"Just tell me what to do." These were the words from a reader who e-mailed me this week. He might as well have asked: "Tim, there's this girl I've been thinking of marrying, but I'm not sure if she's the right one - just tell me what to do." He might have asked: "Tim, I've got this strange rash and I need treatment of some kind - just tell me what to do." In fact, you might find my comments on your relationship and medical issues just as useful. Perhaps next week I'll write about ringworm and other fungal infections.
The problem is that telling someone what to do is impossible without all the facts because every situation is different. Wouldn't it be nice if there was a "one size fits all" approach to wealth management? If you're a business owner, the decision as to how you should pay yourself is one of those questions where one right answer is elusive because "it all depends." The good news? Today I'm going to share some information which should make your decisions a little easier when it comes to compensation planning.
Salary and dividends
If you own a corporation there will be different options available to you when it comes to paying yourself. Many shareholders struggle with how to best extract money from their companies on a tax-smart basis.
The two most common methods of compensation, as I introduced last week, are salary and dividends. Our tax system is designed on the theory that there should be no difference between paying tax on income personally (as would be the case with salary; the company would get a deduction for the amount paid to you and you'd pay the tax personally) and paying tax on the income in your company then distributing the after-tax earnings to yourself as a dividend. This is the theory of integration.
The reality? Integration isn't perfect. And so there will be a difference in the rate of tax you'll pay on salary and dividends. Generally, if your corporate taxable income is below the small business limit (currently $500,000 federally) and that income is subject to lower rates of corporate tax, you'll typically be better off paying yourself dividends than salary. It used to be that if your company income was over that small business limit, you'd be wise to pay sufficient salary or bonuses to bring the corporate income below that threshold. This is not necessarily true any more, given the lower tax rates on eligible dividends introduced in 2006 that I spoke about last week. Today, there may be a tax deferral advantage to taking dividends even on income over the small business limit, rather than salary. Check with a tax pro in your province because the actual rates of tax change annually and vary by province.
Other considerations
The tax dollars you pay on your compensation, whatever form it takes, will be a critical factor, but there are other considerations as well.
Paying yourself salary has the advantage of creating RRSP contribution room, which dividends will not. A common strategy is to pay yourself sufficient salary to create the maximum RRSP room possible ($124,722 paid in 2010 will give you the maximum RRSP room of $22,450 in 2011) and then pay dividends if you want additional income above that. Salaries can also be beneficial to keep your corporation's income down. How so? If your company is engaged in research and development, for example, the research tax credits available could be scaled back if your company's income is over the small business limit. Further, having a high corporate income will mean more tax paid by your company and higher tax instalments required monthly, which could put a strain on cash flow.
Dividends can work well if your company has earned investment income in the past because dividends may entitle your company to a refund of taxes previously paid on that income. In addition, if your company has a balance in its "capital dividend account" (which is often the case where your company has realized capital gains in the past) you may be able to pay dividends to yourself tax free.
Finally, don't forget that you may be able to get money out of your company tax free if you have shareholder loans owing to you and you take repayment of those loans, or where you have "paid up capital" in your shares of the company and repay that capital.
Some of these things are technical, and there are other considerations to think about. So, speak to a tax pro about your compensation planning.