What follows is a digest of an excellent article written by Kevin Tran, Director, Tax Advisory, Scotia Wealth Management.
The choice to draw funds out of a corporation through salary or dividends often puts the Canadian small business owner in a quandary. From an income tax perspective, you should, in theory, find no advantage with one option over the other, as a result of the concept of “integration”. However, integration is usually not perfect in practice and varies with changes in income tax rates and legislation.
A decision to choose dividends over salary may make sense in a given year, whereas the reverse may be true in a different year. Income tax, along with other considerations, typically requires an analysis based on your individual situation, usually on an annual basis. We recommend that you consult your tax advisor before making any changes.
Income tax integration is based on the premise that earning income through a corporation should put you in the same tax position as if you earned the income personally. When you are paid a salary, the company deducts the amount when calculating its taxes. This results in your salary being taxed at your applicable tax rate. In the case of a dividend, corporate income tax is first paid and the after tax
amount is paid to you.
A ‘grossing up’ of the dividend amount in combination with a personal tax credit accounts for the corporate tax paid. Thus, the dividend gets taxed at a preferred rate personally, and, when combined with the corporate tax paid, should in theory result in the same amount of tax paid.
Many factors need to be considered when you are deciding on receiving income as salary or dividends. Salaries offer a flexible way to redistribute business earnings when family members are employed in the business. Any salary paid must be reasonable in relation to the services performed.
Dividends involve less administration and do not require you to perform services for the business. If you own shares of the company, then dividends offer a means to distribute after-tax profits to you as a shareholder.
A situation where a salary may provide a beneﬁt is when your company is a Canadian-Controlled Private Corporation earning active business income eligible for the small business deduction. This preferential tax treatment is currently limited to the first $500,000 of active business income, which is taxed at a reduced rate. Income above this threshold is taxed at the general corporate rate. Paying a salary (or bonus) to reduce your corporation’s business income to $500,000 may be advantageous. The decision to receive dividends or salary should be made with the aid of a tax professional and analyzed based on your individual situation.
Often, a combination of the two proves effective in taking advantage of lower effective personal tax rates on dividends, while obtaining benefits from salary payments such as CPP and RRSP participation.
We recommend that you consult a tax professional if you require further clarification on this issue, or contact Dave Ritcey, The Ritcey Team, 902-678-0048. I will be happy to recommend a qualified tax professional to assist you.