My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Tuesday, January 22, 2013

Part 2 - Salary or Dividend? Numbers, Numbers and More Numbers

In yesterday’s blog post, I discussed the so called “conventional wisdom” in regard to corporate small business owner remuneration. Today, I play accountant and overwhelm you with numbers. Sarcasm aside, this conversation cannot happen without numbers. If this topic is of interest to you, you will probably want to print this blog post and the related links and review this discussion when you have some spare time. You may also want a bottle of scotch and glass beside you.

There are two concepts that need to be understood in relation to this discussion:
1. Absolute income tax savings
2. The power of the deferral of income tax and the time value of money 
I illustrate these two concepts below. Please note that for the purpose of the illustrations, I have used Ontario income tax rates, however, these two concepts hold true for every province.


Absolute Income Tax Savings


The following reflects the absolute income tax savings a business owner would have by utilizing a dividend only strategy over a salary strategy. This example assumes the individual’s income is less than $500,000 (below the Ontario super tax rate) and all personal income is taxed at the marginal income tax rate of 46.41% (the highest non-super tax rate).



Corporate taxable income
$100,000
Corporate income tax
($15,500)
[A]
Corporate funds available for dividends
$ 84,500
Dividend
$ 84,500
Personal income tax on dividend
$ 27,522
[B]
Total corporate and personal taxes
$ 43,022
[A+B]
Tax on salary of $100,000 (no EHT)
$ 46,410
Absolute income tax savings of paying
dividend instead of a salary
$   3,388
($46,410-$43,022)


Below, I again reflect the absolute income tax savings a business owner would have by utilizing a dividend only strategy over a salary strategy. However, this time I assume the $100,000 salary or $84,500 dividend is the business owner's only source of income and they benefit from the lower marginal income tax rates. The numbers below are for 2013, calculated without the use of computer software, so they may be slightly off.

Corporate taxable income
$100,000
Corporate income tax
($15,500)
[A]
Corporate funds available for dividends
$ 84,500
Dividend
$ 84,500
Personal income tax on dividend
$  9,265
[B]
Total corporate and personal taxes
$ 24,765
[A+B]
Tax on salary of $100,000 (no EHT)
$ 26,697
Absolute income tax savings of paying
dividend instead of a salary
$   1,932
($26,697-$24,765)

As reflected in both examples above, there is an absolute income tax saving of approximately 1.9% to 3.4% by utilizing a dividend only strategy and this does not even account for the additional provincial payroll levies that may be applicable.


The Deferral on Corporate Income Eligible for the SBD Limit


The chart below reflects the amount of income that is deferred when a business owner leaves excess funds in their corporation.
 
Salary at highest marginal rate
(non super tax rate)
46.41%
Corporate income tax rate on income
under $500,000
15.50%
Income tax deferred by retaining surplus
cash in your corporation
30.91%
Note: this is not an absolute income tax saving, just a deferral of income tax until you require the money.
The value of the deferral is directly correlated to the number of years you leave the funds in the corporation and the return earned on those funds. An additional benefit will be the possibility to “income smooth” those funds when distributed from your corporation as dividends. It may be possible to pay dividends out over time such that you end up paying substantially less than 46.41% in total tax (or 43.02% in total using the dividend strategy example).

Jamie Golombek quantifies the deferral benefit in his 2011 report I mentioned yesterday. Using $100,000 of after-tax small business income, over a 40 year period, with a 5% return, he says that one would have more money at the end of the 40 year period, by paying a dividend out of small business income as opposed to paying a salary. The savings range from $33,000 in P.E.I. to $66,000 in Ontario.


Dividend Tax Advantage


The numerical analyses above reflect the following:
1. There is a clear absolute income tax advantage (1.9% to 3.4% in Ontario) for corporations that pay dividends rather than salary; and
 2. Where corporate funds are not required for personal use immediately, it is best to pay the higher corporate rate and to retain the funds to be paid out later as dividends.

Bloggers Note: If you are suffering from "numbers fatigue" at this juncture, you can skip directly to the second to last paragraph. The next few paragraphs will most likely be of interest to only those born with a latent accountant gene as I get a little picky with some of John Nicola's numbers.



