Salary or dividends from a corporation
If you thought navigating the maze of investing was challenging enough, from a personal perspective, consider how some business owners may feel.
How to invest inside a corporate account, whether you should pay yourself a salary or a dividend, can be a complex decision for many business owners.
I have some ideas on what might be best, but I never pretend to have all the answers. Options abound!
As so often said: “it depends”!
So, to support this topic today, I’ve enlisted some help. Welcome back a not-so-grumpy accountant Neal Winokur to the site.
Neal Winokur, CPA, started his practice in 2013 and his grumpiness has grown steadily over time – when it comes to our Canadian tax system. An active blogger, several of his articles have been published in the National Post. Neal continues to feel a moral obligation to speak out against any Canadian tax system flaws while educating others as best he can.
You may recall I profiled Neal’s book The Grumpy Accountant here.
Neal, welcome back to the site!
Great to be back Mark and happy to contribute in terms of general financial tax knowledge.
Neal, as someone who is new to incorporating and investing inside a corporation myself, it seems there is a lot for me to learn. Can we back up for readers and explain what the key benefits of incorporating are, from a tax perspective?
Sure thing Mark.
The main benefit of incorporation, from a tax perspective, is what we call a “tax deferral”.
Let me illustrate by using a simple example. Imagine you are self-employed and earn $100,000 of profit from your business. If you report this income on your personal tax return as self-employment income, you will pay $24,000 of income tax (approximate, based on combined Federal + Ontario rates).
Let’s now imagine, instead, you incorporate a corporation and earn this income within the corporation. You will only pay $12,200 of income tax on the $100,000 of profit in the corporation (based on combined Federal + Ontario rates).
This is because “active business income” within a Canadian Controlled Private Corporation (CCPC) is eligible for the “small business deduction” which allows the first $500,000 of profit to be taxed at the low 12.2% rate. Profit above $500,000 is taxed at 26.5%.
So, instead of paying $24,000 of income tax personally, you are only paying $12,200 of income tax in the corporation, resulting in savings of $11,800. This $11,800 can then be invested within the corporation. You will not have to pay personal income tax on these funds until the money is withdrawn from the corporation for personal use. So the idea is to take out as little money as possible from the corporation each year. Take out only what you need for personal use (and some extra to max out your TFSA and possibly RRSP, RESP etc.) but then, leave the rest in the corporation.
Keep in mind, of course, the investment income earned within the corporation is taxed each year. But you are starting off with a higher amount of funds to invest due to paying a lower amount of income tax.
That tax deferral concept is very important.
When it comes to taxation – I’m trying to minimize it. Like other Canadians! Since I’m still working full time – I’m not intending to pay myself a salary (nor dividends) from the corporation for a few years from now.
What are your thoughts on that approach? I mean, it just seems to make sense to keep any money earned inside the corporation (and not spend it?) as much as possible for future investing.
You’re right Mark – don’t pay any more in taxes that you have to!
Again, I think you’re wise to incorporate if your blog or other business ventures are making some money and increasing your personal taxable income.
Like we have discussed, since your corporation is really a transfer from your small home-based business to a corporate structure for tax purposes; and since you’ve stated you don’t need the money from the corporation for any day-to-day living expenses now, then I would leave as much profit as humanly possible within your small business corporation for the coming years.
Assuming you’re going to essentially bank all income earned less a few operating expenses within your corporation, then leave that money there, pay the low corporate tax, and invest the after-tax profit.
I should mention there is a great debate out there regarding whether someone such as yourself should actually pay out the corporate profit as a salary to yourself and then max out your RRSP each year and invest within the RRSP. Jamie Golembek, one of the top tax experts in the country at CIBC, released a whole report showing very detailed calculations. His conclusion was that for most business owners, it makes sense to pay yourself a salary to the point where you can create the maximum RRSP contribution room, you pay into CPP, and contribute to your RRSP. Over the long run, his calculations show you are better off by doing this due to the lower tax bill as a result of contributing to your RRSP as well as having tax-free investment income within your RRSP.
In your case, this would mean paying yourself a salary of $154,611 to create the maximum RRSP contribution room (2020 numbers) – if you ever earned that much of course. If you already have a salary from other sources of income, as you do, then you could just top off your salary from the corporation to bring you up to the maximum RRSP amount and leave the rest of your profit within the corporation.
