Often when owners incorporate a company themselves, they are not aware of the requirements and implications of issuing shares.
This article will help to explain (from an accounting perspective) the reasons for certain share ownership structures of small businesses.
What Are Shares of a Company?
Shares can be classified in several ways. The main differences are:
Voting vs Non-voting
This allows some owners to be silent investors (non-voting) and others to be in control of decisions (voting).
Common vs Preferred
This determines how dividends can be paid out and who gets paid first.
- Preferred shares often have specific payment terms specified in the Company’s articles.
These classifications can also be used in estate freezes or rollovers to lock in the value attributed to one shareholder. (Check out our article on section 85 rollovers to learn more)
- Preferred shares are given fixed values when issued in these situations and Common shares are then attributed the growth of the Company after the freeze/rollover date.
Share Class (A, B, C, D, etc.)
This allows companies to give out multiple types of shares that have the same voting/non-voting and common/preferred qualities. For instance, you can have:
- Class A common voting shares
- Class B common voting shares
- Class C common non-voting shares
- Class D common non-voting shares
- Class E preferred shares
- Class F preferred shares
Authorized and Issued Shares
- This means that the type of share exists but does not mean anyone owns it.
- You can either authorize an unlimited number of a given type of shares or a specific number (1,000 class A shares for example).
- From these authorized shares, the Company can issue specific number of shares to owners.
Issued (and authorized) Shares
- This indicates that a share has been given to or was purchased by an owner/shareholder.
What Does Share Structure Mean for Your Business?
Shares of a company are needed for a variety of reasons. Two major topics around share structure include legal ownership and accounting and taxation.
- Legal - Show the legal owner(s) of the company. Legal ownership is beyond our scope as accountants so we’ll leave the details of this topic to lawyers.
- Accounting and Tax - Indicate how dividends can be paid out and to whom. This is important from a tax and accounting point of view, so will go into more detail below.
Share Structure and Dividends
Where share classification becomes important from a tax perspective is when the Company goes to pay out dividends.
Dividends from a corporation are paid out to a specified share class in proportion to the ownership structure of that share class. This is an important concept, so we’ll look at a specific example.
A Common Dividend Scenario
You and your spouse each own 50 Class A common shares.
Over the year you withdrew a total of $60,000 from the company and need to report this as dividend income.
Because dividends are issued to a specific share class and not to a specific shareholder, you would have to issue $60,000 of dividends which are then split between you and your spouse based on ownership. In this case, 50/50 so $30,000 of dividend income each.
This might be totally fine, but the fact that you both own the same class of shares limits your flexibility when paying dividends. Any dividends must be paid to Class A shareholders which means you will always have to pay out 50/50 between you and your spouse.
This can also create negative tax consequences if your spouse is not active in the company. The reasons for this are explained in our article about tax on split income (TOSI).
In this example, let’s pretend that your spouse is not active in the business and neither of you have any other sources of personal income.
The company must record $30,000 of dividends to both you and your spouse (since you each own 50% of Class A common shares and must pay out dividends based on share class proportionate to ownership).
You pay personal tax of $600 on the $30,000 dividend as you will be taxed at a low marginal rate (BC example).
Your spouse pays personal tax of $14,700 on the $30,000 dividend. Your spouse is taxed at the highest rate of 48.89% (BC example) due to the tax on split income (TOSI) rules.
The total tax paid in this scenario is $15,300 - ouch.
The above scenario is fairly easy to avoid with a bit of planning.
If you are about to incorporate and haven’t set up shares, you may want to consider authorizing and issuing separate classes of shares for different types of owners to allow flexibility in how dividends are paid.
If you have already incorporated and issued just one class of shares between all shareholders, you may want to seek legal assistance to reorganize your shares so that separate classes are held between owners.
This could look something like:
- You both exchange your 50 Class A common voting shares. One person takes 50 new Class B common voting shares, the other takes 50 new Class C common voting shares.
- Ownership and voting remains at 50/50, but the Company can now pay the full $60,000 of dividends just to you on your Class B common voting shares.
- Upon paying the full $60,000 of dividends to the active shareholder, the tax would only be $5,600. That’s a lot better than the $15,300 in the above scenario!
There are additional considerations when determining your share structure, but this is probably the most common pitfall that we see corporate business owners fall into.
Check in with your accountant before making share structure decisions. Sometimes a 5 minute chat can save you a heap of trouble and cash.