Our professional clients and business owners who are incorporated (combined we will refer to both as “business owners”) must juggle a few different balls when it comes to determining corporate versus personal taxation, and the overall combined tax effects. One option is to have all income maintained, and taxed, within the corporation. The challenge with this approach is that owners of corporations often need personal cash flow to live off to fund living expenses.
Canadian small business owners who require cash flow from a corporation generally have two main choices on how to draw funds out - salary or dividends. Over the years, I’ve had lengthy conversations with clients, and their accountants, about which method is preferable. From an income tax perspective, a business owner should, in theory, find no advantage with one option over the other, as a result of the tax concept of “integration.”
The Concept of Integration
For a Canadian business owner, income tax integration is based on the premise that an individual earning income through a corporation should be in the same tax position as if the individual earned the income personally. When a salary is paid, the company deducts the amount when calculating its taxes, resulting in the owner having it taxed at his or her applicable personal tax rate. In the case of a dividend, corporate income tax is paid first, and the after-tax amount is paid to the owner.
A "grossing up" of the dividend amount in combination with a personal tax credit accounts for the corporate tax paid. This results in the dividend being taxed at a preferred rate personally, and when combined with the corporate tax paid, should result in the same amount of tax paid as in the salary example.
The Challenges of Integration
Unfortunately, the theory of integration is usually not perfect in practice. It varies with changes in income tax rates, province of residence, legislation changes, and each clients’ unique situation. In short, perfect integration is rarely achieved.
The concept of integration quite often focuses on a shorter-term outlook. Our view of working with clients focuses on minimizing combined income taxes (both personal and corporate) over your lifetime.
A decision to choose dividends over salary may make sense in a given year, whereas the opposite may be true in a different year. Income tax, along with other considerations outlined in this article, requires an analysis based on an individual’s own situation, usually on an annual basis.
Greenard Group’s 10 Items to Consider
Many factors need to be considered by business owners deciding on receiving income as salary or dividends. The Greenard Group’s top ten discussion areas with clients relate to Registered Retirement Savings Plans (RRSP), Registered Account Carry-forward limits, Payroll Remittances, deductions for the company, income splitting with family, active business income, level of passive income, stability of earnings, flexibility and simplicity, debt financing, and estate planning.
We will use three different business owners to illustrate: Business Owner #1 pays a $100,000 salary, Business Owner #2 pays a $100,000 dividend, and Business Owner #3 keeps funds within the corporation and pays neither a salary nor a dividend.
1) Registered Retirement Savings Plan (RRSP)
Business Owner #1 decides to receive a salary of $100,000 and is going to receive a T4 showing this amount. The T4 salary amount is considered earned income for the purpose of generating Registered Retirement Savings Plan (RRSP) contribution room. After the tax return is filed, Canada Revenue Agency (CRA) will calculate the eligible contribution room as 18 per cent of the earned income, which is shown on the Notice of Assessment.
In this illustration, $18,000 ($100,000 salary x 18 per cent = $18,000) is the additional RRSP contribution room that is generated and amount that can be contributed to a RRSP. The 18 per cent calculation does have a maximum that is indexed each year. For 2021 the maximum RRSP contribution limit is $27,830. If you divide $27,830 by 18 per cent, then the maximum threshold is met when a salary reaches $154,611 for 2021.
Business Owner #2 decides to receive a dividend of $100,000. Since dividend income is not considered earned income, no RRSP room would be generated.
Business Owner #3 decides not to receive a salary or a dividend. Since there is no personal earned income, there would be no RRSP room generated.
2) Registered Account Carry-forward
In many situations, we have clients that have RRSP room and Tax-Free Savings Account (TFSA) deduction limit that have been carried forward from past years. In Canada, if you have been provided with contribution room, and you have not previously used the room, then this would carry forward to future years.
If an owner has significant RRSP carry forward room that has never been utilized, then paying a salary for the purpose of generating more RRSP room may not be a primary factor. If on the other hand, a business owner does not have any RRSP deduction limit, then generating RRSP room by paying a salary may be more of a consideration.
3) Payroll Remittances
One of the factors that should be considered is whether payroll remittances are required.
Business Owner #1 who receives an annual salary of $100,000 must become familiar with the required payroll withholding taxes, such as Canada Pension Plan (CPP) and Income Taxes. A payroll system must be put into place with additional administrative and accounting steps.
Business Owner #2 who receives an annual dividend of $100,000 does not have to be concerned about doing corporate payroll withholding and filings. Payments of dividends are not subject to CPP, Employment Insurance (EI), or payroll taxes.
Business Owner #3 has no payroll items to deal with.
4) Deductions for the Company
Business Owner #1 that receives an annual salary of $100,000 is able to claim the salary as an expense within the corporation. The expense reduces the taxable income within the business. As a result, the corporation would pay lower corporate taxes.