Great stuff Neal. So as a newbie to investing as part of my corporation, based on my situation, I’m wondering how best to invest. (Since I’m not paying myself a salary nor a dividend). I’m leaning on opening a taxable investing account within the corporation structure and investing inside that taxable account – is that tax-wise?
Well, this would be the only way to do it. You can open a self-directed trading investment account within your corporation and invest the funds there. Of course, you should speak to a corporate lawyer to discuss any potential legal liability issues. The major one I see for corporation owners – if they were ever to be sued, these investments could be at risk. Some people open up holding corporations which own the shares of the operating corporations. Then, the operating corporation can pay a tax-free dividend to the holding corporation and the funds can be invested there.
From a tax perspective, investment income within the holding corporation is actually taxed at high rates. For example, interest income is taxed between 47 and 54% depending on the province. Capital gains would be taxed at half that rate because half the capital gain is tax-free, of course. Dividends are taxed more favourably due to the dividend tax credit and refundable dividend tax.
I am aware that as soon as I start withdrawing the funds, for personal income use, I will have to report that as a salary and/or dividend to myself and pay the rates of taxation then.
I had a great interview with my go-to-guy at Horizons ETFs on this, Mark Noble, and it seems any corporate class fund structure could be a great fit.
Thoughts on that? There are also other great all-in-one funds to invest in for growth.
I can’t speak to your personal investing goals nor other parts of your financial plan Mark, and I can’t give specific investment advice, but based on the structure of the Horizons ETFs you cited, this is exactly why these funds are ideal for corporations.
Dividend income is taxed favourable in corporations but these types of ETFs are great if you can minimize the tax by way of not having the dividends be distributed out in the first place.
What about other folks that have incorporated Neal. Some of them cannot just park the money like I might consider. The question I see posted quite a bit is the debate about paying yourself a salary or paying yourself dividends to deliver income. Thoughts? Is one better over the other?
There are pros and cons of each choice. Keep in mind one can also do a combination of both.
Let’s walk through a few different examples of strategies that can be used.
Let’s say someone has $40,000 they want to withdraw from their corporation and they have zero other personal income. In such a case, if they paid themselves a dividend of $40,000, they would pay virtually zero income tax personally. Canadians can earn up to $35,000 or even $40,000 of dividend income with almost zero income tax payable on the personal end. Of course, that dividend is not a deductible expense in the corporation so the corporation would pay corporate income tax at a rate of 12.2% on that income but overall, one is still better off than salary in that particular example.
At amounts higher than that, generally speaking, one will pay very similar amounts of income tax, overall, whether pay salary or dividends, when adding together both corporate income tax and personal income tax. The real difference is CPP contributions and the ability to create RRSP contribution room for yourself.
When you pay yourself salary, you must pay into CPP (Canada Pension Plan). And you must pay double CPP! Meaning, you are the employer and the employee so you must pay both the employer and the employee portion of CPP. Also, when you pay yourself salary, you create RRSP contribution room for yourself. So for example, if you pay yourself a salary of $100,000, you create $18,000 of RRSP contribution room. For 2021, the maximum RRSP room is $27,830 which means if you pay yourself a salary of $154,611 you will create the maximum RRSP room for yourself.
In the long run, both CPP and RRSPs can be potentially more beneficial when compared to paying dividends. I’ve done this analysis many times for clients and although the salary option is slightly more expensive, sometimes, due to the CPP contributions, they are actually still better off because I would rather people pay into CPP than pay income tax. Remember, CPP comes back to you whereas income tax does not. The CPP funds are managed separately from general government revenue (income tax) and cannot be touched by politicians, at least according to the law right now! Hopefully, it stays that way!
I usually recommend people bite the bullet and pay themselves a salary, pay into CPP, which provides some long-term security and create the RRSP contribution room. But again, this might not be the best solution for everyone. It depends on one’s income, on one’s short-term and long-term goals, on one’s cash flow needs, on one’s comfort level and ability to invest and manage their own money and many other factors.
Keep in mind, when paying a salary, the corporation must withhold CPP and income tax from your salary, pay those deductions along with the employer portion of CPP to the CRA, and file a T4 slip for you. However, when paying a dividend, there are no deductions, no remittances to CRA, but a T5 slip must be filed.
It’s important to note that many small business owners used to pay their spouses dividends. If one’s spouse was in a lower income tax bracket personally, then one could pay them a dividend and they would pay a lower overall amount of family income tax. However, in 2017, the federal government implemented a new set of legislation called “TOSI” Tax On Split Income to try to prevent this type of income splitting.