If you did not open the link yesterday to the article by David Milstead, which discusses John Nicola’s dividend only views, please do so now, as it provides required context for the discussion to follow.
In Milstead’s article, John Nicola provides numerical support for his suggestion that a dividend only strategy may be the way to go for incorporated professionals, if not all small business owners (he contends that the dividend strategy may not necessarily be the right approach for businesses such as manufacturing companies that are asset heavy and may be sold in the future).

I really liked the clean and simple manner in which John presented his numbers. However, I would have liked to have seen the following in John’s charts.

1. In his first scenario, Mary Wilson receives what I assume is a reasonable salary of $40,000 because she is either an employee or not an active shareholder. However, in scenario two she receives $120,000 in dividends in her capacity as a shareholder. I feel this is a bit of an “apples to oranges” comparison.

In reality, some business owners may not have a spouse, or they do not wish to have their spouse as a shareholder. In the case of certain professionals like CA’s and lawyers in Ontario, their professional statues may not allow spouses or children to become shareholders. Thus, I would have preferred to have seen an example where apples are compared to apples, for instance: 
  • Scenario 1- Same as John’s scenario 1. Mary receives her $40,000 salary and John Wilson receives a salary.
  • Scenario 2- Mary receives the same $40,000 salary and Mr. Wilson is remunerated by dividends.
If such a calculation is undertaken (with spendable income of $189,000 in each scenario) the following occurs:

In scenario 2, the Wilson’s end up with approximately $24,000 less in RRSP funds than in scenario 1, however, the corporate savings are larger by approximately $43,000.
John’s charts clearly depict that from an income splitting perspective, it is always better to have multiple shareholders remunerated by dividends (especially where a spouse such as Mary is not active in the business). However, in many businesses both spouses are active shareholders. Thus, again I would have preferred an “apples to apples” comparison:
  • Scenario three-Mary is an active shareholder who takes the same salary as John to maximize her RRSP.
  • Scenario four-both John and Mary are only compensated by dividends.

If such a calculation is undertaken with spendable income of $189,000 in each case, the following occurs:

In scenario 4, the Wilson’s end up with no RRSP instead of an RRSP of approximately $47,000 as in scenario 3, however, the corporate savings are larger in scenario 4 by approximately $67,000.

These "apples to apples" comparisons do not alter the dividend tax advantage, however, I feel they provide a fairer comparison for many real life situations.
2. This may be a bit of a red herring, but in John’s chart, there is no mention of the future income tax liability related to the $54,100 in deferred corporate savings maintained in the corporation ($192,500 in scenario #2 minus $138,400 in scenario #1). Granted, I think John assumes that the funds will be left in the corporation indefinitely. However, since the income tax on these deferred earnings could be as high as 36% (at the super rate), depending upon the marginal income tax level of Mr. Wilson & Mrs. Wilson at the time they remove these excess funds, I think readers need to be aware of this potential income tax liability.

I will not debate John’s and Jamie’s conclusions that utilizing a dividend only strategy and keeping the deferred tax savings in your company will result in an overall income tax saving. However, the quantum of savings is subject to each individual personal circumstance, the number of years the funds are left in the company, the rate of return and whether the shareholder(s) are disciplined enough to keep their hands out of the holding company cookie jar.

Tomorrow, I look at why you may not want to employ a dividend only strategy.



The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

23 comments:

  1. Very interesting Mark! So you're saying that one advantage of leaving profits in the corporation is that you can wait to pay them out in a low-income year, reducing the taxes in the same way that an RRSP is intended to work? In your initial scenario the savings from keeping the $100,000 (minus corp tax) in the corporation when you're in the top bracket already, and paying it out in a year when you have no other income (or to another shareholder with no other income this year), is 18.3%.

    In that case it might make sense to speed up the process and withdraw as much as you can while staying below the higher marginal rates. That way you could "de-tax" as much cash as possible for personal investment over time. Of course if your end goal is to leave an estate then a holding company or trust may be better.

    My only concern with this would be potentially more limited passive investment options within the corporation, which may be another advantage to maximizing withdrawals.

    ReplyDelete
    Replies
    1. Hi Simply Rich:

      Yes, would act similar to a RRSP in that you can use to smooth income, however, dividend would be more tax advantageous than a RRSP income inclusion at that point in time.

      I dont follow how you derive the 18.3% number?

      I dont really agree that the corporation would have passive investment limitations. You should be able to invest corporately in the exact same investments as personally.

