income earned through a corporation

As we reviewed in my last blog post, active business income eligible for the small business deduction is levied federal taxes of 10.5%. In Ontario, the combined federal and provincial corporate tax rate is 15% (or $15,000 on $100,000 of active business income). The after-tax business income of $85,000 can then be distributed to shareholders as a non-eligible dividend, which is taxed in their hands. A few adjustments are required to ensure the business owner is no better or worse off than if they had earned the income personally.

Totally grossed up

Once the dividend has been distributed to the shareholder, it must be grossed-up before being taxed. The gross-up is 17% for non-eligible dividends.

In our example, 17% of $85,000 is $14,450. These amounts are then added together to equal the taxable dividend of $99,450. (See what I mean about how $85,000 in non-eligible distributions approximately equals $100,000 of personal income?) Personal income taxes of 53.53% are then levied on the taxable dividend amount, resulting in a tax bill of $53,236.

Giving credit where credit is due

If we stopped right there, the corporate business owner would pay combined corporate and personal taxes of $68,236 ($15,000 corporate + $53,236 individual). Whoa, that’s significantly higher than the $53,530 of taxes payable by the individual in Scenario 1.

No fair! Luckily, federal and provincial dividend tax credits come to the rescue to help offset the corporate taxes already paid.  

First, there’s a federal dividend tax credit for non-eligible dividends. In 2016, that was 10.5217% of the grossed up personal income: $99,450 x 10.5217% = $10,464 credit.

Then there’s the Ontario dividend tax credit for non-eligible dividends, which was 4.2863% in 2016: $99,450 x 4.2863% = $4,263 credit.  

Combined, you get $10,464 + $4,263 = $14,727 in credits, which is mighty similar to the $15,000 of corporate income taxes already levied. After deducting these dividend credits from the personal taxes payable of $53,236, we end up with net personal taxes of $38,509.

Corporate personal combo

Our sausage-making is nearly complete: $15,000 of corporate taxes paid plus $38,509 of personal taxes due equals $53,509, with $46,491 of after-tax cash to stash. Voila! That’s almost identical to the $53,530 of personal taxes and $46,470 in remaining cash from our Scenario 1 taxpayer. Believe it or not, there’s usually a method to all that tax-planning madness.

Here’s a summary of the results.

Income earned through a corporation

General Formula Amount Calculation
Active business income $100,000  
Deduct:
Corporate tax payable
($15,000) $100,000 × 15% (Federal + Ontario)
Equals:
After-tax business income
$85,000 $100,000 - $15,000
Dividend distributed to shareholder $85,000  
Add:
Dividend gross-up (17% ineligible dividend rate)
$14,450 $85,000 × 17%
Equals: $99,450 $85,000 + $14,450
Taxable dividend    
Deduct:
Personal tax payable
($53,236) $99,450 × 53.53% (Federal + Ontario)
Add:
Federal dividend tax credit
$10,464 $99,450 × 10.5217% (Federal)
Add:
Provincial dividend tax credit
$4,263 $99,450 × 4.2863% (Ontario)
Equals:
Net personal tax payable
($38,509) $53,236 - $10,464 - $4,263
     
Equals:
After-tax cash
$46,491 $100,000 - $15,000 - $38,509

Sources: KPMG 2016 Corporate Tax Rates, KPMG 2016 Personal Tax Rates

 

That was some fun, huh? Today’s post was all about earnings distributed to shareholders. What about those earnings that you put to work generating interest income within your corporation? These are also typically integrated, to level the playing field between business owners and individual taxpayers. In my next post, I’ll show you how that’s done.

Appendix:  2016 Provincial/Territorial Personal and Corporate Tax Integration

Example:  $100,000 of Active Business Income Eligible for the Small Business Deduction

Province or territory Top marginal tax rate (%) Top non-eligible dividend rate (%) Tax rate on small business active income (%) Corporate savings or (cost)
Alberta 48.00% 40.24% 13.50% ($313)
British Columbia 47.70% 40.61% 13.00% ($630)
Manitoba 50.40% 45.74% 10.50% ($1,038)
New Brunswick 53.30% 45.81% 14.12% ($164)
Newfoundland and Labrador 49.80% 41.86% 13.50% $91
Northwest Territories 47.05% 35.72% 14.50% $2,011
Nova Scotia 54.00% 46.97% 13.50% ($132)
Nunavut 44.50% 36.35% 14.50% ($1,079)
Ontario 53.53% 45.30% 15.00% $21
Prince Edward Island 51.37% 43.87% 15.00% ($917)
Saskatchewan 48.00% 39.91% 12.50% $579
Yukon 48.00% 40.17% 13.50% ($252)

Sources: KPMG 2016 Corporate Tax Rates, KPMG 2016 Personal Tax Rates

 

By: Justin Bender with 4 comments.
Comments
  11/08/2017 11:14:54 AM
Justin Bender
@Alex: Thanks for the feedback (and for the interesting Canadian small business stats)! Once I’ve laid the foundation for the corporate tax calculations, we’ll start getting into the fun ETF side of things ;)
 
  09/08/2017 2:40:22 PM
Alex
Thanks Justin!

Great idea with this series of posts, I think it fills an information gap.
I've been following your and Dan's posts and podcasts, and although one can find disparate info and opinions on the Couch Potato and other websites, nothing as well put together as this is shaping up.

I have a small business as well and I'm very interested on the most efficient way to build a Couch Potato portfolio split between personal and corporate accounts. I was actually thinking mostly equity in registered personal accounts, especially TFSA, and something like HBB on the corporate side.
I look forward to your next posts.
Cheers!

As of December 2015 Canada has 1,143,630 small businesses out of which about half have 1-4 employees.
Cheers to that too!
 
  07/07/2017 4:46:50 PM
Justin Bender
@Chris: I’m glad that you’ve been enjoying the series – stay tuned for more posts! :)
 
  04/07/2017 2:14:43 PM
Chris
Hey Justin, thank you. This series is brilliant!

As a small business owner in Ontario, I'm in the process of trying to understand where I should invest my money FROM given that it's spread between RRSP, TFSA, operating company and holding company.

I'd like to follow an index investing strategy like yours and Dan's so it's looking like Bonds in the RRSP/TFSA and Equities in the Opco/Holdco's investing accounts.

This ties into the question, how much should I pay myself via dividends vs leaving in the business to invest from there.

Your articles on corporate tax are really helping me understand the pros and cons and getting me closer to answering that question. Thanks!
 



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