dave@lsuc.uucp (David Sherman) (12/21/88)
If you've ever received dividends on a corporation's shares
(whether a publicly-traded corporation or a private corporation
such as an incorporated small business), you may have wondered
why all kinds of funny things happen to the dividend on your tax
return. Here's a quick explanation of what's going on.
Dividends are paid out of a corporation's after-tax income.
That is, they represent distribution of profits to the
owners (shareholders) of the corporation, and so they're not
a deductible expense. The income which is earned to pay a
dividend has already been taxed at the corporate level.
So, when you receive a dividend, tax has already been paid.
Should you pay yet more tax on the dividend? It depends.
The system is design to "integrate" the taxation. The underlying
principle is that, for a small business, it shouldn't matter
whether you run your business as an unincorporated proprietorship
and pay tax on it directly (as an individual), or have the business
incorporated and have the corporation pay you dividends. In other
words, the tax system should be neutral, neither encouraging nor
discouraging incorporation (which will often be appropriate for
other reasons, such as limited liability).
Yet there has to be some corporate tax, or you'd just leave
the profits in the corporation forever, never paying tax
until you actually withdrew the funds to use them.
The "integration" is accomplished by a two-step feature on your
personal tax return, called the "gross-up and credit". The built-in
assumption, as of 1988, is that the corporation's tax is at a
20% rate. (In fact, it can vary widely, but for small businesses
in Ontario it's normally 22.36%.) With the gross-up, you include
in your income on your tax return 5/4 of the actual dividend
received (i.e., add 25% to the dividend, so if you received
$80 you report $100). This grossed-up amount is in theory the
original corporate income earned (i.e., the $100 needed to be
able to pay you an $80 dividend after 20% tax).
Then you calculate your tax based on whatever bracket you're in,
and deduct, as a credit against tax, the amount of the gross-up.
What you're deducting is, in theory, the same $20 that the
corporation originally paid in tax. So the corporate tax
operates as a prepayment which you get back, and you pay
tax on the business's income at the same rate as if you had
earned it in an unincorporated business.
It's all kind of neat when you understand it; it fits
together quite nicely. Technically, the dividend tax
credit is 2/3 of the gross-up (i.e., 2/3 of the $20, or
$13.33). But it's a federal credit which applies before
the provincial tax is calculated, and the provincial tax
is roughly 50% (51% in Ontario in 1988) of the federal
tax, so the extra $6.67 or comes to you in the form of
a reduced provincial tax bill. (Quebec is different.)
There are a couple of deliberate holes in the system.
If you have dividends from a public corporation, which
may have paid 45% of its income in tax instead of 20%,
you still get the same credit, so effectively the income
is taxed twice. That's one of the penalties of being
a public corporation. And if you have so little income
that the credit is worthless to you (you wouldn't pay
tax anyway), the credit isn't refunded, so effectively
the corporate tax becomes the ultimate tax rate on that
income, rather than your (lower) personal rate.
So, the next time you hear stories about how someone
can earn X dollars from dividends and "pay no tax",
think again. The income's already been taxed in the
corporation. As it is, the dividend tax credit has
been substantially reduced (it used to assume a
corporate rate of 33.33% and refund accordingly; for
1987 it became 25%, then 20% for 1988 and beyond).
David Sherman
Tax Lawyer
--
Moderator, mail.yiddish
{ uunet!attcan att pyramid!utai utzoo } !lsuc!dave