Many owner managers include dividends in their compensation arrangements. Dividends have a more favourable tax treatment personally because they are paid by the corporation from after-tax profit; this means that the corporation pays taxes at the corporate rate before distributing any dividends.
In addition, dividends do not require:
- The payment of any taxes withheld to the Canada Revenue Agency (CRA); or
- Any Canada Pension Plan (CPP) payments.
A major issue with dividends is that they should not be paid out when there is negative retained earnings (retained earnings is in a deficit).
Retained earnings are defined as the accumulated earnings of an incorporated company since its inception. Retained earnings are simply the total of each year’s net income or net loss since the company has been in operation. The value of the retained earnings increases in a year when the company earns net income and decreases in a year when the company incurs a net loss. When a dividend is declared and paid, retained earnings are reduced by the amount of the dividend.
Dividends can only be declared and paid:
- If a company has positive retained earnings; and
- Only up to the amount where the retained earnings are brought down to zero.
It is possible to declare and pay a dividend in a year that a company has incurred a net loss, as long as the retained earnings balance is at least zero after the dividend is factored into retained earnings. In this case, dividends could be declared and paid due to the net income earned in prior periods.
As a general rule, you cannot dividend out more earnings than the company has made?
However, If a company is wrapping up its operations, then it can make a dissolution or liquidation dividend payment to shareholders regardless of the condition of retained earnings. In this situation a company can pay a dividend with negative retained earnings or that will put retained earnings into a negative position.
Note that in the vast majority of cases, a company cannot pay a dividend with negative retained earnings or that will put retained earnings into a negative position.
It is advisable to seek professional advice to understand the tax laws that impact your particular situation, and to guide you through the complexities of Canadian Income taxes.
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