The Choice Between Dividends and Salary

You’re the owner/operator of a small business with an upcoming year end; you’ve had a successful year and are now deciding how to pay yourself out from the business.  Two options are available to permanently (i.e., excluding shareholder loans) remove profits from your business - salary (declared personally on a T4) or dividends (declared personally on a T5).

Integration

The Canadian tax system is based on the theory of integration, which is founded on the principle that net taxes payable between paying out income as salary or dividends will be the same.  The system is not always perfect (largely as a result of differing provincial tax rates), but in most cases where it isn’t, the net difference is minimal.  Don’t believe me? Let’s work through a quick example (see Appendix A).

Salary

Salary is a deductible expense for a corporation. Therefore taking a salary results in the corporation paying less tax. The corporation is then responsible for paying the employer portion of CPP (4.95 per cent) on the salary awarded in the year. The employer portion of the CPP will also be a deductible expense for the corporation. 

The salary awarded to the shareholder is included on the shareholder’s T4 (employment income).  Both federal and provincial taxes will be applied against this salary. The shareholder will be responsible for remitting the employee portion of CPP (4.95 per cent) on the salary he or she received in the year.  As seen by the example, the shareholder ends up getting dinged for both the employer portion of CPP (in the corporation) and the employee portion of CPP (on his or her personal tax return).   

Based on the example provided, a $100,000 salary awarded to a shareholder would result in approximately $71,890 in after-tax cash being received by the shareholder (using 2013 tax rates in B.C.).

Dividends

A cash dividend is a payment, distributed to shareholders, of accumulated earnings from prior years. It is not deductible for tax purposes to a corporation. Issuing dividends, as opposed to salary, results in a corporation paying higher corporate taxes. However the corporation is not responsible for remitting CPP on dividends paid. In the example provided, issuing dividends has no impact at the corporatetax level.

The awarded dividend is included on the shareholder’s T5 (investment income).  When receiving a dividend, the amount is “grossed up” (approximate to pretax income of the company) and then entitled to a dividend tax credit (to provide a tax credit for the approximate tax that was paid by the corporation) on your personal tax return. The net result is that dividends are given preferential tax treatment (as opposed to salary) at the personal tax level to compensate for the lack of tax savings at the corporate level. Again no CPP must be remitted on behalf of the employee for dividends paid. This is advantageous now; however, the shareholder is not eligible for CPP income down the road. As a result, the shareholder will need to personally invest a CPP equivalent into a tax free savings account (TFSA). To offset CPP income in the future, the TFSA will need to earn an after-tax rate of return of approximately 4 per cent.

Based on the example provided, corporate income of $100,000 will result in after-tax cash of $86,500 available for distribution as dividends to shareholders. From the dividends issued to the shareholder, federal and provincial taxes will be levied at the personal level, and after-tax cash of $74,105 will be received by the shareholder (using 2013 tax rates in B.C.).

The Bottom Line

In the example provided, from a purely quantitative perspective, issuing dividends is advantageous and results in the shareholder receiving $2,215 of additional cash. (Note that these results will differ at differing income levels and in provinces having tax rates different from B.C.’s). However, there are other factors that should be considered, which are likely to outweigh the minimal difference in tax savings, when coming to a decision:

1.       Leaving Money in the Corporation:

In B.C., small business corporations, pay tax at 13.5 per cent on active business income. (This generally represents income that is not rent, investment or capital gains in nature.)  As you can see from the example, this is significantly less than the 28.1 per cent being paid on salary and the 25.9 per cent being paid on dividends. Therefore, by leaving income in the corporation, you are, in essence, giving yourself an additional vehicle (similar to an RRSP) to defer paying taxes until future years. Leaving income in the corporation will maximize the time value of money. For this to be possible your corporation must earn income in excess of what you need personally to live off.  Be careful, taking out too little this year so that you forced to double up next year will increase your tax bill on account of increasing marginal tax rates.

2.       RRSP Contribution Room:

Your additional RRSP contribution room is a factor of your prior tax year’s earned income.  Salary awarded in the year increases your earned income and creates additional RRSP contribution room in the subsequent year. However, dividends and investment income are not considered earned income and do not create any additional RRSP contribution room for the taxpayer. Therefore, in awarding salary, an additional $17,576 (18 per cent of $97,644) will be added to the taxpayer’s RRSP contribution room for next year, where as no additional RRSP contribution room will have been created by awarding dividends of $86,500.

