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In order to make a decision on whether to remunerate the owner through dividends or salaries, it is necessary to gain an understanding of the personal and corporate tax effects.
A corporation pays tax on its’ net income (revenue minus expenses). Each year, the net income accumulates as retained earnings, which is available for distribution to the shareholders in the form of dividends. The corporation pays tax on its’ income at a lower rate than an individual, but once the corporation pays dividends to the individual, the dividends are taxable, bringing the combined rate to the same as it would have been if the individual had simply run the business without a corporation. A corporation provides a deferral of tax, but not an outright savings of tax.
A bonus or salary is a deduction to the company, while a dividend is not. When an individual receives a bonus, it is taxable at the regular rates, In contrast, when an individual receives a dividend, it is taxable at preferential rates, in recognition of the corporate tax that has already been paid on the income inside the company.
The small business deduction is available to corporations carrying on active business in Canada. This rate must be shared between all companies under common ownership and control. This preferential tax rate will be applicable on income up to $500,000 for the associated group.
When a company earns income that is subject to the small business deduction, the eventual dividends will be taxed as “ineligible dividends”. An individual pays a higher tax rate on an ineligible dividend than an eligible dividend.
A company or associated group will pay tax at the general rate on all income in excess of $500,000. This applies to the companies in the mid-market as well as large public entities. When a company earns income that is subject to the general rate of tax, the eventual dividends paid will be “eligible dividends”, and will be taxed at the lowest dividend rates. If the corporation pays more tax, the individual pays a comparatively lesser amount to bring the total up to the same amount as the bonus.
While the theory is that the amounts should all be equal, they are not. While many provinces are very close, there is no one province where we are perfectly integrated.
Let’s consider a simple fact pattern. A corporation has net income of $100,000 before remunerating the shareholder. This looks at the total income taxes paid by the company and the shareholder once the funds have been paid out as a dividend or a bonus. Remember that a bonus is an expense to the company, while a dividend is not. I have assumed that the individual is already in the highest personal bracket for their province.
If the company is eligible for the small business deduction, in every province, it is slightly better to earn income inside a corporation and have it paid out as a dividend as required by the shareholder. Not only does this result is a lower overall tax rate compared to earning bonus income, there would not be CPP or EI on these dividends. However, the dividend will not create earned income for RRSP or IPP room; as such the shareholder will not be able to contribute into these types of deferred plans.
If the income is subject to the general tax rate, it is slightly worse to earn income inside the company and pay it out as dividends, but there is an immediate deferral of tax, as the personal level tax is not paid until the company pays the dividends to the shareholder.
When determining the remuneration strategy, not only do the relative tax effects matter, care should also be placed on other issues such as benefits, disability insurance, and future CPP benefits.
In order to determine which strategy works better for your situation, it is recommended that you speak with your local MNP Tax advisor.
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