Taxation II Notes

Ms. Morgan wishes to receive $20,000 after-tax from her corporation for a vacation If Ms. Morgan is to receive salary exclusively: After tax retention = $20,000 desired after-tax funds (1 – . 41) = $33,898 salary required from the company If Ms. Morgan is to receive dividends exclusively: Her personal tax rate is: (1. 25)(41%) – (2/3 + 25%)(25%) = 28. 33% total taxes payable After tax retention rate = $20,000 desired after-tax funds (1 – . 2833) = $27,906 dividend required from the company (after corporate taxes have been paid) The corporation must earn pre-tax income of $32,831 ($27,906 ? [1- . 15]) in order to pay Ms.

Morgan a dividend of $27,906. In Conclusion: The dividend option requires that the corporation forfeit less of its earnings to meet Ms. Morgan’s request for vacation money: $33,898 salary vs $32,831 dividend This situation can also be examined by looking at which option has the highest tax cost: Under the Salary Option: The Corporation saves tax on the salary expense: [(15%)($33,898)]( 5,085) Ms. Morgan pays taxes on the salary: [(41%)($33,898)] $ 13,898 The net Tax Cost of the salary alternative $ 8,813 Under the Dividend Option: The corporation is already paying tax on all income, therefore there is no change Nil Ms.

Morgan pays tax on the dividend$ 7,906 The net Tax Cost Of the Dividend alternative $ 7,906 Therefore, from a tax cost perspective, the salary option is $907 more expensive Solution to Assignment Problem 15-10 Facts: Robert Lucas is the sole shareholder of Speelburg Films Ltd. , a CCPC with a December 31 year-end. For 2013, Speelburg’s Taxable Income before salaries or dividends is $123,000 – all active business income. Due to large capital expenditures, the total cash available for payment of income taxes, dividends or salaries is only $49,000. Mr. Lucas spends all his effort on Speelburg and, therefore, has no other source of income.

He has tax credits of $3,900 available. Other Information: His province levies 6% income taxes on personal income up to $43,561. His province provides a tax credit equal to 35% of the gross-up on eligible dividends and 30% on ineligible dividends. All of the company’s activities are in a province that levies 3% tax on income eligible for the small business deduction. Part A: Determine the after-tax amount of cash that Mr. Lucas will retain if all of the company’s cash is used to pay taxes and salary. The combined federal/provincial tax rate applicable to Speelburg Films Ltd. would be 14% = (38% – 10% – 17% + 3%).

The amount of cash available ($49,000) must pay the taxes on $123,000 corporate taxable income and the rest will be Mr. Lucas’s salary. Therefore, let ? be the maximum amount of salary that can be paid. Solving for ? : ? = $49,000 – [(14%)($123,000 – ? )] ? = $36,953. This can be verified by the following calculation: Corporate Taxable Income Before Salary $123,000 Maximum Salary ( 36,953) Corporate Taxable Income After Salary $ 86,047 Corporate Tax @14% = $12,047 This leaves $36,953 ($49,000 – $12,047) available for payment of salary. Mr. Lucas would have the following amount of after tax cash: Salary Payment $36,953.

Tax Before Credits [(15% + 6%)($36,953)]( 7,760) Personal Tax Credits (Given) 3,900 After Tax Cash Retained (All Salary) $33,093 Part B: Determine the after-tax amount of cash that Mr. Lucas will retain if all of the company pays the maximum dividend. Solution: Dividend payments are not deductible to the Company, thus Corporate taxes @(14%)($123,000) will be $17,220. This leaves available cash of $31,780 ($49,000 – $17,220) for the payment of ineligible dividends. Mr. Lucas after-tax retention will be as follows: Ineligible Dividends Received $31,780 Gross Up [(25%)($31,780)] 7,945 Taxable Dividends $39,725.

Personal Tax Rate (15% + 6%) ($39,725)( 8,342) Personal Tax Credits (Given) 3,900 Dividend Tax Credit [(2/3 + 30%)($7,945)] 7,680 Tax Payable Nil As there is no Tax Payable, Mr. Lucas will retain all of the $31,780 in dividends. Part C: Deficit/Unused tax Credits($3,238) There may be an optimal solution combining payment of salary and dividends. Part D: Optimizing salary and dividend payments to the individual: Increase In Salary $1,000. 00 Decrease In Dividend [($1,000)(1 – . 14)] ( 860. 00) Decrease In Dividend Gross Up [(25%)($860. 00)] ( 215. 00) Decrease In Mr. Lucas’ Taxable Income ($ 75. 00).

Decrease In Tax Payable @ (21%)($75. 00)($ 15. 75) Decrease In Dividend Tax Credit: [(2/3 + 30%)($215. 00)] 207. 83 Net Increase In Personal Tax Payable $ 192. 08 Thus, the rate on a $1,000 increase in salary is 19. 208% ($192. 08 ? $1,000). The unused credits of $3,238 = a required increase in salary of $16,858 . 19208 Thus: Corporate Taxable Income $123,000 Salary ( 16,858) Corporate Taxable Income After Salary $106,142 Corporate Tax @ 14%( 14,860) Cash Available minus [Corporate Tax and Salary] equals Dividend Payable = $49,000 – $14,860 – $16,858 = $17,282 After tax retention to Mr. Lucas: Ineligible Dividends Received $17,282.

