Dividend Sprinkling Shares

My neighbor tells me that he pays his adult children out of his business corporation to fund their costs and expenses while they attend university, and saves a lot on tax compared to what he would pay if he personally funded their expenses. How do I set up my business corporation to do this?

Dividend Sprinkling Shares

The strategy used by your neighbor likely involves the issue of “dividend sprinkling” shares to his children. It works only with payments made to children over the age of 18 years. In essence, the strategy works to shift income from the high-tax rate paying parent, to the low-tax rate paying child. In many situations the entire dividend is received by the child free from additional tax. The strategy also works between spouses, shifting income from the high tax rate paying spouse to the lower tax rate paying spouse.

The attributes of “dividend sprinkling” shares typically include: a discretionary dividend right (meaning that you determine in any year the amount, if any, of the dividend paid); the right to redemption by the corporation for a fixed amount – often $10 (meaning that if you no longer wish to have the child own shares, the corporation has the legal right to cancel them for a nominal payment); and are non-voting (meaning you are not giving your child a say in the operation of your business). When shares are issued by an existing corporation, it is advisable that a share freeze be completed prior to their issuance. The “share freeze” is a technique which locks in the current value of a corporation to the existing shareholders with dividends being paid out of increases in value or income of the corporation.

There are significant tax and legal complexities and traps associated with setting up and using a dividend sprinkling share structure - including the risk if not properly structured and implemented that amounts paid on the dividend sprinkling shares will be attributed to someone other than the child. Legal and accounting advice should be obtained.

Frequently Asked Questions

Should I incorporate now, or start as a sole proprietorship and delay incorporation to a later date?

I want to become an entrepreneur and start a business. Should I incorporate now, or start as a sole proprietorship and delay incorporation to a later date?‍

The advisability of incorporation is dependent on the particular facts and personal preferences of the entrepreneur. The role of the Lawyer and other professional advisors is to help draw out the relevant facts and explore personal preferences to assist the entrepreneur in making the decision that is right for her. Some of the relevant factors include:

‍Risk. Is the proposed business inherently risky? The shield of limited liability that an incorporated entity provides to the entrepreneur is an important benefit (note that the shield from liability is not absolute);

‍Tax. A valuable attribute of an incorporated entity is the relatively low tax rate (approx. 16%) payable on the first $500,000 of net income. This allows a profitable incorporated entity to grow much quicker using internally generated working capital than a similarly sole proprietorship where a marginal tax rate in excess of 50% of profits may be payable. An exception is where the sole proprietor has other sources of income and it is anticipated that the new business will suffer losses in the start-up year(s) – it may be possible to set off the losses against the other income and thus reduce the overall tax burden;

‍Costs. Incorporation of the business at an early stage is less expensive than incorporation once the business is up and running. Once the business (sole proprietorship) is up and running it is generally necessary to use a “rollover” transaction to transfer the business from the sole proprietorship to the corporation.

‍Separate Existence. An incorporated entity has a legal existence separate and apart from the entrepreneur. This provides for a number of real and perceived benefits including (generally): broader alternatives for raising capital; easier salability of the business and possible availability of lifetime capital gains exemption to avoid tax on sale, continuous existence past the life of the entrepreneur, public perception of greater substance, and easier separation of personal and business dealings.

How do we protect our excess cash in our business for retirement?

My husband and I are the sole shareholders and directors of an incorporated retail business. We have been quite successful and are generating cash excess to business requirements. We do not want to pay the cash out to ourselves now, and pay high rates of tax, but at the same time this cash is a significant part of a retirement fund. We have no creditors, other than trade creditors payable in the ordinary course. How do we protect this cash for our retirement?

‍You are asking a good question. In the event of an unexpected economic downturn or legal claim against your active business corporation, the excess cash generated in the business could be exposed to potential creditors. Once the liability is crystalized, it may be too late to take action that will protect the cash. You have also correctly identified that the simplest solution –payment of the cash out to yourselves – attracts undesirable tax consequences.

A cost efficient solution is the creation of a holding corporation. The holding corporation structure, when designed properly, allows excess money from your active business corporation to be paid by dividend to the holding corporation, tax free. The holding corporation is a separate legal entity, and is generally insulated from claims against your active business corporation.

Care is required that the desired tax treatment is achieved in the structuring of the holding corporation. There are other financial planning considerations, such as ensuring the availability of the lifetime capital gains exemption, which must be addressed by the new structure. This type of corporate structuring may also be implemented as part of a broader strategy for business succession and included as part of your estate planning.

Should a lawyer review your small business contracts?

I run a small business and I have several small contracts that I am currently in the process of negotiating. Are these worth bringing to a Lawyer for review?

‍Depending on the type of contract, there are a number of areas a Lawyer’s expertise can provide guidance, including contracts relating to employment or contractor relationships, borrowing and secured transactions, equipment leases, and other commercial agreements. Simply because a document is short, this does not mean there aren’t important clauses or terms that require careful consideration.

Contracts often contain important clauses relating to the limitation of liability, indemnification, and the waiver of important legal rights. Such clauses can have legal and financial implications for you or your business down the road. Understanding these implications is crucial and one of the services a Lawyer can provide.

A Lawyer can meet with you for a short consultation in order to review your contractual document and answer any questions you might have. By communicating to the Lawyer your expectations of the proposed contract, a Lawyer can work with you to achieve your goals as well as highlight and help you understand risks and liabilities that you or your business may be taking on as part of the contract.

If you have some questions about a contract and feel you may benefit from meeting with a Lawyer call and ask to set up a meeting.