Salary or Dividend? A Taxing Dilemma for Small Corporate Business Owners

Over the last couple years, tax professionals have questioned the traditional salary based remuneration strategy used to pay corporate small business owners. Numerically, there is hard evidence that a remuneration strategy of paying only dividends and not paying any salary results in an absolute income tax savings and potentially, greater long term retirement savings. However, foregoing a salary means you can no longer contribute to a Registered Retirement Savings Plan (“RRSP”), nor can you contribute to the Canada Pension Plan (“CPP”). In addition, although abstruse in the salary versus dividend analysis, one must somehow account for personal behavioural characteristics. A consequence of utilizing a dividend only strategy is that you “park” your retirement savings in an easily accessible and tempting location (an operating company or a holding company) and human nature being what it is, one may tend to stick a hand in the candy bowl (money bowl in this case) when there is candy (money) there for the taking.

One of the first professional advisors to advocate the use of a dividend only strategy was John Nicola of Nicola Wealth Management. John’s views were discussed in a provocative 2010 article on “Paying yourself in dividends” by David Milstead of the Globe and Mail. I say provocative (since as my friend Alison says, "I find money pretty darn sexy"), because I specifically remember several people calling me to ask my opinion on the article.

Jamie Golombek, the Managing Director, Tax & Estate Planning of CIBC was another early proponent of using a dividend only strategy, or at least considering using such a strategy. In 2010, Jamie wrote an excellent report “Rethinking RRSPs for Business Owners: Why Taking a Salary May Not Make Sense” in which he concluded it may be better to not contribute to an RRSP, but  to essentially create your own “corporate RRSP” by utilizing a dividend only strategy.

Jamie followed up a year later with another paper, this time titled “Bye-bye Bonus! Why small business owners may prefer dividends over a bonus”. In this report, Jamie concluded that a dividend remuneration strategy may be the preferred method of remuneration in many cases for small business owners.

As evidenced by the breadth and depth of Jamie’s reports, this topic is not conducive to a simple analysis. Thus, in order to make this topic more digestible, I have broken the topics on remuneration strategies for corporate small business owners into three separate blog posts:

1. Conventional Wisdom

2. Salary or Dividend - The Numbers

3. Salary or Dividend - Issues to Consider

Conventional Wisdom

So let’s review the so called “conventional wisdom” with respect to how most accountants advise or used to advise their clients to pay and/or distribute their remuneration.

For individuals who operate an active business through a corporation and whose corporation has annual taxable income of less than $500,000, most accountants generally advise or used to advise, a remuneration strategy along these lines:

1. Pay yourself a salary to maximize your RRSP contribution room for the following year (A 2013 salary of $134,833 is required to ensure you will have the ability to contribute the maximum 2014 RRSP deduction of $24,270).
2. Pay reasonable salaries to your spouse and children if they work in the business.
3. Pay dividends to the owner-manager and/or their spouse and children (if shareholders or beneficiaries of a family trust) to fund any additional living expenses not covered by salary.
4. Leave any remaining funds in your business to defer income tax on those funds. This strategy will be discussed in greater detail tomorrow.

Where a corporation has taxable income in excess of the $500,000 small business deduction (“SBD”) limit, the “conventional wisdom” used to be to pay a salary to maximize the business owners RRSP and then pay an additional bonus equal to the corporation’s taxable income in excess of the $500,000 limit (i.e. Pay a bonus to reduce the corporations taxable income to the $500,000 threshold limit at which the corporations income is taxed at a favourable low rate [15.5% in Ontario]).

However, as corporate income tax rates have declined over the last few years, “conventional wisdom” has changed with respect to paying a bonus when the corporate taxable income exceeds the $500k SBD limit. Most accountants continue to advise their clients pay a salary to maximize their RRSPs, but many 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 even if you can only leave the money in the corporation for 2 to 3 years.

For the purposes of this blog post and my two upcoming posts, I will not comment any further in regard to private corporations with taxable income greater than $500,000 as many accountants tend to agree on the above remuneration strategy.

Tomorrow, I put on my bean counter hat and throw some numbers around.

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.