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.

26 comments:

  1. Mark, these three posts were perfect - very practical. One of my favourite. PS - Aside from tax/accounting, I also find your "psychology of money" posts very interesting. Hopefully this hobby of yours isn't burning you out... Keep it up!

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    1. Thx Anon, glad you found them useful. I actually needed to write these blogs to clarify some issues in my mind regarding the strategy, which were answered in most part by some of Jamie's models and mini studies when I put everything together.

      Glad u like the psychology of money posts, actually my favourite posts to write. As for burnout, yes definitely at times, we shall see how long I continue with this. Thx for your kind words.

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  2. Thanks for the nice summary and all the links. I read Jamie's original article and have been pursuing the dividend only strategy since. As you noted so clearly, you need financial discipline, which I have (fortunately).

    I have printed your articles and added them to my personal file of useful things.

    Bill

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    1. Thx Bill. Jamie's articles were very well done and really set forth the issues. Glad it is working for you and u can keep your hand out of the cash jar:)

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  3. When I have run the numbers for clients, I find the tax savings minimal and are mostly CPP savings. That said, most of them are not paying themselves at the highest tax rate. I think I need to do what you did and run the scenarios again to gel it in my mind. Also find it messes it up when you can't income split easily with the spouse if they have earned income of their own.

    Do you charge clients to do an individual analysis?

    It would also be interesting to see a similar analysis on automobile benefits.

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    1. Hi Anon

      I partially wrote this paper to distil this issue in my own mind. My clients typically are all high rate taxpayers, so a bit different than you. I think if you look at Jamie’s model’s for RRSPs and his numbers for the benefit of the deferral, the advantages are furthered clarified.

      Typically we don’t charge, as it is part of our year end tax planning, but if we have a time consuming case I would charge.

      Don’t hold your breath waiting for on an auto benefit analysis. I have no interest in spending the time required to do a proper analysis.

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  4. Hi Mark,

    I must compliment you on the excellent 3-part series on dividends vs salaries. You explained the issues beautifully.

    I would add one consideration to the mix, which considers how the investment capital is invested once contributed to an RRSP or retained in a corporation.

    Let's say someone is paid a salary so that they can make RRSP contributions. Inside the RRSP, they invest in a balanced portfolio consisting of 60% equities and 40% fixed income. All interest, dividends and capital gains earned/realized within the RRSP are not taxable, but all withdrawals will be taxed at the full rate in the future.

    Contrast this to the dividend recipient, who leaves the balance of his retained earnings in his corporation to be invested (or moved to a holdco, or moved to a family trust). In this scenario, the income is taxed on a current basis, but only interest and foreign dividends will be taxed at the full rate. Capital gains and Canadian dividends of course receive much more favourable tax treatment.

    So an additional part of the salary vs dividend question should consider the type of investments that the individual plans on holding in the RRSP or in the corporation. If s/he is a real conservative, GIC-oriented investor, s/he may be better served by paying a salary to create RRSP contribution room, so that the RRSP can hold fixed income investments. The same fixed income investments made inside a corporation would be subject to much more severe taxation.

    Conversely, if the investor is growth-oriented, you may prefer the dividend route, which would retain more capital inside the corporation, where capital gains feed the capital dividend account and Canadian dividends are taxed in a more friendly way that foreign dividends and interest.

    Other considerations: a) if a family trust is used, conceivably the income earned could be allocated to low-income family members and the tax hit could be considerably lower; b) for assets retained in the corporation (or the trust) there are numerous investment structures available that convert highly-taxed income into lower-taxed income or converted into current or deferred capital gains, which can help manage one's overall tax bill going forward.

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    1. Hi Anon:

      Wow, awesome analysis. I definitely have some of the smartest blog readers out there. I am not sure you will agree, but in Jamie Golombek’s 2010 paper he looked at 3 scenario’s, a 100% equity portfolio, a balanced portfolio and a 100% fixed income strategy. His models reflected all 3 portfolios’s created higher after-tax cash for the business owner when using a dividend vs salary strategy. I will let you argue that one with Jamie.

      I do agree however you must consider the income splitting benefits of a family trust.

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  5. Thank you very much for taking the time and effort to make these posts. At age 51, i have switched from a salary to all dividend strategy. My spouse and I are also business partners, so we each receive around 60 K/yr in dividend income. RRSPS are now all interest income and foreign dividend ETFs, and investments in Holdco are for cap gains. Reading these posts make me more comfortable with my chosen strategy. Still a bit anxious about opting out of CPP, esp. The disability portion. Hopefully will never need this or my private disability coverage.

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    1. Hi Tickerdoc

      I think the key is to understand what you are giving up by going with an all dividend strategy and if u r willing to give up RRSPs, CPP etc, than it is incumbent upon you to ensure you are disciplined and leave the money in your corporation and don't stick your hand in the money jar. I am glad you have private disability coverage, that is very important at your age.

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  6. Great series of posts! When I was a partner in public practice a few years ago, we mostly recommended a fairly substantial salary, particularly for our younger clients as banks, at least at the time, did not give dividend income the same weight when granting a mortgage. And of course the client who never paid into CPP complained about it on retirement even though we'd had the conversation (documented!) every year about the ramifications.

