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.

Wednesday, January 23, 2013

Part 3 - Salary or Dividend? Issues to Consider

In my blog post yesterday, the numbers reflected that corporate small business owners, who employ a dividend only strategy and retain the deferred income tax savings in their corporations, will end up with more after-tax funds than if they were remunerated by salary.

The above statement begs the question: why would any small business owner pay themselves by salary, in any case other than where they need to show T4 income on their personal income tax return for a specific purpose?  I examine some of the possible reasons below.

Loss of RRSP

 

One of the most significant issues that arise when a corporate small business owner remunerates themselves solely by dividends is that they can no longer contribute to an RRSP. The reason for this is that your RRSP deduction limit is dependent upon having “earned income”, which includes employment income, but does not include dividends.

Jamie Golombek suggests in his 2011 paper "Bye-bye Bonus! Why small business owners may prefer dividends over a bonus" that “a business owner with no other source of earned income needs to consider whether he or she would be better off with a dividends-only strategy, rather than paying out enough salary/bonus to maximize his or her RRSP contributions”. He goes on to reference his 2010 paper “Rethinking RRSPs for Business Owners: Why Taking a Salary May Not Make Sense ” which concludes that small business owners whose corporations do not make more than $500,000 of taxable income are typically better off not contributing to an RRSP, but in essence using their corporations to create their own “corporate RRSP” (my term, not Jamie's).

Jamie supported his assertion by comparing two scenarios’: the first where a salary is paid and the maximum RRSP contribution is made and the second where dividends are paid and surplus funds are invested in the corporation. He then utilized 3 different portfolios to test his hypothesis. His model showed that the dividend only remuneration strategy outperformed the salary strategy over all three portfolios.

Jamie noted three reasons for this result (the first two were discussed in yesterday's blog post): (1) There is an absolute tax saving advantage by paying dividends over salary (2) The income tax deferral advantage provides more investable funds and (3) Within a RRSP, capital gains lose their tax preferred status of only being 50% taxable, since they are 100% taxable as income when withdrawn from a RRSP.

It is slightly ironic that Jamie’s numbers support building your own “corporate RRSP", since he has noted in the past that the rate of RRSP withdrawals suggest that Canadians do not consider their RRSPs as the Holy Grail of retirement savings. Thus, by  extension, if Canadians are not repelled by the "invisible fence" surrounding their RRSPs, I wonder if Jamie is concerned small business owners will not be disciplined enough to keep their hand out of their new "corporate RRSP", held by an unfenced holding company?

In the David Milstead article I discussed yesterday, Clay Gillespie of Rogers Group Financial in Vancouver says that although he likes the dividend strategy, he notes it could be derailed by human nature. “People tend to spend money they can get their hands on, he said, as opposed to dollars socked away in tax-advantaged retirement plans. It's whether people will be disciplined enough to take the money and invest in a way to take advantage of the strategy. It's important to make sure retirement savings are sacrosanct, given that future CPP benefits (but not benefits accrued previously) will be lost under this strategy.”

Before I leave this topic, I want to clarify one thing about the deferred corporate funds that accumulate if you utilize a dividend only strategy. There are two components to these deferred funds: 1. Funds that would have been contributed to your RRSP if you had used a salary strategy and 2. Excess funds that were not required for your day to day living expenses and were left in the corporation to take advantage of the corporate income tax deferral. If you were to only remove the “excess funds” component from your corporation, you at worst would still have achieved an absolute income tax savings. The insidious aspect of these deferred funds is where a small business owner withdraws money that would have been “protected” RRSP money under a salary strategy.

Despite my reservations about human nature, I must concede, if you are financially disciplined, a dividend only strategy “sans RRSP” may make sense subject to the comments below.

No CPP


If a salary is not paid, your CPP entitlement at retirement will be significantly reduced, as you cannot contribute to CPP unless you are paid a salary or earn self-employment income. For 2013, the maximum CPP entitlement is approximately $12,200 (not to mention the disability and death benefit CPP provides). It must be noted that the combined cost of the employee and employer CPP premiums’ for 2013 is almost $4,800.

OAS Clawback


For income tax purposes, the actual dividend you receive from a private corporation will typically be grossed-up by 25%. For example, if you were paid a dividend of $50,000, you would report $62,500 on your income tax return. This "artificial increase" in income can result in a partial clawback of your old age security, subject to your actual net income.

Child Care


For those with young families, if you are the lower income spouse and paid solely by dividend, you will not have any earned income and will not be entitled to claim your child care costs. If you and your spouse are both shareholders and take only dividends, you may need to take some salary to maximize your child care claim.

$750,000 Capital Gains Exemption


To be eligible to access the $750,000 capital gains exemption upon the sale of your corporation’s shares, certain criteria must be met. If you utilize the dividend strategy, your corporation or your holding company will accumulate a substantial cash position that may put the corporation offside in terms of the rules. If an offer to purchase your company comes out of left field, your shares may not qualify for the $750,000 capital gains exemption.

In order to alleviate the above concerns, you may be able to “purify” your corporation of excess cash. If you intend to use a dividend only remuneration strategy, you may want to consider implementing a family trust which would potentially have your spouse, children and a holding company as beneficiaries. The holding company would provide an outlet to remove excess cash so that you could still claim the capital gains exemption, while providing creditor protection (see below). If a family trust is not practical, there are alternative ways to purify your corporation, but some of these can be problematic or expensive to undertake.

Creditor Protection


If you utilize a dividend only strategy, the cash you are accumulating becomes exposed to creditors, should your business fail or you are sued by a customer, employee etc. Thus, at a minimum, you would want a holding company as the owner of the corporation (excess cash is paid as a tax-free dividend to the holding company) or have a holding company as a beneficiary of the family trust as noted above.

Although a holding company may provide creditor protection if you are sued by the creditors of your operating company, these assets would be at risk if you had to declare personal bankruptcy for any reason. RRSPs on the other hand are protected from creditors upon bankruptcy, except for any contributions made within the last 12 months.

Research and Development (“R&D”) Companies


For corporate small businesses engaged in R&D, a dividend only strategy may not be the correct strategy. This is because the expenditure limit for purposes of claiming Investment Tax Credits (“ITC”) is reduced where taxable income exceeds certain thresholds. Consequently, the payment of a salary will reduce taxable income and potentially allow for a larger ITC claim. In addition, the owner’s salary (specified employees) may be an eligible R&D expense, whereas dividends provide no R&D tax benefit.

Summary


My practical experience is mixed. Some people are not willing to give up taking a salary and they definitely do not want to stop contributing to their RRSP. Some also do not like the idea of not contributing to CPP and others have concerns regarding their capital gains exemption eligibility. However, the numbers, which need to be run individually for each person’s specific circumstances, do reflect that a dividend only strategy is advantageous in many circumstances and some clients have taken this route. First and foremost, you must be honest with yourself and determine whether you will be disciplined enough to not dip into your easily accessible corporate retirement fund and whether you can mitigate some of the negative consequences associated with a dividend only remuneration 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.