Business owners, how should you pay yourself this year?

Article content

With a new year upon us, business owners – those receiving compensation from a corporation carrying on an active business – once again have the opportunity to decide how they wish to be compensated by that business.

So, what are your options?

Business owners can receive either dividends (eligible/non-eligible) or a salary/bonus.

First, let’s review the varying tax rates across the country on different forms of income, as shown in Figure 1.

From a tax planning standpoint, it may generally make sense for corporate business owners to draw a salary or bonus rather than dividends.

Drawing a salary/bonus

In a world of perfect tax integration, you would be indifferent to receiving dividends or salary, since the total taxes paid (corporate plus personal) would be identical.

However, as you may have noticed, we don’t live in a perfect world. There is a “tax cost” or under-integration when it comes to receiving dividends vs. salary, since the total corporate and personal tax using the dividend strategy is higher than the personal tax paid on a salary/bonus. Higher total tax means you would receive less cash with dividends than with a salary or bonus compensation approach.

To be specific, the charts below show a tax cost of $586 (the top marginal rate in Ontario is assumed). This means the total tax would be $586 higher (and you would have $586 less cash) using the dividend strategy than with a bonus. As a percentage of corporate income, the tax cost is 0.59%, calculated as negative $586 divided by $100,000.

(Source for Figures 1-3: CIBC, Jamie Golombek and Tess Francis)

This is the exact opposite of how the salary-vs.-dividend tax rates compared several years ago, since the tax rates on dividends have been increasing.

Other considerations: Drawing salary or bonus creates RRSP contribution room and allows for CPP contributions. Since business owners usually do not have a defined benefit pension plan, access to a fully indexed government pension may be very desirable.

Also, where salaries/bonuses can be justified as being reasonable for family members, paying salaries instead of dividends avoids any issues with TOSI (Tax On Split Income) rules, which can cause dividends to be taxed at top marginal rates in the hands of the recipient under many conditions.

How much do I draw? In general, it is often reasonable to draw enough salary to cover:

• Annual lifestyle expenses: Your annual needs will likely change somewhat year by year. Therefore, you may wish to pay yourself a reasonable fixed monthly amount to cover basic expenses/savings and top up via a shareholder bonus at the end of the year based on any additional needs. For example, assuming you live in Ontario and wish to live on approximately $115,000 or so after tax (and assuming no RRSP contributions), a gross salary of approximately $171,000 will allow you to accomplish this, which also happens to create the maximum RRSP contribution space for 2023: $30,780.
• Personal savings: You will also need to decide whether to draw additional funds to make RRSP and/or TFSA contributions or whether it’s best to leave more funds invested inside your corporation. Whether to save personally versus corporately, and which option will leave you with greater retirement/estate dollars, depends on a number of things such as your investment strategy and time horizon, actual rates of return along with your current and projected inflation-adjusted personal marginal rates in retirement, etc.
• Corporate savings: Generally speaking, you will want to invest any surplus corporate earnings inside the corporate structure to maximize your tax-deferral opportunity. Please see this recent article about growing your corporate savings/investments. The Small Business Deduction allows up to the first $500,000 of active business income earned annually by a Canadian-controlled private corporation to be taxed at 12.2 per cent. The tax rate on active business income in excess of the SBD is 26.5 per cent. Compared to combined federal and provincial personal tax rates, which range from 48 per cent to almost 55 per cent, depending on your province, there may be a significant tax deferral opportunity, from 33 per cent to 43 per cent across the country. Specifically, the deferral in Ontario is as much as 41 per cent by leaving funds invested inside the corporate structure.

Low tax brackets: Often overlooked, if personal taxable income is still quite low, is to consider drawing out additional salary to use bottom tax brackets (approximately $54,000 and $87,000, respectively, for 2023).

• More from Nancy Grouni: Real-life cases show benefits of ‘quarterback’ planning for business owners

Setting up payroll: Paying yourself a salary does require some planning. You need to set up a payroll account with CRA if you don’t already have one. Your accountant or bookkeeper could set up payroll; usually this is done by the bookkeeper. For most small employers, the payroll remittances are due on the 15th of the following month or the next business day if the 15th falls on a weekend or holiday. For example, for any wages paid in January, the payroll would be due Feb. 15th with CRA.

Here is the CRA Online Payroll Deductions calculator. You can use this to calculate federal, provincial (except for Quebec) and territorial payroll deductions. It will confirm the deductions you include on your official statement of earnings.

Note that each November, CRA reviews the prior 2 years’ total source deductions to determine if a more frequent remittance period is required. Please review your CRA correspondence to determine what your 2023 remittance frequency is.

When to draw dividends

Consider drawing dividends if:

• Your corporation has large ERDTOH/NERDTOH (Eligible or Non-Eligible Refundable Dividend Tax On Hand) balances, as the payment of taxable dividends allows the corporation to recover previously paid refundable tax on passive investment income. The dividend refund provision is under subsection 129(1) of the Income Tax Act and allows the CRA to refund to corporations (without application) the lesser of the corporation’s RDTOH account or 38.33% of all taxable dividends paid by the corporation.
• You are retired. Retired business owners sometimes pay themselves a salary, although they probably shouldn’t. Salary can be deducted against active business income, but may not be reasonable to deduct against passive investment income. More importantly, paying yourself a salary in retirement just may not be that tax-efficient.

Conclusion

To summarize, if you are pre-retirement, it may generally make sense to pay yourself a salary based on current tax rates. However, there is a lot to consider when it comes to business owner compensation planning. Current annual tax rates, annual living expenses, your tax-efficient savings strategy, your risk tolerance and investment strategy, and time horizon/proximity to retirement, etc., all need to be carefully considered and balanced in light of your holistic planning needs to determine your ideal compensation strategy in any given year.

An advice-only Certified Financial Planner specializing in the area of corporate planning can help navigate this complex area in tandem with the appropriate corporate tax expertise.

After all, to borrow Yogi Berra’s famous words: “If you don’t know where you are going, you may end up some place else.” Planning is not an exact science, but it can definitely help, and even a little can go a long way. Is there a cost? Sure there is. But the cost of not planning or not planning enough can be far more expensive.

The thoughts in this article are intended to provide general tax planning guidance only and should be reviewed with your Financial Planner and tax consultant in the context of your own personal circumstance to determine reasonable tax planning/compensation planning solutions.

Nancy Grouni, a Certified Financial Planner with Objective Financial Partners Inc., specializes in financial, tax and estate planning for business owners and professionals. She is based in Markham, Ont.

More from Canadian Family Offices: 

• ‘Young money’ advisor builds different kind of wealth management firm
• Money and relationships: Power dynamics can unravel the knot
• Business owners, don’t neglect your CDA account – it’s a beautiful thing
• How to best pass on wealth and the business

Please visit here to see information about our standards of journalistic excellence.