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    1. Thx Leanne

      You raise a great point regarding the banks giving the same weight to dividends as salary. That is why I have the comment at the beginning of this blog about whether you need to show T4 income. I am not 100% sure the banks have fully grasped this shift in remuneration strategy, even where enough salary is paid to contribute to a RRSP and the rest of your remuneration is paid via dividend.

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  7. Thanks for a great series of posts. I really enjoy reading your blog.

    Could I ask a question about CPP? If a professional incorporated in mid-career, and paid into CPP at the top rate for 15-20 years based on salary, and then switched at age 45 to dividends, would entitlement to CPP benefits (disability if needed, and retirement at 65) carry forward?

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    1. Thx John:

      I do not really deal with CPP that often and the rules are complicated. For disability, go to this link and answer these questions http://www.servicecanada.gc.ca/eng/isp/cpp/applicant.shtml#b
      For regular benefits you would get something, however, you would have to ask Service Canada to provide the benefit you would be entitled to.

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  8. Very interesting. I don't think I will be changing my own strategy because of your series (at this time), but it certainly gives me something to think about.

    I am taking salary to maximize my CPP, and leaving the rest in my Corp. This way I get CPP and RRSP room (and a T4), and probably will take some of my early partial retirement from the Corp. as salary.

    Thanks for crunching the numbers.

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    1. Hi Anon:

      Thx

      The idea of the series was to discuss the considerations and provide something to think about. Many of my clients still are taking salary to maximize RRSP and CPP.

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  9. Excellent post. I'm a huge fan of dividends but what about childcare for our 2 kids? Could we pay a 14k mgmt fee to the lower income spouse and write that off against 14k childcare expenses? I think there is no cpp on the management fee correct? With those 2 offsetting the full personal exemption can be used for dividends. Could you please comment on this strategy as a way to overcome the childcare negative of the dividend strategy

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    1. Anon, a management fee can be problematic.But assuming you did so, I would suggest it should be reflected as business income and CCP would be exigible. Speak to your accountant who knows your personal details.

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  10. Excellent Posts.
    I am still unclear about Dividend vs Salary in the scenario with the following assumptions:
    1)Net corporate income exceeds SBD (i.e. > 500,000). Corporation will leave the first 500,000 (whatever is left after paying lower tax rate) in the corporation and excess to paid to owner (either as salary or eligible dividend).
    2)Individual already has net personal income exceeding max tax rate and allowing full RRSP contribution (i.e. >135,000)

    In the above situation, what is most tax efficient, for example if taxable corporate income is 600,000:
    a) Take 100,000 salary bonus (and pay highest personal tax rate); or
    b) Pay coporate higher general income tax rate on 100,000 and take the remaining money (73,500) as an eligible dividend and pay personal tax on it (at highest tax bracket)

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    1. Hi Anon

      The answer is not clear cut, but many accountants now suggest their clients pay the higher general rate of corporate income tax (26.5% in Ontario) when taxable income is greater than $500,000 rather than pay the additional bonus, if the money is not needed immediately.

      The reason for this is to take advantage of the 19.91% income tax deferral (46.41% highest non "super tax" personal tax rate - 26.5% corporate rate in Ontario) or 23.03% deferral at the "super tax" rate. Our firm calculates that if your anticipated after-tax investment return is 3%, this strategy makes sense after 2-3 years.

      Thus, if you can leave the money for several years, many accountants would suggest paying the high rate corp tax because of the deferral

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    2. Thanks. My question is if you do want the money in the current year, is it better to take a bonus or a dividend in the above scenario?

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    3. Depends upon whether EHT is applicable and whether eligible dividend. Not huge difference one way or the other, have you accountant run the numbers for your situation.

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  11. Could you comment on the advantage of dividends given the new rules in the 2013 federal budget (other than no CPP)

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    1. Hi Anon

      The absolute tax saving advantage of dividends I reflected in part 2 of the series is now cut in half to around 1.6%. However, the deferral is still significant and unchanged. I don't think based on my initial review that the budget proposals would cause anyone to change their strategy if they are already using a dividend strategy.

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  12. Hello!
    My husband and I sold the assets of our business in 2015 and are now left with a holding company that we use to invest. We are both 50 and are starting a new business. In 2016 and 2017, we expect to make under $10,000 personally (after business expenses). Our new company is currently a sole proprietorship, but that may change as it grows. Our holding company had approx. $18000 in taxable capital gains, interest and dividends last year. Our question is, rather than just bonus out the $18000, would you consider bonusing out to our YMPE to maximize CPP and future RRSP contributions (we would not use the RRSP deduction this year), since our income is currently so low?

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    1. Hi Brenda

      I do not provide specific personal tax planning advice on this blog. That being said, if you have minimal personal income, it may make a lot of sense to consider paying dividends to you and your husband from the Holdco. If you pay say $30k each, you likely can receive such with no to little tax based on your comments above. Thus, I suggest you speak to your accountant or engage one, as you may have some useful tax planning opps. while building your new biz, however, they must be analyzed based on your specific circumstances

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