Compensating Team Members

FA writes: When a Canadian startup starts to make revenue, how do you pay yourself and your team without a) getting hit by lots of taxes and b) doing it wrong and making it an accounting nightmare.

Dear FA,

First of all, if your wish is that you could pay no taxes on this, join the club. We have a large membership.

The only thing we all aim for is the best combination of techniques that reduce or defer payment of taxes. The important questions, as I see them, are:

a) can you defer the taxation of money received to a point in time when the person won't be taxed too heavily when (s)he receives it?

b) can you defer the tax on money received to a point in time where it needs to be taxed differently, i.e. ordinary income versus dividend income versus capital gains?

c) can you move the money from income directly to expenditure without ever receiving it, so the money is never taxable as income in your hands?

Let's say all of your team are shareholders and employees in the company.

When the company makes revenue, you can:

a) channel money to the employees through their employment payments. That will probably be taxed in their hands as ordinary income and your corporation will get a deduction for it.

b) channel money to them as dividends. That will probably be taxed as ordinary income as well (it may be taxed on a lower rate because of the dividend tax credit but unlikely in the case of a startup because startups often benefit from preferential tax rates.)

c) channel money to the employees if they are managers through other mechanisms such as management fees (basically turning the employment relationship to an arm's length business-to-business relationship.)

d) benefit your employees in other ways through things like lunches or other general employment benefits (which will probably not be appreciated as much as cold hard cash.)

e) keep most of the money in the company so that when you sell all or  part of the company, your team gets the money as a 'capital gain' (rather than ordinary income.) 
     - [If the corporation is a "qualifying small business corporation" then it is possible to take the money out of a corporation through a tax strategy called crystallisation. However it will be important to do that over a long term tax plan and this is something to discuss with a friendly tax planner I can put you in touch with.] 
     - This has the added benefit of moving the money from income to expense without taxation. The corporation can benefit from deduction of income whereas Johnny Employee or Johnny Shareholder can't.

Now suppose your team doesn't hold shares in the company directly but each of them has, say 100% of the shares in a corporation (a holding company or Holdco) then you can issue dividend from your company to their companies on a tax free basis. 

 [This allowance is to ensure that money only gets taxed once (the exception to that rule is taxation on consumption, i.e. sales tax, GST)]

If each team member has his or her own holding company, then (s)he will have some flexibility as to how to take the money out but the tax issues related to that Holdco will be another story.

Now, suppose your business grows to the point where it isn't benefitting from small business tax rates. Then you can think of running the partnership as a limited partnership between holding companies.

Finally, you can use a bonus plan or a stock option plan. But such plans bring up a lot more complexity.

Moral of the story. It's hard to reduce the tax burden markedly without a combination of things, a.k.a, accounting nightmare. Of course, if the amount in question is large enough, any nightmare can be overcome.

You'll have to tailor your solution after a more detailed discussion with a tax lawyer/accountant. Ping me for a referral.