How Income Tax Works

In an attempt to save myself a ton of grief I am going to endeavor to explain how corporate and personal taxes work and the interaction between the two.  In order to properly explain all of this I will first give you some perspective.

Employees

When you are an employee you don’t get all your money.  Your salary may be $100,000 per year, but the total cash you actually receive is only $80,000.  The difference is sent to the government for payment of taxes.

When you file your income tax return you report $100,000 as income and report the $20,000 as taxes withheld, and then you either pay more or get a refund.  Oversimplification?  Yes, but you get the idea.

Corporations (small business)

Corporations pay tax at a lower rate than individuals because in theory there are no personal expenses.  In addition, at the end of the day a corporation is merely a means of running a business so that individuals can eventually get paid.  Amounts paid to individuals are taxed at personal tax rates.  And this is where the problems start.

Shareholders of Corporations

Shareholders are usually paid dividends and these dividends do not have any taxes withheld, which means if you are receiving dividends you WILL owe personal taxes.  The taxes you pay will be reduced by the dividend tax credit (corporate taxes paid by the corporation).  At the end of the day the net result of being a shareholder of a small business corporation is that between your personal taxes and the corporate taxes you will effectively pay personal rate income tax on any money you receive from the corporation.  THERE IS NO DOUBLE TAXATION!!!!!!

Owner / Employee / shareholder of Small business corporation

Most small business owners don’t want to put themselves on payroll (calculate and remit source deductions to the CRA monthly).  As a result when they take money from the corporation they get 100% of the funds.  The problem is that since no taxes have been sent in to the government people often have trouble paying their taxes.  What often happens is that more funds are removed from the corporation to pay the personal taxes.  This causes further confusion in that people are confused by why they have to pay additional income tax on the money they are sending to the government for their personal taxes.  The answer is contained in the point above called “Employees”.  You got more cash than you should have.  Employees only get about 80% of the actual salary amount, where as individuals described in this paragraph are getting 100% of the funds and are not remitting income tax.  At the end of the day to put this in perspective you should be reporting on your income tax return the amount of money you took out plus the taxes that should have been sent in to the CRA.  In short, if you took out $100K then your actual income is probably closer to $120K, once you factor in the income taxes that still need to be paid.

Summary

Most of you who read this will think I am wrong because what I am telling you is not what you want to hear.  But like it or not, I am right.  If you require further explanation, I highly recommend that you come in and see me so that we can discuss your unique situation.