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tax & estate Revisiting salary versus dividends in light of federal tax changes New considerations for incorporated small business owners by Curtis Davis, FMA, CIM, RRC, CFP, senior consultant for tax, retirement and estate planning services, retail markets at Manulife The theory of integration doesn’t always work for business owners Other dividend advantages 1 If the only source of personal income is non-eligible dividends, it’s possible to receive up to $26,370 tax free in 2019, excluding the Ontario Health Premium. 2 Dividends don’t require the shareholder to be an employee of the business; salaries do, and must be reasonable for the work performed. 3 Paying dividends doesn’t require personal taxes to be remitted at source; salaries require income tax, EI and CPP amounts to be withheld by the employer and remit- ted within days or weeks. Other salary advantages Incorporated small business owners have many decisions to make, but one with large potential tax implications is whether to pay themselves using salary or divi- dends. That decision hasn’t gotten easier since the Liberal government’s 2018 small business tax changes. Even owners with- out large amounts of passive income, and with no spouses or children with whom they can split income, should review them. I covered the salary-versus-dividends choice in 2017, prior to the new rules. The following is an update. The theory of integration holds that you should receive the same after-tax income regardless of whether you earn income personally (salary) or through a combination of corporately and personally (dividend) taxed income. However, the theory doesn’t always work for business owners. Consider Frances, a fictitional single woman in Cornwall, Ont., who owns a software corporation that generates $200,000 per year in active business income (ABI). The money Frances pays herself from the corporation will be her only income source for the year. If she goes the salary route, she wants to maximize CPP contributions and con- tribute 18% of her salary to her RRSP. If she chooses dividends, she wants the same after-tax income as the salary option for living expenses, so any surplus would be invested. The corporation’s adjusted aggregate investment income (AAII) is under $50,000 and therefore there’s no reduction to the small business deduction (SBD) limit. The first $500,000 of ABI is taxed at 12.5% (combined federal and provincial). The rate increases to 26.5% once ABI exceeds $500,000. Frances’s salary, employer CPP contribution and EI pre- mium are deducted from the corporation’s income, leaving it with taxable income of $138,647. With the dividend, however, the full $200,000 of ABI is subject to corporate tax (see Table 1). Looking at Frances’s personal taxes, her salary, net of RRSP contribution, is fully taxable income, leaving her with net income of $36,697 (see Table 2). The dividend is subject to a much lower rate of personal tax, thanks to the divi- dend gross-up and subsequent tax credit. In order to maintain a net income of $36,697, she must set aside $15,425 for investment. Table 1: Ontario corporation (2019 rates) Salary Dividend Corporate business income $200,000 $200,000 Less: CPP and EI premiums ($3,953) N/A Less: Salary ($57,400) N/A Corporate taxable income $138,647 $200,000 Less: Corporate tax @ 12.5% ($17,331) ($25,000) Less: Dividend to shareholder N/A ($57,400) Retained earnings $121,316 $117,600 Table 2: Personal taxes (2019 rates) Salary Dividend Salary $57,400 — Dividend — $57,400 Less: RRSP contribution @ 18% ($10,332) — Less: Income tax1 ($10,371) ($5,278) Net income $36,697 $52,122 Difference (to invest) — $15,425 1 Includes CPP and EI premiums Table 3 shows that the difference in both total taxes (including CPP contributions and EI premiums) and total investments (combined corporate and personal) for salary and dividends is $1,377. It appears the theory of integration is imperfect in Frances’s case, with dividends pro- viding a slight advantage over the salary option. 1 2 3 4 5 Salaries entitle the recipient to the Canada employment amount. If the company’s taxable income exceeds its SBD in 2019, salaries can reduce exposure to corporate income tax at the higher corporate income tax rates. A dividend recipient may be required to remit quarterly personal income tax instal- ments in future years; this is unlikely for salaried employees, since tax is withheld at source. If personal income is so low that the divi- dend tax credit would be unused, a salary may be more tax-efficient. Paying for employer and employee CPP contributions and EI premiums entitles the business owner to a fully indexed pension in retirement and/or in the event of disability, as well as income insurance in the event of involuntary job loss. EI also provides parental, sickness and compas- sionate care benefits. AE Table 3: Summary Salary Dividend Corporate income tax $17,331 $25,000 CPP and EI premiums2 $7,562 N/A Personal income tax $6,762 $5,278 Total tax and deductions $31,655 $30,278 Corporate investment $121,316 $117,600 Personal investment $10,332 $15,425 Total investments $131,648 $133,025 2 Includes both employer and employee CPP and EI premiums 12 OCTOBER 2019