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. Please note the blog posts are time sensitive and subject to changes in legislation or law.

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. Please note the blog post is time sensitive and subject to changes in legislation or law.