Gross Up [(25%)($17,282)] 4,321 Salary 16,858 Mr. Lucas’ Taxable Income $38,461 Personal Tax (15% + 6%) $ 8,077 Personal Tax Credits (Given) ( 3,900) Dividend Tax Credit: [(2/3 + 30%)($4,321)] ( 4,177) Tax Payable Nil Amounts Received ($17,282 + $16,858) $34,140 Personal Tax Payable Nil After Tax Cash Retained (Salary And Dividends) $34,140 Comparison of Alternatives: All Salary $33,093 All Dividends $31,780 Salary/Dividend Combination $34,140 Part E – Other Factors:

The Canada employment tax credit was ignored in the calculations as it is not a credit against provincial taxes. However, it would allow the first $1,117 of salary to be received with a nil federal tax cost. If the effect of CPP was considered, both Mr. Lucas and Speelburg Films Ltd. would pay CPP contributions if salary was paid.

Paying CPP contributions would allow him to receive CPP payments in the future, but would require both a personal and a corporate cash outflow at the present time. If Speelburg Films Ltd. has benefits for employees, such as a private health services plan, this could make being an employee (by taking salary) more advantageous. Dividend payments are not Earned Income for purposes of making RRSP contributions or deducting child care costs.

If Mr. Lucas has a CNIL balance, dividend payments will serve to reduce this constraint on the lifetime capital gains deduction. Mr. Lucas should consider declaring a bonus (a form of salary) to be paid after the end of the calendar year if he does not require the cash immediately. This would defer the personal taxes without affecting corporate taxes as long as the bonus was paid within 180 days of December 31. Though not relevant in this problem, some provinces have payroll taxes which could be incurred. Assignment Problem 15-6 Facts: Ms. Joan Wells can join a partnership as the 5th partner in one of three ways: 1.

As an individual partner 2. As a corporation which pays all income as a dividend 3. As a corporation which pays amounts over the annual limit as a salary and the rest as a dividend The partnership income for the year is $725,000 If Ms. Wells incorporates, her share of the annual limit is $100,000 Approach 1 Joan Wells’ share of the partnership income would $145,000 [(20%)($725,000)]. The Tax Payable on this income would be calculated as follows: Federal Tax On First $132,406$ 28,020 Federal Tax On Next $12,594 At 29%3,652 Provincial Tax [(12%)($145,000)]17,400 Tax Payable Before Credits$49,072.

Personal Tax Credits – Given( 3,920) Tax Payable$45,152 The total after tax income is $99,848 ($145,000 – $45,152). Approach 2 The total corporate taxes would be: First $100,000 At 14 Percent$14,000 Remaining $45,000 At 29 Percent13,050 Total Corporate Tax$27,050 Corporate Income$145,000 Less Corporate Tax( 27,050) Dividend Payable$117,950 GRIP balance of [(72%)($45,000)] Results in an eligible dividend of$ 32,400 Non-Eligible Dividend$ 85,550 Joan’s Taxable Income would be: Eligible Dividend$ 32,400 Gross Up at 38 Percent12,312 Non-Eligible Dividend85,550 Gross Up at 25 Percent21,388 Total Taxable Income$151,650.

Her Tax Payable would be as follows: Federal Tax On First $132,406$ 28,020 Federal Tax on $19,244 @ 29%5,581 Provincial Tax [(12%)($151,650)18,198 Tax Payable Before Credits$51,799 Personal Tax Credits – Given( 3,920) Dividend Tax Credits: [(6/11 + 28%)($12,312)] ($10,163) [(2/3 + 28%)($21,388)( 30,410) Tax Payable$17,469 After tax income is $100,481 ($32,400 + $85,550 – $17,469). Approach 3 The corporation pays $45,000 in salaries to reduce corporate income to its $100,000 share of the small business deduction. Corporate Income$145,000 Less Salary( 45,000) Corporate Taxable Income$100,000 Corporaste Tax @14%( 14,000).

Non-Eligible Dividend Payable$ 86,000 Joan’s Taxable Income would be: Salary $ 45,000 Non-Eligible Dividend86,000 Gross Up at 25%21,500 Taxable Income$152,500 Joan’s Tax Payable would be: Federal Tax On First $132,406$ 28,020 Federal Tax on $20,094 @29%5,827 Provincial Tax [(12%)($152,500)18,300 Tax Payable Before Credits$52,147 Personal Tax Credits – Given( 3,920) Dividend Tax Credit: [(2/3 + 28%)($21,500)( 20,353) Tax Payable$27,874 After tax income is $103,126 ($45,000 + $86,000 – $27,874). Evaluation The after tax amount retained for each of the three approaches is as follows: Approach 1 (Joins as Individual) $ 99,848.

Approach 2 (All Dividends) $100,481 Approach 3 (Salary & Dividends) $103,126 Analysis of Alternatives: The difference between the lowest and highest after-tax retention is $3,278 ($103,126 – $99,848). What would be the cost of the annual legal and accounting services need for the corporation? Once that is taken into account, the difference between the options may be irrelevant. How old is Ms. Wells? The all salary option would provide her with an opportunity to invest more into her RRSP, since only salary is “earned income”. That may hold more appeal to an older client than the few extra dollars under Approach 3.