To stay onside of the TOSI rules can be very complicated and an explanation of the TOSI rules is well beyond the scope of these comments. In fact, TOSI has been described by some tax experts as one of the most complicated and punitive pieces of tax legislation they have ever seen! For this reason, it’s usually not recommended to pay spouses dividends unless they are really actively involved in the business in a real way and it’s definitely highly recommended to speak to a tax expert who is very familiar with these TOSI rules.
Overall Mark, I like your summary below for readers!
If paying yourself a salary
- Payments are a deductible expense.
- The corporation must prepare and file a T4 slip and summary
- The salary expense reduces the corporation’s taxable income which reduces corporate taxes owing.
- You will need to register a payroll account with CRA, the corporation will need to withhold source deductions like CPP and income tax.
Benefits of paying a salary?
- Predictable income – good for large corporations who have staff.
- You can generate RRSP contribution room via salary from a corporation – but that room cannot exceed any overall, existing personal RRSP contribution room.
- Generates Canada Pension Plan (CPP) contributions – a salary allows you to contribute to CPP but it also means CPP contributions are a corporation cost – less cash now, more cash later.
- Less tax surprises – given income tax is withheld, you have already paid some income tax come tax filing time.
If you are paying yourself a dividend
- Dividends (payments to shareholders of a corporation that are paid from the after tax earnings), are not a corporate expense and do not reduce the corporate taxes paid.
- Dividends are declared and cash is transferred from the corporate account to a shareholder’s personal account. The corporation must prepare a T5 for any shareholders who the dividends. Dividends are issued based on share ownership (e.g., 100%, 50%, other).
Benefits of paying a dividend?
- Very simple – you can just declare a dividend and transfer cash from the company to your personal account. No need to register for payroll and remit source deductions but you must register a “RZ” account to file the T5.
- Lower costs – paying dividends to shareholders removes the need to contribute to CPP, which reduces corporate and personal costs. (However, you cannot contribute to the Canada Pension Plan either). More cash now, less cash later.
- Less payroll issues – paying dividends eliminates the chance of late or missed payroll remittances.
Final question Neal. Based on some of the horror stories you’ve helped clients work through over the years, when it comes to corporate structures, what tidbits of advice or words of wisdom do you have for newbie folks like myself? Anything I need to be very mindful of?
Also, other than tax experts like yourself, where can small businesses find accurate and relevant information on successfully managing their corporation in Canada?
I think it’s very important that people who are thinking of incorporating speak to both a tax accountant as well as a corporate lawyer. Some people think they must incorporate when they start a new business when, in fact, they can simply run their business as a sole proprietor with proper business insurance.
Others think there will be no benefit from incorporating or it’s too much hassle but then start to earn unexpected very high amounts of income. The bottom line is the Canadian tax system is WAY too complicated to figure this out on one’s own. I truly wish it wasn’t this complicated. I wish there would be no reason for the job of a ‘tax accountant’ or ‘tax advisor’ to even exist.
I also recommend people do NOT incorporate their own corporations online. I would rather people use a corporate lawyer that they develop a relationship with so the incorporation is done properly. Many people don’t realize they might need to file a Section 85 rollover when they incorporate and they need to physically deposit share capital into their corporate bank account to purchase the shares of the corporation. There are a lot of little things like that people forget or ignore, which I do not recommend.
Great insights and thanks very much for this overview Neal.
Folks, certainly lots to think about and I would like to hear from you if you have incorporated.
How do you manage your salary or dividends for your income stream? Do you do a combination of both?
Do you find our Canadian tax system as messed-up as Neal and I think it is? Do share!
About this post:
Neal Winokur, CPA, started his practice in 2013 and his grumpiness has grown ever since. An active blogger, several of his articles have been published in the National Post. Neal feels a moral obligation to speak out against the inherent flaws, unfairness and needless complexities that define Canadian tax. His dream is for the Canadian tax system to be massively simplified to the point where his job as a tax accountant would no longer exist. His wife won’t be too happy about this, but it’s for the good of the nation!
This post is about general tax perspectives and is not considered personal tax advice to My Own Advisor or any reader. You are encouraged to seek professional tax expertise whenever you are in doubt or should you need any support for your personal or corporate investing needs.