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When it comes to their own compensation, a business owner with a corporation has three primary choices: To pay themselves a salary; to pay themselves dividends; or to leave business income in the corporation. Let’s take a high-level look at what’s involved in each case.
When a business owner pays a salary, the corporation receives a tax deduction that reduces its taxable income. If it pays out all of its business income as salary, there is no profit left in the company and therefore no corporate tax to pay (assuming no investments or other income sources for the corporation).
Business income left in a corporation as profit is taxable. Corporate income that is eligible for the small business rate (generally for income under $500,000) is taxable at between 9% and 14%. A business owner can then pay these after-tax corporate profits out as dividends in the current or any future year that is taxable personally; because 9% to 14% tax was already paid, the personal tax payable on a corporate dividend is lower. The personal tax could be anywhere from nothing (even possibly generating a tax refund at low levels of income) to 49%. The combined corporate and personal tax payable on a dividend is similar to the personal tax payable on salary. To give an example, $100,000 of salary has about $25,000 of personal tax; meanwhile, $100,000 of business income has about $12,000 corporate tax, and then $88,000 paid as a dividend has about $13,000 of personal tax. So, it’s the same $100,000 to begin with, and about the same $75,000 after tax.
If a business is highly profitable, with taxable income of more than $500,000, corporate tax is payable at higher active business income rates, instead of the preferable small business income rate. The corporate tax payable is generally between 26.5% and 31%, but dividends subsequently paid—known as eligible dividends—are taxed at an even more preferable personal tax rate. In all cases, for dividends, there’s corporate and personal tax payable; for salary, only personal tax payable. The combined corporate/personal tax on dividends is higher than the personal tax on salary.
Beyond the question of taxes, generally speaking, paying a salary is preferable to dividends in most provinces. (Note that a bonus is taxable in the same way as a salary: as employment income.)
Paying salary may, for example, allow a business owner to deduct child care expenses. Dividend income is not considered earned income when it comes to child care expense deductibility.
Salary is considered earned income for Registered Retirement Savings Plan purposes and generates RRSP room. Dividend income is not.
Paying a salary allows a business owner to contribute to Canada Pension Plan (CPP). However, they must contribute both the employee and employer portion. This reduces the “return” on paying into CPP to earn a future retirement pension.
However, rates often change and there are other personal considerations, so compensation planning should be an annual conversation with an accountant to determine which option is better.
A corporation can employ a family member and pay a salary. This includes a spouse or a child, including a minor child. However, the salary paid must be reasonable for the work performed and in line with what might otherwise be paid to an arm’s length third party. If an unreasonable salary is paid, there is a risk the Canada Revenue Agency (CRA) could deny the deduction against income for the corporation, and the income would still be taxable to the recipient.
A family member can also be a shareholder and receive dividends (even if they also receive a salary). Tax on Split Income (TOSI) rules may cause dividends paid to family members to be taxable at the top tax rate unless certain criteria are met. The most common exceptions include a family member who is actively involved in the business (working 20 hours or more each week on average) or if the dividend recipient’s spouse is 65 or older. The TOSI rules are complex and should be discussed with an accountant.
A common mistake for retired business owners is to continue paying a salary. It may be difficult for a corporation to justify deducting a salary paid for an investment holding company that is no longer an active business. The salary tax deduction may be wasted due to low corporate income or lack of deductibility, and the salary could be taxable at a higher rate personally than dividends. Retired business owners should generally pay themselves dividends instead of salary.
Some business owners, especially those in their 60s, should consider whether to pay out any salary or dividends from their corporation at all. If a business owner has a large RRSP balance, especially if their spending is relatively modest relative to their assets, they may want to consider starting RRSP withdrawals. They may be able to leave their business income in their corporation, pay a relatively low rate of corporate tax, invest their corporate savings, and instead start drawing down RRSPs.
Having a large RRSP is a good problem to have, but it can be very taxing in retirement or upon one’s death. Some retirees can pay as much as 62% tax on RRSP withdrawals after age 65 if they are subject to Old Age Security (OAS) clawback. On the death of the second spouse, a remaining RRSP balance can be taxable at up to 54% tax.
RRSP withdrawals may be deferred until age 72, but it is often advantageous to begin withdrawals earlier. Corporations, on the other hand, have no mandatory withdrawals. Unlike RRSPs, there can be tax efficient ways to leave corporate assets to children or grandchildren using trusts, life insurance or other strategies to reduce tax payable on withdrawals from a corporation after death.
If a business owner has investments in their corporation, it sometimes makes sense to pay dividends to themselves and other shareholders even if they do not need the money. Certain dividends result in tax refunds to a corporation, and the tax savings to the corporation may be more than the tax payable by the individual. Certain dividends may also be tax-free to the recipient. In other cases, the subsequent investment income earned by the individual may be taxable at a lower rate than what would otherwise be paid by the corporation (which pays a high rate of tax on investment income).
Business owners have lots of largely tax-driven financial planning considerations to consider. It is a mistake simply to have an accountant do your tax return without proactively discussing tax-planning considerations, like compensation planning, that consider corporate and personal income and assets.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
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