Note: this article discusses the process for determining salary vs. dividends, but does not specifically include the effects of the Department of Finance’s proposals released July 18, 2017. Read more about those here.
All incorporated small business owners eventually must decide how to pay themselves: by salary or dividends. There’s no simple response, so let’s unpack the process to answer that question.
Theory of integration
No discussion about an incorporated business owner’s compensation can start without introducing the theory of integration. The idea behind that theory is simple: regardless of whether you earn income personally (salary) or through a combination of corporately and personally (dividend) taxed income, the net income after all tax is paid should be the same.
But this theory doesn’t always hold in reality. As a result, it’s a good idea to run the numbers for a business owner’s specific situation to see if one method of compensation is more tax efficient than another. Let’s do that.
Roberto is single and owns a profitable Ontario corporation. He’s trying to determine the best way to compensate himself. His corporation generates $200,000 a year in active business income, and the money he will pay himself from his corporation will be his only source of income for the year.
If he goes the salary route, he wants to maximize his contributions to CPP and his RRSP. If he goes the dividend route, he wants to have the same after-tax income as the salary option for living expenses, so any surplus above that would be invested.
Chart 1: Ontario corporation (2017 rates)
|Corporate business income||$200,000||$200,000|
|Less: CPP and EI premiums||($3,735)||N/A|
|Corporate taxable income||$140,965||$200,000|
|Less: Corporate tax @ 15%||($21,145)||($30,000)|
|Less: Dividend to shareholder||__N/A__||($55,300)|
Chart 2: Personal taxes (2017 rates)
|Less: RRSP contribution @ 18%||($9,954)||–|
|Less: Income tax1||($9,954)||($3,688)|
|Difference (to invest)||$16,220|
1 Includes CPP and EI premiums
Since Roberto owns an Ontario corporation, the first $500,000 of active business income is taxed at 15% (combined federal and provincial). His salary, the employer CPP contribution and EI premium are deducted from the corporation’s income, leaving it with taxable income of $140,965.
The dividend, on the other hand, is paid with corporate after-tax income, meaning the full $200,000 of active business income is subject to corporate tax.
Roberto’s personal tax situation follows a similar pattern. His salary, net of his RRSP contribution is fully taxable income, which leaves him with net income of $35,392. The dividend is subject to a much lower rate of personal tax, thanks to the dividend gross-up and subsequent tax credit. In order to maintain a net income of $35,392, Roberto must set aside $16,220 for personal investment in either a TFSA, non-registered account or some combination of the two.
Chart 3: Summary
|Corporate income tax||$21,145||$30,000|
|CPP and EI premiums2||$7,135||N/A|
|Personal income tax||$6,553||$3,688|
|Total tax and deductions||$34,833||$33,688|
2 Includes both employer and employee CPP and EI premiums
As you can see, the difference in both total taxes (including CPP contributions and EI premiums) as well as total investments (combined corporate and personal) are very similar. It appears the theory of integration holds up quite well in Roberto’s case, with dividends providing a slight advantage over the salary option.
Going beyond the numbers
For business owners like Roberto, there are other factors to consider beyond simple arithmetic. When considering paying oneself dividends, there are additional advantages:
- If the only source of personal income was non-eligible dividends, it is possible to receive up to $33,305 tax-free in 2017, excluding the Ontario Health Premium.
- Dividends do not require the shareholder to be an employee of the business, whereas salaries do and must be reasonable for the work and role performed.
- The payment of dividends doesn’t require personal taxes to be remitted at source; salaries require income tax and CPP amounts to be withheld by the employer and remitted within days or weeks.
On the flip side, when evaluating the advantages of paying a salary, consider the following:
- Salaries entitle the recipient to the Canada employment credit.
- If the company’s taxable income exceeds $500,000 in 2017, salaries can reduce exposure to corporate income tax that would be payable at the higher corporate income tax rates.
- A dividend recipient may be required to remit quarterly personal income tax instalments in future years; this is unlikely for salary since tax is withheld at source.
- If personal income is so low that the dividend tax credit would be unused, a salary may be more tax-efficient.
CPP and EI
As you saw from Roberto’s situation, there’s an additional cost under the salary option over dividends to pay both the employer and employee CPP contributions and EI premiums.
These costs come with associated benefits: one is a future, fully indexed pension in retirement and/or in the event of disability, while the second is income insurance in the event of involuntary job loss. Employment Insurance also provides income such as parental, sickness and compassionate care benefits.
The benefits that both of these programs could provide should be evaluated against their annual costs. Someone like Roberto should consider whether he will be able to save enough money to replace the CPP retirement pension if he chooses to compensate himself with dividends, or what he’ll do in the event of disability or future child rearing.
Both the salary and dividend options provide for the possibility to income split with other family members. In the case of salary, family members must be employed by the company and paid a reasonable salary for the work performed. With dividends, family members must be shareholders, but there’s no requirement for them to be employees.
Note that income splitting using dividends is one aspect of tax planning for business owners that the federal government will be reviewing over the coming months. This review was announced as part of the 2017 Federal Budget. The results of this government review could lead to business owners revisiting their current dividend income-splitting strategy with their tax advisors.
For business owners in most provinces, the method of personal compensation should not change net income after all taxes (i.e., corporate and/or personal) are paid. It’s important to confirm this by making the calculations based on the owner’s specific circumstances.
As a next step, consider other factors related to salary or dividend income. From there, the compensation decision becomes a cost-benefit analysis where the owner will choose her compensation based on which method provides more benefits and less costs.
Finally, potential tax changes can lead to revisiting the analysis to assess whether the current compensation mix still provides the owner with the desired benefits at an acceptable cost.
Curtis Davis, FMA, CIM, RRC, CFP, is senior consultant, Tax, Retirement & Estate Planning Services, Retail Markets at Manulife. Reach him at Curtis_Davis@manulife.com