      Delete
    2. The personal tax on dividends drops from $27,522 to $9,265 if you have no other income (following your example). That should be the gain you would get by deferring or re-directing dividends.

      I haven't looked into corporately-owned investments much yet but I have heard of different treatment if the corporation gets too much of its income from those. That may only be under certain conditions such as a sale but any limitations would create a potential cost. All the same it looks like the strategy you outlined is the best way to go.

      Delete
    3. Ok, now I follow, but not really an apples to apples comparison, as income and tax rates are significantly different in the two examples. So I would not use the 18.3% number.

      The CRA does not like you to defer income tax on investments, so has two sets of rules, one for active companies (see the 15.5% tax rate) and one for investment companies (46% tax rate), but, there are complicated refundable rules that prevent double tax. These rules are not detrimental where you leave the excess savings from your active business as per my examples because of this refundable mechanism. Way to complicated to discuss here.

      Delete
  2. Great post Mark!
    On top of the absolute tax savings, there would be an additional $4,700 approximately, in CPP contributions (employer & employee portions) saved by utilizing a dividend only strategy which can be retained and invested in the corporation also. Only down side is one would then not qualify for CPP disability coverage if something may happen where they can no longer work. I thought this would be relevant to your blog post. Hopefully you agree.

    ReplyDelete
    Replies
    1. Anon, I agree. You are to quick, I discuss this tomorrow.

      Delete
  3. Very interesting! As our family gears up towards career changes of various kinds, this is a fascinating look at the options and benefits possible for some types of businesses.

    As a person new to the small business field I'm not sure exactly which kinds of small businesses can take advantage of payment by dividend.

    I assume sole proprietorships cannot as there are no shareholders?

    What if a person was, say, a business consultant to energy corporations and became an incorporated business. The business would be providing clients with written advice and evaluations, presentations etc. Work would be done from their own office etc, not at the client's site.

    Could the consultant be paid following these types of income vs dividend rules?

    Or is it only applicable to businesses like retail stores and manufacturing businesses?

    The possibility of minimizing the double contribution to CPP is also interesting, particularly as premiums continue to climb.

    Anyway, I found the posts very interesting, and I only had a cup of unfortified tea beside me!

    ReplyDelete
    Replies
    1. Bet, see answers below:

      I assume sole proprietorships cannot as there are no shareholders?

      A: Correct

      What if a person was, say, a business consultant to energy corporations and became an incorporated business. The business would be providing clients with written advice and evaluations, presentations etc. Work would be done from their own office etc, not at the client's site.

      A: Yes, but you would have to be careful to not be a personal service business, so you would want more than one client.

      Could the consultant be paid following these types of income vs dividend rules?

      A: The consultant would be paid consulting fees to their corporation which would then pay a salary or dividend to the shareholder

      Or is it only applicable to businesses like retail stores and manufacturing businesses?

      A: applicable to any active business that is incorporated

      The possibility of minimizing the double contribution to CPP is also interesting, particularly as premiums continue to climb.

      A: Yes, but trade off is no CPP upon retirement


      Delete
    2. Thank you again very much. I find this very interesting info, and possibly very important in the coming years as our careers change, too.
      Cheers!

      Delete
  4. Fantastic Article Mark...

    I have couple of question... suppose I make 100K in my corporation, and I distribute this equally between me and my spouse (through a family trust i guess !) with the following conditions :
    1. we have no other income beside this dividend income.
    2. we claimed the following tax credit in calculation of tax(Basic personal amount,Public transit amount,Dependent children under 18,Small business dividend tax credit)
    3. we wont be needing RRSP and CPP contributions for retirement (hopefully)

    Questions
    1. Will there be any additional tax credit that will be available to us, since dividend is not classified as income and hence we have ZERO income ?
    2. Will it create problem for us with CRA in future ?

    Thanks Again for all the good work.

    ReplyDelete
    Replies
    1. Thx Shah:

      You and your wife would still owe around $2k each in tax if your received $50k each in divdends. As for the tax credis, I cannot tell without doing a return and knowing how many kids you have etc.

      You do not have zero income. You would still have taxable income of $62k or so, you would just owe very little tax and would have no earned income for purposes of your RRSP deduction.

      No issue with the CRA, you can pay salary or pay dividends, they dont care.

