Banka: Deciding between dividends and salary for company income
In getting money out of your corporation, what is the better option—dividends or salary?
Keep in mind that in an owner/managed incorporated business, usually everything comes out of the same pocket.
Depending on the kind of business, the corporate tax rates (13.5%) are currently lower than the lowest personal tax rates (20.5%).
Rental, investment and personal service businesses do not qualify for the small business deduction which results in a higher corporate tax rate.
Paying a salary will provide a monthly amount paid to the shareholder and also the payroll taxes and Canada Pension Plan are remitted on a periodic basis, which is easier on the cash flow.
If the shareholder withdraws money from the company on a regular basis anyway, this may be a good option and it also creates RRSP contribution room.
There have been cases of the Canada Revenue Agency ruling against a corporation, stating that the company should have been paying a salary and withholding the taxes due to the amount of regular withdrawals being made by the shareholder.
The company would have then been charged a penalty and interest for not making payroll remittances.
Dividends on the other hand, do not require the payment of any taxes withheld to the CRA, nor any CPP payments, nor will there be any RRSP contribution room created.
Dividends are paid by the corporation from after-tax profit, which means that the corporation needs to pay taxes on the income before distributing any dividends.
Currently the required deductions for the CPP are at 4.95% as an employee which is matched by another 4.95% as the employer for a total of 9.9% for a shareholder/employee. These funds are then left in the government’s care to grow at perhaps 1-2% annually.
If, as a business owner, you weren’t going to rely on your CPP for retirement, one option may be to take the 9.9% yourself and invest it into a Tax Free Savings Account.
You need to be careful that you don’t exceed the annual TFSA contribution limits, but you may be able to get a better return on your money by letting it grow within the TFSA.
One issue with the payment of dividends is that they should not be paid out when there is negative retained earnings. How can you dividend out more earnings than the company has made?
Apparently, this is not an issue with the CRA because retained earnings represent after-tax income.
It does become an issue for creditors, though, because if after payment of these dividends, the company becomes unable to pay its creditors as due, then those creditors may be able to seek satisfaction from the owners themselves which negates the limited liability protection of incorporation.
The other issue with payment of dividends is whether it will put the shareholder in a higher tax bracket.
Dividends are grossed up by 25% in the hands of the shareholder, so in order to avoid taxes on the dividends, the amount of dividends need to be limited to the level of the lowest tax bracket or $42,707 federally.
The taxpayer will then receive a dividend tax credit of 13.33%, which is supposed to offset the gross up and put the taxpayer in the same position that the corporation issuing the dividends would have been in.
There have been some legislative changes to separate the issuing of dividends by a privately owned corporation from a publicly held corporation.
The dividends issued by a publicly held corporation are classified as ‘eligible’ dividends and their gross up is 45% and the tax credit attached to this kind of dividend is 18.97%.
Although there is nothing that indicates that a privately owned corporation cannot issue eligible dividends, the classification is normally only used by public corporations.
Another problem with the issuing of too high of a dividend also arises in the case of those credits that are based on taxable income (line 234) of the income tax return.
Some of these credits are OAS, GIS, HST, Age Credit and Pharmacare. If line 234 is over a certain threshold amount (different for each credit) then these credits or a portion of them are ‘clawed back’ as taxes until the next year’s income tax return is filed.