Will it be salary or dividends?
Time is running out for business owners who operate their businesses through a corporation with a Dec. 31 year end to determine whether any excess profits earned in the corporation in 2013 should be paid out as a year-end bonus or be left inside the company to be distributed as a dividend either now or at some future date.
Recent increases in the provincial tax rates in several provinces along with an upcoming increase announced for 2014 in the taxes payable on certain private company dividends means that business owners need to revisit their compensation strategy for the current and future years.
The reason for needing to take action stems from the fact that ownermanagers who run their businesses through corporations can choose to receive compensation as either a salary (including a bonus) or dividends. If salary compensation is chosen, the corporation claims a deduction against its income for the amount of salary or bonus paid and the ownermanager pays personal tax on the salary or bonus income received.
Alternatively, if dividend compensation is chosen, the company pays corporate tax on the income earned and the owner-manager pays personal tax when proceeds are distributed as a dividend. In tax parlance, "perfect integration" is said to exist when the amount of after-tax cash in the owner-manager's hands is the same regardless of whether the corporate earnings are paid out as a salary or taxed first in the corporation and then paid out as a dividend and taxed in the owner's hands at dividend tax rates.
Absent perfect integration, however, a tax savings benefit exists when there is a "tax rate advantage" from paying dividends, whereby the total corporate and personal tax paid on dividend compensation is less than the personal tax paid on salary compensation.
For small business owners who need to withdraw funds in 2013 to live on, paying dividends is generally the best option in most provinces when the company earns active business income below the small business deduction limit of $500,000, yielding a tax rate advantage which ranges from 0.56% to 4.54%, depending on the province.
If you don't need the cash in 2013, however, consider taking dividends in a future year due to the "tax deferral advantage" which exists since corporate tax on business income is payable in the current year but personal tax on the dividend can be deferred until the money is ultimately taken out in a future year. The difference between the corporate tax and the personal tax (the deferred amount) can be reinvested within the corporation to earn additional income until the dividend is ultimately paid, possibly many years later.