What are dividends all about?
You’ve heard of them before: dividends. What are they, and how do they work with dentistry professional corporations? Well, there are only a few ways to suck money out of a corporation:
- as an employee earning employment income;
- as an independent contractor earning business income;
- as a person who has given a loan to, or taken a loan from, the corporation; or
- as a shareholder who receives dividends.
With respect to dividends, here’s how it works. First, the corporation is created. This is done initially by filing documents called Articles of Incorporation with the Ontario government. In those Articles, there will be a section that asks about the share structure of the corporation. The share structure basically means two things:
- How many and what type of shares is the corporation authorized to issue (i.e. to give to people)?; and
- What are the rights, privileges, and obligations of those shares?
Now, when I set up the Articles of Incorporation for a dentist, I typically create (in conjunction with consultations from your accountant) about ten classes of shares – each with its own rights, privileges, and obligations. I also authorize the corporation to issue an unlimited number of any type of share it wants. It doesn’t have to, but I leave it open for the corporation’s directors to do so. If there were multiple shareholders and they wanted to limit the number of shares of a particular class of shares that the corporation could issue, then they would either place restrictions on the number of shares that the corporation can issue in the Articles of Incorporation or have a Shareholders Agreement that says so.
Now: why so many classes of shares? To be flexible, of course! In fact, if you set up (or had someone else set up) a dentistry professional corporation without all of these different classes of shares, I would have to amend your articles of incorporation (which is a process in and of itself) in order to give you that flexible share structure.
Differences between the classes of shares?
To start off, it doesn’t matter what you call the classes. You can call them Class A, Class B, Special Class A, Common, Voting, Non-Voting, Preferred, etc. At a minimum, however, you must have at least one class of shares with voting rights. This means that whoever owns these shares (either they were issued directly from the corporation to a person or that person purchased them from another person who owned them) has the right to vote at meetings. What are they voting for? Well, they’re casting their vote for who they want to be a director of the corporation. In other words, the shareholders are voting for who they want to manage the corporation. Now, in reality, the shareholder and director of a dentistry professional corporation will be the same person: the dentist.
Now, getting back to the different classes of shares, here’s what you need to think about. First, whoever owns the non-redeemable voting shares essentially owns the value of the corporation. The non-redeemable part means that the corporation has no right to have the shares redeemed at a set price. Why are there redeemable shares to begin with, you ask? Well, if you’re issuing shares to family members or to a trustee on behalf of minor children of a voting shareholder dentist, then you will want the ability (as a director of the corporation) to essentially take back those shares by redeeming them for a set price (e.g. $1 per share; $2 per share, etc.) without their consent. This essentially makes each redeemable shares’ intrinsic value worthless. In other words, if they can be easily redeemed for a low price without the shareholder’s consent, then they do not represent any real value of the corporation. You typically issue redeemable shares to a family member who you want to sprinkle dividends upon, but without giving up control over the corporation. You do this, for example, to avoid having a family member stop you from selling your company (e.g. they’re holding out and you need to do something about it!). You also do this in other situations, such as the breakdown of a marriage, upon the death of a family member, if your children have grown up, etc.
So how do you issue dividends?
Dividends are payments made to shareholders. If you only had one class of shares, the directors of the corporation you wouldn’t be able to differentiate who gets paid what. You can’t discriminate against shareholders of the same class. They are all entitled to the same rights, privileges, etc. So if you want to pay dividends to some shareholders but not others, you need to create other classes of shares. We call these ‘dividend sprinkling shares’. They are typically redeemable special shares that are given to dentists and their family members.
Now, in order for dividends to be given to shareholders, you need to realize where they come from after-tax dollars. Unlike employment income or business income that is paid by a corporation as a pre-tax labour expense attributable to a dentist, a dividend can only be declared by the board of directors of the corporation if there is money left over after net income has been calculated and taxes have been paid. There are certain duties imposed on directors which would also prevent them from declaring dividends. For example, under section 38(3) of the Ontario Business Corporations Act, directors of a corporation are not allowed to be declared or paid by a corporation if there are reasonable grounds for believing that the corporation, after payment, wouldn’t be able to pay its liabilities as they become due OR if the realizable value of the corporation’s assets would be less than the sum of its liabilities and stated capital of all classes of shares.
In order to properly document the declaration and issuing of dividends, the financial statements for a fiscal period should be prepared, the directors should have a meeting, and minutes should be taken at that meeting. The minutes will reflect that the directors understood their obligations in issuing dividends and decided to do so in a certain amount and to a certain class of shareholders. The dividends are declared to be paid to the shareholders of a certain class or classes on record as at a certain date. Then, it’s up to the corporation to pay out those shareholders.