      Delete
    2. Perfect...thx Mark

      Shah

      Delete
  5. I agree with the merits of the dividend strategy, however, the one big flaw being overlooked is that how many people are in a financial position to not taken out any money out of their corporation to live. If you are pulling funds out anyways to cover annual expenses, and integration exists between salary and dividends, you might as well take advantage of the RRSP room and the CPP via salary as with the dividend payment you get nothing, except possibly minor absolute tax savings (which after the RRSP deduction would turn the absolute tax savings from dividend to salary). If an individual has significant funds personally, I assume the financial advice would be to draw upon those assets first and implement the dividend only strategy.

    ReplyDelete
    Replies
    1. Hi anon

      It was not a flaw but intentional. The blog was written for those who leave money in their corp

      Delete
  6. Hi, Mark,
    Thank you for this post. It's very informative.
    My husband and I are launching a new incorporated entity to augment our inflation stressed, pensions and over age 65 benefits. We are already income splitting just under six figures. Initially the business will be small, but we are looking at the long-view of a modest income return. We will have no need to pay RRSPs or CPP. We are both shareholders.
    Questions: Which form of withdrawal of income from the corporation would be best? Salary, Dividend or Combination? Is this done annually, monthly?
    Mark, I see this as an issue that will become extremely more topical as us Boomers search to extend our incomes. Any help you can provide would be great. Thanks for your help.
    p.s. sorry if this is a duplication, I'm a novice at blog posts and I fear I put my initial post in the wrong place "mea culpa"

    ReplyDelete
    Replies
    1. Hi Anon:

      No worries, Blogger does not make posting a comment that easy.

      I was actually interviewed last week for an article related to baby boomers going back to work, seems to be hot topic, so I will consider a blog on the topic in the next couple months.

      I cannot answer your question properly without seeing your actual tax returns.

      However, I have the following general comments in no particular order:

      1. Read my April 8th blog post on CPP requirements and elections for those over 60

      2. If you receive OAS, dividends may not be preferable because they are grossed-up and may result in an OAS Clawback.

      3. The 2013 budget raised the rate on non-eligible dividends. However, if you don't have OAS clawback issues, non-eligible dividends still have around a 2% or so absolute tax savings over taking salary at the high rate.

      You can take salary or dividends at any time or once a year. Most people just choose monthly for cash flow purposes.

      In conclusion, you need your accountant to analyze your overall tax situation for the best remuneration strategy, but hopefully I have given you some food for thought.

      Delete
    2. HI, Mark,
      Thanks for your quick reply from my post earlier today. I've just read your April 8th blog and my initial response was, "wow, turn your back for five minutes and all the rules change!" I will take your comments to heart and they will give me a talking point for when I meet with our accountant. I am also subscribing to your blog and I'll be looking forward to your future blog on boomers. We've always sort of led the charge and I can't imagine that will change as we enter retirement.
      Thank you, again, Mark, for your help.

      Delete
  7. Mark. I'm not up on how CPP penalizes for years where YMPE is not attained and so CPP contributions are less than the maximum. What merit would there be to paying salary up to the YMPE each year and divvying out anything additional that is wanted? In my case, I have made the maximum CPP contribution for essentially my entire career and have about 15 years left to qualify for CPP. Thanks!

    ReplyDelete
    Replies
    1. Hi Anon

      I know little about the CPP and how the YMPE works.

      I typically pay enough salary to maximized my clients RRSP, but paying only enough to maximize CPP will probably have some absolute tax benefit (which I cannot quantify without running numbers) and a deferral benefit.

      Delete
  8. What if your living expenses are low - i.e. is you withdraw around 36K from the corporation? Does it make sense to draw a salary as the personal tax is actually less than the 15.5 corporate tax on the same amount? Or does it not really matter ?

    ReplyDelete
    Replies
    1. Sapna,

      I dont answer personal tax planning questions on this blog. However, in general you can take around $40k in div tax free if you have minimal other income, so div may be preferable to salary in your case, speak to ur accountant who has all the facts.

      Delete
  9. Do you have an updated for this for 2014? CIBC did a report on exactly this and found the deferral for 2014 for Ontario is only 0.21%, down from 3.21% in 2013. Those numbers are on page 3 of this CIBC report:
    https://www.cibc.com/ca/pdf/small-business/compensation-conundrum-nov-13-en.pdf

    ReplyDelete
  10. Hi Noel

    I am considering updating when I resume blogging in the fall

    ReplyDelete