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 tax partner and the managing partner of Cunningham LLP 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 do not reflect the position of Cunningham LLP. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, January 6, 2014

Salary or Dividend? A Taxing Dilemma for Small Business Owners -2014 Update

Effective January 1, 2014 the personal income tax rate on non-eligible dividends paid by private corporations will increase. As result of this uptick in rates, the absolute income savings that were available in most provinces in 2013, when small business owners paid themselves by dividends (as opposed to salary) have been virtually eliminated.  

With these changes, the government has achieved almost perfect integration, at least in my home province of Ontario. By integration, I mean a person will be indifferent as to whether they receive a dividend or salary from a private corporation, since the ultimate income tax cost (total of both corporate and personal taxes) is exactly the same.  

Although the government has effectively removed any absolute income tax savings, a significant income tax deferral is still available where corporations earn active business income. For example, if a corporation earns active income in Ontario, the corporate tax rate is only 15.5% as opposed to a personal tax rate of 46.41% (on taxable income over $136,270). This means to the extent that a small business owner does not need all their corporate earnings to live on and can leave funds in their corporation, they are deferring 30.91% in taxes (34.03% if they are a super-tax rate taxpayer paying 49.53%).  

Jamie Golombek, the Managing Director, Tax & Estate Planning of CIBC, recently released a report titled “The Compensation Conundrum: Will it be salary or dividends?”  This is Jamie’s third report in an excellent series on owner-manager remuneration, the first two being “Rethinking RRSPs for Business Owners: Why Taking a Salary May Not Make Sense” and “Bye-bye Bonus! Why small business owners may prefer dividends over a bonus”.

The chart below, taken from Jamie’s most recent report, reflects the impact of the dividend tax changes on small business owners, who distribute their income as non-eligible dividends instead of salary; where their corporations are eligible for the $500,000 small business deduction limit (“SBD”). The absolute tax rates which Jamie denotes as tax rate (dis)-advantage reflect significant decreases from 2013 to 2014, while the tax deferral advantage is either unaffected or has grown larger in almost all provinces. For example: In Ontario, in 2013, there was an absolute tax savings of 3.21% if a small business owner received non-eligible dividends instead of salary. However, in 2014, that benefit is now only .12%. The tax deferral remains the same at 34.03%.

Tax rate (dis)advantage and tax deferral advantage
on SBD Income in 2013 and 2014
                                             2013                                                     2014
                       Tax Rate                    Tax                    Tax Rate                    Tax
                          (Dis)-                  Deferral                  (Dis)-                  Deferral
Province   advantage          Advantage          advantage          Advantage
AB                    1.17%                   25.00%                 (0.69%)                 25.00%
BC                     1.04%                   30.20%                 (0.56%)                 32.30%
MB                   0.56%                   35.40%                 (0.89%)                 35.40%
NB                    1.65%                   29.57%                   0.91%                   31.34%
NL                     1.84%                   27.30%                   0.94%                   27.30%
NS                    4.54%                   35.50%                   2.40%                   36.00%
ON                   3.21%                   34.03%                   0.12%                   34.03%
PE                   (0.18%)                 32.73%                 (1.95%)                 31.87%
QU                  (0.25%)                 30.97%                 (1.26%)                 30.97%
SK                     2.00%                   31.00%                   0.27%                   31.00%
Chart reproduced with permission from Jamie Golombek, the Managing Director, Tax & Estate Planning of CIBC from his recently released report “The Compensation Conundrum: Will it be salary or dividends?” December 2013.

For active business income (“ABI”) in excess of the $500,000 small business deduction limit (i.e.: taxable income from $500,001 upwards) the dividends distributed are considered eligible dividends and thus the absolute tax savings and tax deferral advantage are largely unaffected as noted below.

Tax rate (dis)advantage and tax deferral advantage
on ABI Income in 2013 and 2014
                                             2013                                                     2014
                       Tax Rate                    Tax                    Tax Rate                    Tax
                          (Dis)-                  Deferral                  (Dis)-                  Deferral
Province   advantage          Advantage          advantage          Advantage
AB                   (0.47%)                 14.00%                 (0.47%)                 14.00%
BC                   (1.19%)                 17.95%                 (1.42%)                 19.80%
MB                 (4.15%)                 19.40%                 (4.15%)                 19.40%
NB                    0.63%                   19.06%                 (0.13%)                 19.84%
NL                   (2.65%)                 13.30%                 (2.65%)                 13.30%
NS                   (5.88%)                 19.00%                 (5.88%)                 19.00%
ON                  (1.85%)                 23.03%                 (1.83%)                 23.03%
PE                   (3.44%)                 16.37%                 (3.44%)                 16.37%
QU                  (2.68%)                 23.07%                 (2.68%)                 23.07%
SK                   (1.11%)                 17.00%                 (1.11%)                 17.00%
Chart reproduced with permission from Jamie Golombek, the Managing Director, Tax & Estate Planning of CIBC from his recently released report “The Compensation Conundrum: Will it be salary or dividends?” December 2013.

