Tuesday, May 22, 2012

Pay yourself or pay the business?

Which is more tax-efficient for the incorporated small business owner – pay yourself via a salary or dividends, or a combination of the two?  The answer appears to be easy and obvious – all three options should result in the same tax bill.  That’s because the Canadian tax system is based on integration, a theory that says there should be zero difference between personally earned income and income earned in the corporation and paid out as dividends.  The reality is, however, integration doesn’t work perfectly in a country where personal and corporate taxes vary significantly depending on your province of residence.

And here’s another important consideration: Leaving more money in your company might also gain you more tax-advantaged money in retirement.  It works like this:
  • Active Business income that you leave in your corporation is taxed at the much lower small business corporate tax rate. 
  • When you take money out of your corporation as salary, the tax rules allow your company to deduct that amount as an expense and the money you receive is taxed in your hands at your marginal rate. 
  • When you pay yourself with after-tax dividends from your corporation, your company doesn’t get a deduction for that expense and the dividends are taxed in your hands but at a lower tax rate than for a salary. 
  • Until recently, financial planning experts often advised small business owners to take enough in salary from the corporation to maximize Registered Retirement Savings Plan (RRSP) contributions. Recently, a new theory has gained traction - take only enough money from your corporation in dividends to pay personal living expenses, leave the rest inside your company, and reinvest those funds as you would for an RRSP. You’ll pay tax on the dividends at a lower rate and the money left inside your corporation is taxed at the lower small business rate. 
  • When you retire, instead of withdrawing funds from your RRSP, you can sell your corporate investments and take the after-tax amounts as dividends. Unlike RRSP contributions which must be transferred to a Registered Retirement Income Plan (RRIF) by age 71, and unlike RRIFs which require that you take specific withdrawals, dividends give you better control over when you take your savings and how much tax you will pay. 
  • By paying yourself with dividends, your corporation is not required to make Canada Pension Plan (CPP) contributions or make EI premium or other provincial payroll deductions on your behalf. That could be a benefit or a drawback because your CPP income will be reduced at retirement.
Salary vs. dividends; corporate vs. RRSP investments – which is right for you? Before you make your decisions, talk to your professional advisors.

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