Introduction
In small privately held companies in Canada, it is common for employees to also be shareholders. For example, you can think of family businesses where the family members are usually active in running the business while also being the main (or only) shareholders.
This dual role can offer several advantages, including a stronger sense of ownership and alignment with the company’s goals. However, determining the most effective and tax-efficient methods for paying money out to these employee-shareholders is a crucial consideration. In this article, we will explore the various options available for distributing funds to employee-shareholders in privately held Canadian companies.
Repayment of Shareholder Loans
Definition and Process
It is very common for shareholders to loan funds to the corporations that they own. We refer to those as “shareholders’ loans”. Shareholders’ loans most often occur early in the life of a company, when the founders/shareholders are putting money into the company to get it off the ground. Shareholder loans are also common when companies hit hard times and need additional cash resources quickly—for example, to make payroll or to pay a critical supplier—and no better options are available.
Tax Implications
The beauty of repaying shareholder loans is that it is tax-free. So, if excess cash in a company is available to be paid out to shareholders, it should first be used to repay any outstanding shareholder loans.
Dividends
Definition and Process
Dividends are a common method of distributing profits to shareholders. In Canada, dividends can be paid in cash or by issuing additional shares. Dividends are essentially paid out of excess cash in the business.
Corporate law in Canada is very strict about when dividends can be paid out; dividends can only be paid out when (1) the company would have enough liquidity, after the dividend payment, to pay its outstanding liabilities when they become due, and (2) the company’s assets would, after the dividend payment, still be greater than the company’s total liabilities and the capital paid by its shareholders to acquire their shares.
Dividends are only supposed to be paid out if the directors of the company pass a resolution issuing the dividend and authorizing the payout. Companies can use the Tobuso platform to generate the necessary resolutions, have them signed, and keep them in the company’s up-to-date digital minute book on the platform.
Tax Implications
For individual shareholders, dividends are generally taxed at a lower rate than salary or bonus income. This is due to the dividend tax credit, which reduces the overall tax liability on dividend income. However, the tax treatment of dividends can vary depending on the province or territory.
Salaries and Bonuses
Definition and Process
Employees who are also shareholders can receive compensation in the form of salaries and bonuses. Salaries are regular payments for services rendered, while bonuses are typically one-time or performance-based payments.
Tax Implications
Salaries and bonuses are considered employment income and are subject to regular income tax rates. This means that they are generally taxed at higher rates compared to dividends. However, salaries and bonuses are also deductible expenses for the company, reducing its taxable income.
Share Buybacks and Redemptions
Definition and Process
Share buybacks involve a company repurchasing its own shares from shareholders. Share redemptions involve a company paying the price set for redeeming such shares to cancel out or redeem those shares effectively. Either can be an effective way to return value to shareholders, including employee-shareholders. The repurchased shares can either be cancelled or held in treasury.
Share buybacks and redemptions are similar to dividends because they can only occur when a corporation meets the liquidity and asset tests described above (in the dividend section), and a directors’ resolution should be passed to authorize them. Similar to dividends, the tobuso.ca platform can generate the appropriate resolutions and keep a company’s minute book up to date.
Tax Implications
From a tax perspective, share buybacks might be considered a capital transaction or a deemed dividend. If considered a capital transaction, then the capital gain or loss from the buyback is determined based on the original cost of the shares and the repurchase price. If considered a deemed dividend, then the proceeds will be taxed as dividends to the employee- shareholder. Employee-shareholders will need to consult with their tax advisors about the tax treatment.
Documenting Payouts
It is critical to keep accurate and complete records of all payouts from the company to shareholders, regardless of which payout method is used. There are a few reasons for this:
- If you get audited by the Canada Revenue Agency (CRA), and you do not have clear records, then the CRA is most likely going to treat the payment as employment income, which has the least favourable tax treatment and also carries with it payroll tax remittance and reporting obligations; and
- It’s always a good idea to keep a clear record of these payouts to know where the company’s money is going and avoid shareholder disputes.
The Tobuso platform is a perfect place to create and store these records. Your digital minute book at tobuso.ca has tabs specifically for keeping records of the payouts. As described above, you can also use the platform to generate all the documents you need to document the payouts appropriately. It’s easy and can save a lot of headaches down the road.
Conclusion
When it comes to distributing funds to employee-shareholders in privately held Canadian companies, there are several options to consider. Each option has its own advantages and tax implications, and the most suitable method will depend on the company’s specific circumstances and the preferences of its shareholders. It is recommended that companies seek professional advice from tax experts or financial advisors to navigate the complexities and make informed decisions regarding payouts to employee-shareholders. By carefully considering the available options, companies can effectively balance rewarding their employees and preserving the financial health of the business.
