For those of you who have a family business and thinking about incorporating, there is a tax strategy that you can use to your advantage that will minimize the overall taxation of company income. It’s called “Dividend Sprinkling”.
We’ve mentioned dividend sprinkling briefly before in the discussion about holding corporations, but lets explain it with a bit more detail.
What is dividend sprinkling
Dividend sprinkling is where family members are given shares of a private corporation setup with the intention of paying dividends to the members with the lowest tax bracket. The result is that the corporate income gets paid to the family at the lowest tax rate possible.
Why use this strategy?
In my previous article about taxation of private corps, we concluded that when money is withdrawn from a private corporation, the net taxation is about the same as if the company was a sole proprietorship. However, that was assuming that all the of income was withdrawn under the one shareholder/owner.
With the dividend sprinkling strategy, the director can “declare” dividends for specific classes of shares while excluding others. That is, if one spouse/shareholder makes less income than another thus in a lower tax bracket, then simply declare dividends for that shareholder only
How to set up dividend sprinkling?
When creating a private corporation, the business owner has the option of setting up the share structure in any way that they see fit. In this case (check the rules of your province/jurisdiction):
- The majority owner/director would be assigned common shares
- The spouse is assigned non-voting Class A Preferred Shares
- Any other family members are assigned non-voting Class B, C and so on. Note though that if dividends are distributed to children under the age of 18, there is a “kiddie tax” which taxes dividends at the highest possible rate.
A lawyer would help greatly with structuring your private corporation to take advantage of dividend sprinkling.
An example of the tax benefits
Lets assume that there is a new company to be setup, ABC Inc. in Ontario. Wife is the director/business owner and at a higher tax bracket than husband. Common shares would be assigned to Wife while non-voting Class A Preferred shares would be given to Husband. Assume that Wife makes $60k/year while Husband makes $30k/year.
If they wanted to withdraw $20k from the company to pay down the mortgage (assuming that the company is cash flow rich) in the form of a dividend, the director would declare a dividend for the class A shares (husband) only, the lower income spouse. If the dividend was declared for the common shares (wife), the tax on the dividend would be approximately $4,108. On the other hand, if the dividend was declared for Class A shares (husband), then the tax on the dividend would be about $2,733, a significant difference of $1,375 more in pocket. Do this a few times over the years and the savings are quite substantial.
While it may take a bit more work to setup a corporation with proper share structure, it is well worth it if there is a significant difference in income between spouses. As I mentioned before, it is recommended that you consult with an experienced lawyer to setup your private corporation properly.