For Business Owner #2 that receives dividends of $100,000, the dividend is paid from retained earnings (after tax profits). Essentially this means that the payment of dividends is not a corporate deduction or expense.
Business Owner #3 has no deductions within the corporation and no payments of after-tax profits as no distributions are made.
5) Income Splitting With Family
Salaries offer a flexible way to redistribute business earnings when family members are employed in the business. Any salary paid must be reasonable in relation to the services performed.
Dividends involve less administration and do not require the recipient to perform services for the business. If the recipient owns shares of the company, then dividends offer a means to distribute after-tax profits to family members that are shareholders.
It’s often recommended to avoid paying dividends to shareholders that are minors, since dividends from a private corporation to minor children are taxed at the highest personal tax rate, often referred to as the “Kiddie Tax.” Under the new Tax on Split Income (TOSI) rules that were effective Jan. 1, 2018, this would also be extended to related adult family members (“specified individuals”) unless exclusions apply.
The rules are expanded to include certain debts, capital gains and second-generation income, casting a much wider net. These rules generally apply to specified individuals that are not actively engaged in the business or do not contribute a “reasonable amount” of capital or labour to the related business. These changes are intended to reduce income splitting opportunities by taxing these individuals at the highest marginal tax rates.
It is important to note that the TOSI rules do not apply to split income if the business owner’s spouse is age 65 or older. Often at times, the strategy may shift to paying the spouse a dividend. As noted above, the spouse is not required to perform services for the business.
Business Owner #3 may have chosen to keep as much funds within the corporation as possible until the business owner’s spouse reach age 65. At age 65, the possibility exists to income split with your spouse.
6) Active Business Income
A situation where a salary may provide a benefit is when the company is a Canadian Controlled Private Corporation (CCPC) earning active business income eligible for the small business deduction.
This preferential tax treatment is currently limited to the first $500,000 of active business income, which is taxed at a reduced rate. Income above this threshold is taxed at the general corporate rate. Paying a salary (or bonus) to reduce the company’s business income to $500,000 may be advantageous.
7) Level of Passive Income
For tax years starting after 2018, there is a new rule, known as the “passive income rule”, which is a straight-line reduction to the small business limit for CCPCs when associated corporations earn adjusted aggregate investment income (AAII) of $50,000 or more. AAII includes investment income and expenses with certain adjustments.
The small business limit would be reduced by $5 for every $1 of AAII above the $50,000 threshold, such that the small business limit would be eliminated when AAII reaches $150,000 in a tax year. Paying a salary would be a business deduction which reduces the amount of taxable business income subject to the general rate, which is higher than the small business rate.
8) Stability of Earnings, Flexibility and Simplicity
Some of our business owner clients have fluctuating incomes. When a salary is paid throughout the year at a predetermined level it is not necessarily reflective of the income generated. In fact, it may be materially different.
As noted above, if a business is having a high-income year, the business owner should consider paying a salary to get income below the $500,000 threshold. This can be done through a bonus, rather than a monthly salary. This provides some flexibility and is often viewed as a simpler approach.
In other cases, if the corporation is not having a good year, then payments of a significant salary during the year could result in operating losses.
Business Owner #1 has stable operating income every year and the payment of a salary is the best option.
Business Owner #2 has income that fluctuates considerably every year and has chosen primarily to pay dividends.
9) Debt Financing
Many of the business owners that we work with will also have personal assets such as a principal residence. In some situations, our clients would like to have a mortgage or debt to finance different opportunities that are not within the corporation.
A key factor on whether to pay a salary or dividends is whether our business owner clients will want to obtain financing in the future for a personally owned asset(s).
In the process of applying for debt or a mortgage, our clients must provide their personal tax returns as part of the approval process. A regular and consistent salary is viewed more favourably than a fluctuating dividend payment. If our clients wish to take on additional personal debt for opportunities, then the payment of regular salaries is the best option.
10) Estate Planning
One of the items that we discuss with all our business owner clients is the tax consequences of passing away with shares of a CCPC. In many cases after these discussions we map out a detailed plan that involves the payment of both a salary and a dividend. This is especially true when income splitting opportunities are available, and registered account carry-forward room exists.
The decision to receive income as dividends or salary should be made with the aid of a tax professional and analyzed based on each individual’s situation. Often, a combination of the two proves effective in taking advantage of lower effective personal tax rates on dividends while obtaining benefits from salary payments, such as CPP and RRSP participation. Various factors, such as household income requirements, other sources of income for each spouse and province of residence should be considered in deciding the optimal mix of salary and dividends.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email firstname.lastname@example.org or visit greenardgroup.com/secondopinion