Business owners: Should you take a Salary or a Dividend??

Today I would like to share an excellent article written by Tim Cesnick published in The Globe and Mail.

Business owners: Should you take a Salary or a Dividend??

Business owners face all types of challenges. Human resources issues may be the greatest – but tax issues are also near the top of the list. How should you compensate yourself? Should you pay yourself more salary? How about dividends? Are there other alternatives? Let’s talk about your compensation.

The Theory

If you own an incorporated business, there are two primary ways to pay yourself: salary, and/or dividends. If you pay yourself salary, the amount is a deductible expense to your company and is taxable in your hands. Another alternative is to have the income taxed in your corporation and then pay the after-tax earnings to yourself as dividends. Your company doesn’t claim a deduction for dividends paid. You’ll face tax on the dividends paid to you, but at a lower tax rate than salary. Why? Because the corporation has already paid tax on the income. When you receive dividends, the amount is “grossed up” (to approximate the pretax income of the company) and then you’re entitled to a dividend tax credit (to provide a tax credit for the approximate tax that was paid by the company).

Our tax system is based on the theory of integration. The theory is that there should be no difference between earning income personally, or earning it in a corporation and then paying that income out to yourself as dividends. If integration is perfect, the amount of income in your hands would be exactly the same, either way.

In the past, integration only worked, albeit not perfectly, in the case of small, Canadian-controlled private corporations (CCPCs) that have been eligible for a lower rate of tax (on the first $500,000 of taxable income today; this results from the “small business deduction” available only to CCPCs). The government changed this in 2006 when it introduced “eligible dividends.” To make a long story short, eligible dividends are those paid after 2005 out of business income that was taxed at a higher rate – rates applicable, for example, to income earned by publicly traded companies or smaller-company income that is not sheltered by the small business deduction. Eligible dividends have been subject to a different gross-up and tax credit rate. This effectively reduced the level of personal tax paid on those dividends, to make integration work better where the company has paid higher rates of tax.

Today, you’ll face a different tax rate on eligible dividends (paid out of corporate income taxed at higher rates) and ineligible dividends (paid out of corporate income subject to lower rates, thanks to the small business deduction).

The Reality

The fact is, integration doesn’t work perfectly. And so there may be advantages to paying dividends over salary, or vice versa. To complicate things, general corporate tax rates are falling over the next couple of years, which may shift your approach. You see, as corporate tax rates fall, the level of tax you’ll pay personally on eligible dividends is due to increase. Why? To keep integration as close to perfect as possible.

The general federal corporate tax rate is currently 18 per cent in 2010, will be 16.5 per cent in 2011, and 15 per cent in 2012. The top federal marginal tax rate on eligible dividends is 15.88 per cent in 2010, will be 17.72 per cent in 2011, and 19.29 per cent in 2012. Regardless of your province of residence, it’s still true that the tax rate on eligible dividends is going up.

So, what does all this mean for you? First, if you do plan to pay yourself eligible dividends, your best bet may be to accelerate those dividends to pay them out in an earlier year rather than later, to take advantage of the current lower tax rates. There was some confusion from my article last week where I had mentioned that it could be beneficial to wait until 2011 to pay out eligible dividends. That read incorrectly. I had intended to suggest that paying dividends sooner, say in 2010, would be better.