3.       Income Splitting Opportunities:

The Canada Revenue Agency takes the stance that salary awarded must be reasonable based on the extent and type of work performed. Splitting salary with a spouse and/or children is not possible in cases where the spouse and children are not in fact employees of the corporation. No such rules are attached to dividends. Provided your spouse and children are shareholders of the corporation, distributions can be split amongst them to take advantage of lower marginal tax rates.

4.       Share Ownership Structure:

Be aware that dividends must be equally awarded to all shareholders, of the same class of shares, based on their percentages of ownership. If you and your spouse both own 10 class A common shares (representing 100 per cent ownership in a corporation), then equal dividends must be awarded to both you and your spouse. This can become an issue if your spouse is already earning income from other sources, because he or she may now be at an even higher marginal tax rate as a result.  In these cases, awarding salary may be your only option. This is a classic example of why visiting a lawyer or professional accountant is important at the time of incorporation. You will receive expertise in properly designing an ownership structure to ensure future flexibility down the road.

Perhaps what you were hoping for was that there is a simple right answer.  Well there is a right answer but unfortunately it is dependent on your individual circumstances.  Finding the solution involves careful planning and consideration.   This is an area where a professional accountant can provide you with real value-added service in planning properly for your retirement.  At the end of the day, a $1,000 bill paid to your accountant will often be recovered four or five times over in future tax savings.

Salary Negotiations for the Employee

So your employer has made its annual salary offer, and it does not quite meet your expectations.  Not to worry you may have some wiggle room to negotiate. Additional salary may not be an option, but non-taxable benefits could be. Non-taxable benefits can have similar effects to a salary increase and may even be advantageous. 

Here’s an example: Let’s say you earn $75,000 annually and have marginal tax rate of approximately 33 per cent.  If your employer were to pay you an additional $1 of salary, your net take-home pay after taxes would be $0.67.  At $75,000 (assuming basic credits only), your after-tax income would be approximately $57,300. 

Now let’s assume, this year, your employer offered you a raise of $3,000. This would give you a gross income of $78,000. Assuming just basic credits, your after-tax income would be approximately $59,200. However, what you were really hoping for was a $5,000 raise, which would bump you up to $80,000 before taxes.  At this gross salary, your approximate take-home pay would be $60,600.

Here comes the negotiation aspect: We've already determined that your employer is willing to give you an additional $3,000 in deductible costs. Instead of this $3,000 coming as additional salary, why not request that your raise be given as a non-taxable benefit (available options to follow). 

Under this method, you will pay equivalent tax as last year on your $75,000 salary. This will result in after- tax income of $57,300 plus the benefit of an additional $3,000 tax free, giving you an after-tax income of $60,300. Your take-home pay is now $1,100 more than if you had received an additional $3,000 in salary and only $300 worse than if you had received the $5,000 raise you were originally hoping for.

Initial Salary	Raise: Salary	Non-taxable benefits	Consideration Received	After-Tax Income
$75,000	$3,000	$0	$78,000	$59,200
$75,000	$0	$3,000	$78,000	$60,300
$75,000	$5,000	$0	$80,000	$60,600

Here are some of the most popular non-taxable benefits you can negotiate, if they meet the requirements mentioned below:

1.   Discounts on in-store merchandise:

These discounts must be available to all employees, and the goods must not be sold to staff below cost (unless the goods are used/refurbished or damaged).   

2.   Education costs:

      

      The education or training must be primarily for your employer’s benefit (i.e., must relate to your current position of employment).

      3.   Membership fees:

Membership fees must be related to social and athletic clubs where membership is principally deemed to be for the benefit of the employer (i.e., must relate to your current position of employment).

      4.   Employer-provided daycare:

The daycare must be in-house provided daycare by the employer.

      5.   Interest subsidies on mortgage or other financing:

The mortgage or other financing arrangement must be arranged by your employer, and the employer must make the payments directly to the financial institution for the portion of your interest costs.  The employee’s share of the interest costs must remain at or above CRA’s quarterly prescribed rate (presently, one per cent).