Business owners have a lot to consider when it comes to taking salary or dividends from a corporation.Anton Vierietin/iStockPhoto / Getty Images
Business owners have a financial planning opportunity that isn’t available to full-time employees and sole proprietors: they can choose to pay themselves a salary, dividends or a mix of the two.
This flexibility, used strategically, can save money on taxes, but it may be glossed over without much thought among the day-to-day decisions required to run a company.
Decision factors
Salary is paid to employees and reported on a T4 tax slip. It’s a deductible expense for the corporation and reported as income on the recipient’s personal tax return.
Dividends are paid to shareholders and reported on a T5 tax slip. They’re paid from after-tax profits, so they’re not tax-deductible for the corporation. They’re taxable to the recipient, but the dividend tax credit means they’re generally taxed at a lower rate than salary.
Another important difference is that salary withholds income tax, Canada Pension Plan (CPP)/Quebec Pension Plan (QPP) contributions and sometimes Employment Insurance premiums. It builds registered retirement savings plan (RRSP) contribution room and counts as earned income against which people can deduct child care expenses. It may also be more easily accepted by lenders evaluating loan applications.
In contrast, as dividends don’t withhold income tax, the business owner may have to pay personal tax in instalments. And because dividends don’t generate either CPP/QPP contributions or RRSP contribution room, they may require alternative retirement planning strategies.
“It’s one of these opportunities that can be customized many different ways,” says Kyle Westhaver, wealth advisor and client relationship manager with Nicola Wealth Management Ltd. in Toronto.
“But when I really strip it down, you’re trying to optimize your after-tax cash flow today, your long-term ability to compound wealth and your future tax bill when the money does come out [of the corporation].”
On paper, with tax integration, taxes paid should end up roughly the same, he says. But depending on the situation and the marginal tax rate, “you can make a meaningful difference.”
Maximizing marginal tax rate advantages
To determine the best form(s) of compensation, Mr. Westhaver starts with the amount someone needs to take out of the corporation on an after-tax basis to pay for personal expenses, alongside the amount of salary needed to get the desired CPP/QPP contributions and RRSP contribution room for the client’s retirement plan.
“The easiest value-add is making sure clients aren’t pulling more out of their company than they need for lifestyle expenses,” Mr. Westhaver says.
“Whether you take it as salary or dividends, paying too much out personally means a personal tax rate of roughly 50 to 53.5 per cent. Leave it in the company and you’re paying 11.2 per cent or 26.5 per cent in Ontario, depending on eligibility for the small business deduction.”
That said, it makes sense to take advantage of years when someone’s marginal tax rate is low, says Ryan Minor, director of tax with CPA Canada.
Business owners who don’t have much taxable income in a given year may benefit from withdrawing from a corporation even if they don’t need the funds to support their lifestyle. When it comes to low marginal tax rates, he points out, “if you don’t use it, you lose it.”
Factoring in other sources of income
Andrew Feindel, portfolio manager, senior wealth advisor and senior investment advisor with Richie Feindel Wealth Management at Richardson Wealth Ltd. in Toronto, considers two other tax-effective income sources alongside salary and dividends: capital gains within the corporation and non-registered investments.
The 50 per cent of capital gains realized within a corporation that is tax-free can be extracted tax-free through the capital dividend account (CDA). For example, a $1-million investment that generates a 10 per cent capital gain within a corporation provides $50,000 in income with no personal taxes due.
If a client needs $100,000 in income this year, they’re halfway there; the rest can come from salary, dividends and non-registered assets.
Conservative investors get less benefit from this approach because they have fewer investments that generate capital gains. So, Mr. Feindel says someone who plans to invest primarily in bonds may do better by taking enough salary to maximize RRSP contribution room.
He says there can also be a behavioural finance advantage in moving corporate funds into an RRSP; while RRSP portfolios are usually fully invested, corporate funds too often sit uninvested in a chequing account.
On balance, though, if someone has a risk tolerance that allows them to earn capital gains, reducing salary and extracting funds through the CDA is extremely tax-efficient.
This approach also avoids building up excess RRSP funds that will be taxable upon withdrawal from a registered retirement income fund and/or to a client’s estate.
Making mid-year adjustments
If a client needs extra income to bridge a gap temporarily, Mr. Westhaver says a shareholder loan may make more sense than a dividend.
“You can withdraw the funds and then you have a full fiscal year to either declare that as a dividend or you could pay it back.”
For those who need to keep and use an extra lump sum, it’s possible to declare a bonus (which counts as salary) just before the company’s year-end and pay it up to 179 days later, Mr. Minor says.
The corporation gets the tax deduction in the current corporate tax year, while the business owner pays taxes in the calendar year they receive the money.
Opening the door to this tax-deferral strategy can be a good reason to set the corporate year-end to a date up to 179 days before Dec. 31.
Overall, Mr. Feindel says, business owners need customized strategies to pay themselves from their corporation, but having access to multiple potential income sources is a good thing.
“Financial planning and tax planning are all about options. The more options you have to take money, the better the plan you’ll have and the less taxes you’ll pay,” he says.