Saturday, February 27, 2010

Owners/Managers: Take a Fresh Look at Your Remuneration Strategy *

If you are a small business owner, you have a fair amount of flexibility when it comes to setting your remuneration strategy and deciding how you get paid. The amount that you pay to yourself and how you pay yourself may have been set a number of years ago, and may no longer be optimal. This discussion will focus on remuneration strategies as they relate to business owners who carry on business through a corporation.

If you are a business owner, you may have a great deal of flexibility in setting a remuneration strategy. You do not have carte blanche. There can be some constraints that will limit how you can remunerate yourself:

- the Income Tax Act will deny a deduction which is not considered reasonable in relation to the services being provided. If you take too much salary, all or a portion of the expense may be denied to the corporation. The salary will still be taxed in your hands, leading to a clear case of double taxation. Administratively, the CRA will not challenge the salary paid to an owner manager who is active in the business and to whom the success and profits of the company could be attributed. However, if part of the remuneration strategy involves paying salary to family members, such as your spouse or children who are involved in the business, you should be respectful of the reasonableness requirements;

- a Shareholders' Agreement may exist, and it is possible that the Agreement may put limitations on how much can be drawn from the company, or the form in which it can be drawn;

- there may be a restrictive covenant resulting from a bank loan or other lending arrangement which could put a limit on what could be taken out of the company by the owners, or which require the company to maintain certain working capital requirements. This may limit your remuneration options. Violation of the restrictive covenants in a lending arrangement can have very serious consequences.

- corporate law may also restrict your remuneration options. For example, if part of your remuneration plan involves the payment of dividends to you, corporate law will require all shareholders of the same class to receive their pro-rata share of dividends as well. This may not be something that you want to happen. Most jurisdictions also limit your ability to pay dividends if it will render the corporation incapable of satisfying its' creditors.

Although this may seem like a rather daunting list of constraints, in practice there are often few constraints that operate to limit how you remunerate yourself.

Setting the amount of your remuneration is a process which is usually based on your personal cash needs. The starting point should be to figure out how much after-tax cash you and your family need each month. From there, we reverse engineer this number to arrive at the gross compensation that you need to receive in order to reach your target after-tax cash. As a general rule, you will be better off leaving cash in the corporation if your personal cash needs are modest. For example, if you require $40,000 of after-tax cash each year to meet personal needs, you will most likely be incurring additional and unnecessary taxes if your remuneration provides you with $60,000 of after-tax cash. While that is really just a generalization, it usually holds true because of the fact that personal rates of tax in most provinces exceed the corporate rate of tax on active business income.

Once you've determined how much after-tax cash you'll need, the next big decision is to determine in what form that cash will be provided to you. The decision is whether or not to remunerate yourself by way of salary, dividends, or some combination of the two.

You will need to understand a little tax theory in order to understand what is best for you. If you take your compensation in the form of salary, the salary expense will be deductible to the corporation. While you will pay tax on the receiving end, the company will benefit and save tax because of the deduction that it receives. Salary is also considered to be earned income for the purposes of generating RRSP contribution room and for the purposes of determining whether you are eligible to deduct child care expenses. These are some of the benefits associated with drawing salary. On the downside, however, salary does attract payroll taxes such as CPP, EI, worker's compensation and Employer Health Tax (EHT) in Ontario. These payroll taxes are not inconsequential. In many instances, the owner-manager will be exempt from EI by virtue of his or her shareholdings, and may also be exempt from worker's compensation by virtue of their position as a director of the company. Still, it is quite possible that the salary will attract CPP and EHT, thus increasing the overall costs associated with a salary based remuneration plan.

Dividends will be subject to a lower rate of tax than salary. While that may seem attractive at first, it is important to bear in mind that dividends are not tax-deductible to the corporation which pays the dividend. The tax that you pay on the dividend that you receive should be combined with the tax that the corporation has already paid in order to arrive at the true tax cost of a dividend-only remuneration strategy.

To narrow the thought process, it is important to determine how important RRSP contribution room is to you, and to a lesser extent, how important it is to build up future CPP entitlements. If you do not believe that RRSP contributions are important, and you do not believe that CPP is a universal social program that will even exist when you're ready to retire, then you may be leaning towards a dividend only scenario. If RRSP room is important, then you may be leaning towards a remuneration strategy which is heavily weighted towards salary. Such a strategy would provide you with a salary sufficient to generate the maximum RRSP contribution room, with any excess cash being provided to you through dividends.

It is important to realize that there is no right or wrong answer when looking at a remuneration strategy. There are simply too many variables, including RRSP investment returns, to make a precise determination of how you should be remunerated. Your personal feelings regarding RRSP room will have a strong impact on the remuneration strategy.

To illustrate the differences between various remuneration strategies, consider the following hypothetical, but realistic, example. An Ontario resident individual is the sole shareholder of an Ontario resident corporation, which generates annual profits of about $200,000. The individual has very high cash needs, and needs approximately $100,000 of after tax cash each year to meet living expenses, which would include an RRSP contribution of $14,500. Let's assume that if we adopt an approach which does not generate any RRSP room, their cash needs will drop from $100,000 per year to $85,500 per year, since they will not be making the $14,500 RRSP contribution. The company has a number of employees, and all salary earned by the shareholder would be fully subject to Ontario EHT.

The calculations show the overall results of three possible remuneration strategies: salary sufficient to generate maximum RRSP room with dividends to supplement the salary, an entirely salary driven compensation plan, and an entirely dividend driven compensation plan. The calculations indicate that a dividend only scenario would provide the shareholder with the lowest overall tax cost. The salary + dividend approach would provide the shareholder with maximum RRSP room, but would be more expensive from a tax perspective. Is the RRSP room worth the extra $4,196 in tax cost? Maybe, but that depends on how the RRSP performs, and a host of other variables.

And just to make a complex decision even more complex, consider these additional points:

- You may be able to get a better result if your corporate structure allows you to stream dividends to select individuals. This would allow you to take salary personally to generate RRSP room, and put dividends into the hands of other family members who are in a lower marginal tax return. Unlike salary, dividends do not need to be reasonable in relation to the services being provided by the dividend recipient.


- You should carefully review your disability insurance plan to make sure that you are not causing problems for yourself in the event of disability. If your disability policy will provide you with benefits based on salary only, then a remuneration strategy which is heavily weighted towards dividends may result in a lower benefit in the event of disability. Many newer disability policies take into account all forms of remuneration when determining your benefits. You should, nonetheless, have your disability policy reviewed by someone who is qualified to determine the impact, if any, that your remuneration strategy will have on your disability payout.

Tax rates change over time. Your cash needs change over time. CPP rates are scheduled to increase substantially over the coming years. This means that today's remuneration strategy may not be the best one for you in a few years. Ideally, you should review your remuneration strategy every year.

As always, seek professional advice.

* written by J. Rolland Vaive, CA, TEP, CPA - Rollie can be contacted at rvaive@taxadvice.ca

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