How to Get Retained Earnings Tax-free
Our method of eliminating income tax liability doesn't work just for employees' salaries. It also works for corporations that have retained earnings.
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Procedure to Get the Retained Earnings out of the Corporation Tax-free
Please note: this procedure does not require the actual transfer of the retained earnings. All "transfers" of funds ("payments" and "loans") can be done merely as bookkeeping entries and signed documents.
Let us assume that the President of the Corporation has been working as an employee of the Corporation, but his salary has been less than the business earns. So, the earnings of the corporation have accumulated over the years.
Now the President can work through one of our corporations (Graycliff). In the United States, such a corporation is called a service corporation providing leased employees, referred to in IRS Publication 15-A at page 4 [see the "USA" tab in the left column of this web page]. In Canada, it is called a corporation engaged in a personal services business, referred to in the Income Tax Act, Section 18(1)(p).
Graycliff then provides the services of the President to his Corporation in the same way that temporary services corporations provide the services of temporary employees to businesses that need an employee temporarily.
In such cases, there are no payroll deduction when the business pays for the services. Instead, the business merely pays the invoice of the temporary services company.
However, instead of the temporary services company then paying a salary to the individual who does the work, taking payroll deductions, Graycliff loans the money to the President, as follows:
The money that is payable to Graycliff is loaned by Graycliff to the President at an interest rate that is at least as much as fair market rates for such a loan. (This interest rate is used to avoid the deemed interest that would arise if the interest rate charged were below fair market rates for such a loan.) [The reason for this is set out in IRS Publication 535, referred to in the "USA" tab in the left column of this web page. In Canada, the authority for this is Sections 80.4(1) and 80.4(3) of the Income Tax Act]
This loan is secured by the salary owing to the President by Graycliff, and the interest payable by Graycliff on the unpaid salary is at the same rate as the rate of interest on the loan from Graycliff to the President.
Consequently, the loan amount payable, including accrued interest, is always equal to the salary amount owing, including accrued interest. So, there is never any net amount owing by either the President or by Graycliff to each other.
If the entire net earnings of the Corporation and the entire retained earnings of the Corporation are paid out to the President as salary, through Graycliff, in one fiscal year, then the result is:
For the year, instead of a profit, the corporation will have a loss equal to the retained earnings. The payment for services rendered will be the sum of the retained earnings and the company earnings for the year.
The Corporation will then be able to carry forward a loss equal to the retained earnings for 20 years, and backward for 2 years in the United States, pursuant to Section 172(b) of the Internal Revenue Code, and 3 years in Canada, pursuant to Section 111(1)(a) of the Income Tax Act.
So, amended corporation tax returns for the past two or three years can be filed to get refunds of all taxes paid in those years by the Corporation. And corporation tax returns for the next twenty years will show no net income until the entire loss (equal to the retained earnings) is used up.
A payment of such a large amount for services rendered by the President is high for one year of work, but it is not high for the many years of work over which the retained earnings have accumulated. In fact, the source of the retained earnings is the President's work. So, the deductibility of salary equal to the sum of the retained earnings and net income as a reasonable business expense is not in doubt. It is a reasonable business expense for the Corporation.
Deemed Cash Flow
Instead of money being actually transferred through Graycliff, the following simplified procedure can be used:
When Graycliff issues an invoice to the Corporation for an amount equal to the sum of the net earnings and the retained earnings for services rendered by the President, Graycliff also provides a signed Authorization and Direction to the Corporation to pay the funds to the President in trust.
So, pursuant to that signed Authorization and Direction, and for the payment of the invoice issued by Graycliff to the Corporation, the Corporation would normally issue a cheque to the President in trust. This money would be held in trust for Graycliff by the President.
Then, pursuant to a loan agreement in which Graycliff agrees to lend the money to the President, Graycliff provides a signed Authorization and Direction to the President, as trustee, to pay the loan proceeds to the President. So, a cheque for that amount would be issued from the trust account of the President to the President (in his personal capacity). That cheque would be deposited into the President's personal account.
However, since the President is the ultimate recipient of the funds, and since signed Authorizations and Directions are provided for every step along the path that the funds take, the only payment from the Corporation that need be made is one from the Corporation to the President in his personal capacity.
And, if the money is currently tied up in securities, either they can be transferred to the President, or they can be declared to be held in trust for the President by the Corporation. (This is done by using a simple "Declaration of Trust" form.)
Graycliff's fee for this service, in which Graycliff is required by income tax laws and regulations to assume all future tax liabilities that could arise in respect of the retained earnings and net income, is 7% of the amount involved. So, this amount would be paid by the President, as trustee, at the time the Graycliff loan was advanced to the President.