Q: I’m starting my own company and would like your thoughts on taking a salary versus dividends. I’m thinking of going the dividend route simply to avoid Canada Pension Plan (CPP) premiums. What are the pros and cons of this? — Jason in Alberta
FP Answers: The first thing I would consider, Jason, is whether to incorporate in the first place. You can be self-employed, earn income as a sole proprietor and report it on your personal tax return. If you incorporate, this comes with legal fees, accounting fees and additional bookkeeping.
iStock-1445692627
Common reasons to incorporate are liability protection, involving shareholders, and if you expect to earn more income than is needed for your lifestyle expenses. The last point can result in serious tax savings if you can retain some of your profit corporately rather than withdrawing it personally. Tax deferral can be more than 40 per cent when comparing corporate tax rates to the top personal tax rates in some provinces.
The decision to take a salary or dividends involves an understanding of corporate and personal tax integration. If an owner-manager pays out all their corporate income as salary, it would be similar to if they earned it all personally in the first place. The corporation would claim a tax deduction for the income paid out, so the corporation would have no taxable income, and the employee would pay tax on the income instead.
Dividends are a bit different. A dividend is a payment of after-tax profit to a shareholder. A small-business corporation typically pays between eight per cent and 16 per cent tax on its income. It can then pay a dividend to a shareholder that is taxed at a lower rate than salary, generally about the same eight per cent to 16 per cent lower, but the rate differential can be less or more depending on a taxpayer’s income, deductions and credits.
The lower tax rate on dividends is meant to account for the corporate tax already paid. Corporate-personal tax integration is not perfect, but pretty close. The point being that an owner-manager should be nearly indifferent between salary and dividends from an all-in tax perspective.
It is possible for a new business to not pay out income to employees and/or shareholders in its early days, especially when starting up or before becoming profitable. Since paying salary involves registering a payroll account with the Canada Revenue Agency and remitting CPP contributions and income tax to the CRA, it can be more complex for new business owners.
Dividends can be simpler since the corporation can pay them out without having to worry about withholding tax and government remittances. The drawback is you could end up spending money that has not had sufficient (or any) tax withheld and being surprised by your tax bill at year-end.
If you want to avoid CPP premiums, paying out dividends would accomplish this. That said, avoiding CPP will not necessarily put you ahead. CPP may be considered a payroll tax, but it is not exactly a tax. It is a contribution to a pension plan that will pay you an income in the future.
The implied rate of return when a business owner has to pay the employer and employee CPP contributions may not be high, but it is still effectively a benefit. It is also a form of forced savings that someone might not otherwise replicate on their own.
The benefits of choosing a salary go beyond more predictable tax payments and CPP benefits. Salary also counts as earned income and creates registered retirement savings plan (RRSP) contribution room, whereas dividends do not. Salary also has the potential for easier income verification when applying for credit, can qualify for certain tax credits such as the Canadian Employment Credit, and allows for certain deductions like child-care expenses.
Depending on the rationale behind your decision, Jason, it may not make sense to contribute to CPP. This may be the case if you are a disciplined and aggressive self-directed investor with low investment fees. A shortened life expectancy may be another reason. You may have already maximized CPP based on your past contributions or have other defined-benefit pension income that is sufficient to meet your income needs.
Regardless, I believe that it will be prudent to review the benefits of CPP ahead of tax savings because avoiding CPP can provide short-term savings at the expense of a long-term reduction in retirement income.
Comments are closed.