Question 1: Are there any specific tax exposures that the company may be facing at that they do not seem to have realized?
On the Hart Brakes Ltd. Balance Sheet, there is a balance of $270,000 in Bonuses Payable. Bonuses are typically declared in addition to management salary, to reduce taxable income (via an Income Statement expense), and pay less tax. Since the balance is sitting at $270,000 on December 31, 2013, and we know that Clarence declares himself a bonus of $90,000 per year, the balance is composed of three years’ worth of bonuses. According to ITA 78(4), all bonuses must be paid within 180 days of the end of the taxation year in which it was expensed. Since the balance comprises 2011, 2012, and 2013 bonuses, at least 180,000 (2011 and 2012 bonuses) of the amount must be paid out in 2013 or they would not have been deductible in their respective years. Hart Brakes will have a tax liability from 2011’s bonus because it was not deducted within 180 days after that year end. However, if they pay out the entire $270,000, the bonuses from 2011 and 2013 would be deductible in fiscal 2013, and the 2012 bonus would be correctly deductible in 2012 (provided it was paid within the first half of the year of 2013). This means that the business would have less tax payable, but Clarence would have to include the bonuses in his corresponding personal tax years.
Hart Brakes may also be paying more tax than necessary, since it is preferable for the company to pay salary versus dividends. See calculations below:
*Using Ontario Tax Rates from 2013:
Personal Tax above 135,054 but below $509,000 is taxed at 46.41% + 41817
Personal Tax above 509,000 is taxed at 49.53% +
Corporate Tax for Small Businesses is 15.5%
Current Scenario: $120,000 in Dividends and $180,000 in Salary
Total Tax Payable $179,941
Corporate Tax on Business Income = (0.155) x 480,000 = $74,400
Personal Tax on Salary of $180,000 = $41,817 + (180,000-135055) (0.4641) = $62,676
Personal Tax on Dividend = 120,000 x 1.25 = 150,000 Tax Payable before Credits = (150,000) (0.4641) = 69,615 Federal Dividend Tax Credit = (20,000) Prov. Dividend Tax Credit = (6750) Tax Payable = $42,865
Proposed Scenario: All salary and no dividends (total of $300,000)
Total Tax Payable $174,168
Corporate Tax on Business Income of $480,000-120,000 of additional salary deduction = (0.155) (360,000) = $55,800
Personal Tax on Salary of $300,000 = (300,000 - 135,055) (0.4641) = $118,368
Conclusion:
Although this is not specifically a tax exposure, Clarence Hart and Hart Brakes Ltd. could be paying less overall tax if they restructure their salary and dividend amounts.
Question 2: What are the different ways that Clarence can handle compensating John for the value of his shares (value = 1,600,000)? What are the tax consequences of each?
Option 1: Take money from Clarence’s RRSPs to Buy John’s Shares?
Income withdrawn from an RRSP must be included in one’s income in the year that it is deducted. If Clarence withdraws the required $1.6 million from his RRSPs to pay for the shares, he will have to pay a great amount of tax on this “income” when he prepares his personal tax return for 2013. Clarence’s income for the year would be taxed at the highest personal tax rate in Ontario of 29% + 20% = 49%. This is not a great option for purchasing John’s shares because an additional tax of $755,731 will be assessed on his income tax return.
Calculation = 41817 + (509,000 – 135,055)(0.4641) + (1,600,000-509,000)(0.4953) = $755,731
There are some benefits of an RRSP, however these do not apply to Clarence Hart’s situation.
When purchasing a home for the first time, up to $25,000 can be withdrawn tax-free, so long as you