During my last net worth update, I wrote a little bit about our strategy on getting cash out of a privately owned corporation in a tax efficient manner. While it’s tax efficient to have retained earnings within a corporation, the goal is to extract cash by the most tax efficient means possible. One way to do this is to pay personal tax deductible expenses with dividends from the corporation.
I’ve actually touched on this topic before on using your business to pay for charity donations with the idea that non-eligible dividends are taxed less than the actual tax deduction. The strategy is to arbitrage the income tax rate on the dividends, with the tax deduction on the personal expense. The end result is that the shareholder can withdraw more in dividends than what’s required to pay the expense, and pay no tax on the withdrawal from the company.
Charity Donation Example
There’s no better way to show this than an example. Say that Mr. Owner, from NL, typically donates $10,000 annually to his favorite charity. Instead of using his own cash flow, he can pay himself a dividend from his company, then use the dividend cash to pay for his donation.
The donation tax credit will more than offset any income tax payable on the dividend received. In this case, since the donation tax credit is calculated at the top marginal rate (on amounts greater than $200), there is a significant spread between the donation tax credit and the tax rate on the dividend. This simply means that Mr. Owner is able to withdraw more out of his company via dividends than what he will pay the charity, keep the difference, all while paying no additional income tax.
How much more can he withdraw? It depends on his overall income after the dividend withdrawal. On the conservative side, the worst case scenario is that he is already in the top marginal tax bracket which means that that his non-eligible dividend rate is 29.96% (via taxtips).
Ready for some numbers? With the dividend tax credit calculated at the top tax rate (42.3% ) which is about 41.2% greater than the dividend tax of 29.96%, it means that the dividend withdrawn can be 41.2% greater than the charity contribution. In this case, Mr. Owner can withdraw $14,230 from his company via dividend, donate $10,000 to his favorite charity, and keep the difference tax free.
Approximate dividend withdrawn from company = (Charity Donation Amount * Top marginal rate)/dividend tax rate
For charity donations, the lower the dividend tax rate/marginal tax bracket, the more effective this strategy becomes as the spread between the donation tax credit and the non eligible dividend tax increases.
RRSPs and Other Tax Deductions
For regular RRSP contributions or other tax deductible expenses, the tax refund is approximately the contribution * marginal tax rate. In this case, the formula is:
Approximate dividend withdrawn from company = (Tax Deductible Expense * Marginal tax rate)/dividend tax rate
So say Mrs. Owner (in NL) makes an RRSP contribution of $5,000 with a marginal tax rate of 27.5% and a non-eligible dividend tax rate of 11.46%. Using the formula, she could withdraw almost $12,000 from the corporation, deposit $5,000 into her RRSP, and keep the remaining $7,000 without paying any additional personal tax.
Note that the formulas above are an approximation as the dividend withdrawn, depending on how large, can bump the shareholder into the next bracket. This post is more of an illustration rather than a recommendation on how much to withdraw per tax deductible cost. Best bet would be to use an online tax calculator to figure out your overall picture and determine how much in dividends that you can take out after counting all deductions.
For you business owners out there, what strategies do you use to get cash out of the corp?
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