Last January I wrote extensively about the decision of whether to pay a salary or a dividend and the benefit of accumulating a “retirement fund” inside your corporation by taking advantage of the income tax deferral. Part 1 discussed conventional wisdom in respect of the salary versus dividend issues, Part 2 demonstrated the numerical benefits of deferring income and Part 3 discussed the various issues that can impact that decision. I do not have the time or the energy to redo these posts and much of what I said is still relevant or covered by Jamie's new report. However, I would suggest there are two key changes.

If your remuneration strategy was to pay yourself a salary to the RRSP limit and then pay yourself a dividend on any amounts over the RRSP limit, the increased tax rate on non-eligible dividends means that in many provinces, there will be little to no benefit to remunerate yourself in this manner in 2014 (EHT should be considered in this analysis).

If you leave after-tax corporate funds to grow in your company, you will now pay more income tax on the eventual withdrawal of those funds, to the extent the funds are withdrawn as non-eligible dividends.

With the change to the taxation of non-eligible dividends, small business owners need to consult their accountants early in 2014 to determine if they need to consider changing the manner in which they are remunerated.

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.

10 comments:

  1. With the taxes more closely integrated, is there still an advantage for the dividend strategy since it doesn't require payments for things like the CPP?

    ReplyDelete
    Replies
    1. Hi Richard:

      I cannot provide a definitive answer. The dividend strategy involves paying dividends and saving more in your corporation, so the answer is multi-layered. Jamie showed in his 2011 paper that there is a definite benefit to using the dividend strategy to build your own corporate RRSP. However, I am not sure how much this benefit has been affected by the dividend change, but you will not have a RRSP or CPP benefits under this strategy.

      On a current basis, yes, you would probably save money by paying dividends. You may avoid the Employer Health Tax and CPP costs. In his 2010 paper Jamie said "For example, ignoring inflation of both CPP contributions, the retirement pension and ignoring any real growth in wages, imagine investing $4,326
      for 40 years to collect a $11,210 CPP pension from age 65 to say age 82. The implicit real rate of return in this admittedly unrealistic example is a mere 0.49%. This also ignores the tax deductibility of the CPP to the business and
      the tax credit to the employee, which mitigates the cost of both the employer’s and employee’s contributions. Informal discussions with several actuaries more realistically estimated internal rate of return for present CPP contributors to be around 3%.

      So the answer is yes and no and depends on several factors and preferences. I am sure not the clear answer you wanted.

      Delete
    2. Hi Mark, I think I understand... maybe :) It sounds like you're confirming what I thought, that the taxes are pretty much identical either way but other charges are not equal since they apply only to a salary. So if I take those savings and invest them at a rate of return better than 3% (I calculated about the same rate myself) then I'm better off than someone who gets CPP benefits.

      Delete
    3. That's it pretty much. But again, some people do not wish to give up their RRSP or CPP which you do if you only take dividends.

      Delete
  2. Have an one year old company started in Jan 2013, Jan-Dec is financial period.
    Now during the year I have withdrawn money multiple times for personal expenses, I have/had no intentions of taking a salary from my corporation and these withdrawals were planned to be treated as dividends, now couple of questions :

    1. Can I take dividend before the tax is paid from corporation at year end ?
    2. Assuming I can do point 1, Can I award dividend to myself multiple times in a year (by following proper process of T5 slips?)

    ReplyDelete
  3. Hi Anon

    If you have withdrawn monies during the year, it is fairly standard practice to reflect those draws as dividends by having your accountant make an adjusting entry at the Dec 31, 2013 year end reflecting such. Those dividends are then reflected on a T5 that must be issued by Feb 28, 2014.

    I don't fully understand your question about taking dividends before paying tax. However, you can pay dividends or reflect them paid before you pay your corporate tax.

    ReplyDelete
  4. Jeepers. This is stuff I always leave to my accountant. Looks like I better have a chat with him.

    I think he pays us mostly dividends, because it's more income. The tradeoff is, no RRSP room (which is another matter entirely, does a small business owner contribute, or are they better off funneling money back into the business). If there's no pro's to dividends, and one is pulling all their income out, then dividends are actually a disadvantage because you lose the RRSP room.

    ReplyDelete
    Replies
    1. Hey Glenn:

      I think you should sit down with your accountant and discuss his planning for you. I would guess you receive only dividends because you are trying to build up your "own RRSP" in your company.

      Even though you rely on your accountant you should understand why he is telling you to take dividends and ensure you are on the same page.

      Delete
  5. I was operating an IT consulting firm until 2012 and received dividends. I have recently received an Requirement to Pay notice for corporate taxes that are still owed. It was sent to the corporation but the agent is telling me that I will be personally liable as director since I was not entitled to dividends if there was a tax balance.

    ReplyDelete
    Replies
    1. Hi Dom

      You need ask a lawyer. I am not sure of the answer because u have two issues. The basic non payment of taxes and the dividend payment and I am not sure how they tie together

      Delete