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

How do partnerships work and how are they setup?

My friend and I have an idea for a business and we are considering forming a partnership. How does a partnership work and how should one be setup?

Whether or not a partnership exists is a fundamentally a legal question. Ontario’s Partnerships Act says that a relationship between “persons carrying on a business in common with a view to profit” is a partnership within the meaning of the Act. This is important because it means that whether or not you declare yourself to be a partnership, legally speaking, you might be a partnership anyways, whether you intended to or not.

A partnership can exist between you and your friend personally, or even as between two corporations controlled by each of you. Unlike a corporation, however, a partnership has no separate legal existence from the partners themselves and each partner has the power to bind the partnership and each partner is jointly liable for any obligations incurred on behalf of the firm. This is why, when deciding to form a partnership, a partnership agreement can be very practical.

A partnership agreement sets out the rights and obligations for partners in the partnership and provides for what should happen in circumstances of partnership incapacity, retirement or death. Without one, the Partnerships Act will provide for what happens to the partnership in these circumstances, often with unintended results. A partnership agreement can also provide mechanisms for the distribution of partnership income and a process for bringing additional persons into the partnership. Creating a partnership agreement that meets your goals with the help of a commercial Lawyer ensures that your partnership will continue in a manner of your design.

Should I incorporate my medical practice as a professional corporation?

I am a practicing family physician with two young children. My accountant mentioned the idea of incorporating my practice into a professional corporation. How does this work?

As a physician, you are generally permitted to create a physician corporation. The Ontario Business Corporations Act (OBCA) and the Regulated Health Professions Act govern physician corporations. Once incorporated, a Certificate of Authorization from the College of Physicians and Surgeons of Ontario (CPSO) is required for your professional corporation to practice medicine in Ontario.

There may be significant benefits to incorporation arising from income splitting through the payment of dividends to adult shareholders and the deferral of tax through retention of excess cash and investing in the corporation.

A professional corporation carries on the practice of medicine with you as both a shareholder and employee of your corporation. It is important to note that under the provisions of the OBCA, a professional corporation does not shield the shareholders from professional liability as acts of a professional corporation are deemed to be acts of the shareholders. Non-voting shareholders who are not members of the CPSO are exempted from any professional liability.

All voting shares of the corporation must be held by a member of the CPSO. Non-voting shares can be held by a parent, spouse or child (and minor children must have their shares held in trust). Professional corporations are only permitted to carry on the practice of the profession or activities that are related to or ancillary to the profession. Furthermore, a professional corporation is permitted to invest its surplus funds in passive investments.

A Lawyer with experience in incorporating professionals can help you set up your professional corporation such that your objectives may be realized.

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.