Kim asked:

My friend recently incorporated his business and I am the one who does the bookkeeping. He withdraws a certain amount of money from his business. How do I record it? Is he allowed to draw money the same way as in a partnership or sole proprietorship? If this is considered a salary, is it insurable earnings?

Dave Rickards answered:

There are differences between proprietorships, partnerships, and corporations. With a proprietorship you can basically draw money out of those as you see fit. What is taxable for tax purposes is not the money you're drawing out. The income is calculated either at the partnership or proprietorship level and then that is basically, allocated to the individual partner or proprietor. That person then includes that income on their individual return for taxes.

The cashflow is just that, it does not necessarily reflect income. In fact for the proprietorship, or the partnership, even if the individual didn't draw any cash throughout the year there would still be income from the proprietorship or partnership that the individual would have to pay tax on. Income out of a proprietorship or partnership is not insurable earnings.

A corporation is a separate and distinct entity. The corporation documents it's income, which, if not distributed to the owner, or it's employees then that income is taxed at the corporate level.

When the owner of the company draws money out of that company, in the absence of noting it as compensation or as a dividend, then amount is just a loan or a draw. There are adverse tax consequences to a shareholder or company who, in effect, draws money out of the company creating a shareholder debit balance. To the extent that you can, you want to avoid that. What that means is that you either have the shareholder set themselves up as an employee and pay themselves a salary, that would be regular compensation subject to all of the regular with holdings.

Alternatively, often in small business you don't necessarily want to have the shareholder set-up as the regular salary because you don't know how much it's going to be so what they'll do is pay periodic income by way of a bonus. Rather than having a weekly salary they'll pay themselves once a month, or even once a year. Of course the bonus is subject to withholdings, the way that the salary is, and you move ahead. If you don't with hold things like CPP and EI you will be subject to serious consequences by the CCRA.

The salary or the bonus is deductible to the corporation and it's taxable on an individual level, that income will be earned income for the purposes of calculating RRSP room.

An alternative to the salary or bonus scenario is to pay a dividend to the shareholder. A dividend is not deductible at the corporate level. So the income that gave rise to the cash that's available for the dividend is taxed at the corporate level. The dividend is then paid out to the shareholder and it is taxed at the preferential rate in the hands of the shareholder. Rather than being subject to the full personal tax rates as with the salary or bonus, the dividend is subject to a preferential tax rate. You have to record this as a director's resolution; you can't just pay out the money and call it a dividend.

What you typically do to determine a salary or a dividend is perform a calculation to find out if the overall level of tax of paying a dividend is less than other types of compensation. Whether or not you choose a salary, bonus, or dividend will be completely dependent on the individual's tax circumstances. You may find that it's better to pay a dividend.

Now there are drawbacks to paying a dividend. One of those drawbacks is that a dividend is not earned income for the purposes of making an RRSP contribution. So if the individual draws from the corporation as their only source of income, they may not want to draw a dividend because there is no RRSP room.

Finally, if the individual is a 40 per cent shareholder than the amount of compensation being a salary or bonus is not insurable earnings. If the individual owns the corporation a 100 per cent and pays a salary to themselves, that salary would not be insurable earnings. A dividend is never insurable earnings.

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