Dividends for business owners

For a 2017 article on salaries versus dividends, go here. The below piece is based on figures and assumptions from 2013.

Business owners should consider drawing dividends rather than salaries from their corporations.

This is because “the cost of CPP is double for the typical Canadian entrepreneur compared to a general employee,” says Ken Morrison, CA and owner of Provision Accounting Group in Vancouver.

If an owner makes $50,100 a year before taxes, he would have paid $2,306.70 toward CPP in 2012. His employer would have matched that for a total contribution of $4,813.40. In contrast, an entrepeneur would shoulder this entire cost. Both he and his business have to contribute to CPP get the same benefits.

Owners are also taxed more heavily on wages than on dividend income. They could have earned up to $47,892 in dividends in 2012 before any federal taxes are payable due to the small business dividend tax credit.

Dividend income is first taxed at a corporate level, so owners can claim the tax credit to offset personal taxes. They claim a grossed-up amount of income based on the approximate corporate taxes paid, and the dividend credit returns some of this inflated amount.

Budget 2013 changes

By choosing dividends your clients can keep more of their earnings — though they should keep track of corporate tax rates. Most recently, Budget 2013 targeted the dividend tax credit. The budget documents claim, “The current dividend tax credit and gross-up factor for these dividends over-compensate individuals.”

The federal government wants to eliminate such advantages offered by bridging the gap between how dividends and normal wages are taxed (see “Budget 2013 limits dividend payouts,” this page).

This will impact how much clients can save using dividends, says Morrison, but the strategy is still works since the maximum dividend tax rate is 34.52%.

“Further, the Supreme Court says the share structure of private Canadian companies allows for even allocation of income to all family members involved in the company.”

Family advantages

Splitting dividend income amongst family shareholders takes advantage of lower marginal tax rates.

“This is the case whether spouses or children work within the business or not,” adds Morrison. “They have to be shareholders, so [your clients] must include them when structuring the company.”

Say you have a business-owner client whose husband has a low-paying job. If he’s a shareholder and she takes out $120,000 in dividends per year, she can split that evenly between them to ensure they’re each taxed in a lower bracket.

This same client could adjust dividend income allocation if needed. She could raise her share of the payout if her husband gets a raise, for example. But don’t set wages too high, because CRA will deem them unreasonable and double taxation will occur. Morrison says it’s common for owners to distribute dividends once a year, and pay them monthly. When it comes to children, owners use family trusts so company money can’t be accessed until kids are older.

Dividends better than RRSPs

This client also saves money by withdrawing dividends instead of collecting wages and contributing to an RRSP.

Though she can defer taxes with an RRSP, she’d miss out on significantly lower rates now through income splitting and the dividend tax credit, says Morrison.

When using an RRSP she’d eventually face high taxes on withdrawals. Today, RRSP income is taxed at 47.97% federally, which means she’d pay 13% more than the maximum dividend tax rate.

In estate planning, it’s also beneficial to avoid RRSPs. Although a wife can roll over balances in her deceased husband’s RRSP tax-free, the money will be taxed at her marginal tax rate when she dies.

However, if the two held these savings within their family company — and if children are granted share ownership — these residual amounts will also pass to the kids free from tax.

Over the life of the business

During business development, the dividend strategy helps maximize family cash flow when it would usually be tight due to startup costs. Then, rather than locking money into an RRSP, owners can keep more cash on hand to both invest and cover emergency expenses.

Advisors have to make sure customers use funds wisely, so evaluate clients’ discipline levels and investing styles before recommending dividends. It’s crucial you don’t stretch their money management skills if they prefer security and predictability, both of which are offered by CPP and RRSPs.

For investing dividends and for saving, Morrison suggests TFSAs for their flexibility. Also, owners can switch back to wages if the dividend strategy doesn’t work.

That said, there are some cases when the dividend option isn’t advantageous, says Morrison. “Say you have a dentist client who has education credits and she’d like to claim them to offset her regular income. In this case, she’d be better served by switching to the dividend strategy only after using up these credits.”

FEDERAL & PROVINCIAL / TERRITORIAL SMALL BUSINESS DIVIDEND TAX CREDIT RATES

Small business dividend tax credit using Ontario tax rates for 2009	Tax Bracket 1	Tax Bracket 2
Combined federal + Ontario tax rate	21.05%	24.15%
Dividends eligible for enhanced DTC	$100.00	$100.00
Gross-up	$25.00	$25.00
Taxable dividend	$125.00	$125.00
Federal + ON tax (at 21.05% & 24.15%)	$26.31	$30.19
Less dividend tax credits:
Federal 13.333% x $125	$16.67	$16.67
Ontario 5.13% x $125	$6.41	$6.41
Total dividend tax credits	$23.08	$23.08
Tax payable on dividends	$3.23	$7.11
Marginal tax rate	3.23%	7.11%

Source: TaxTips.ca

FEDERAL & PROVINCIAL / TERRITORIAL SMALL BUSINESS DIVIDEND TAX CREDIT RATES

Small Business Dividend Tax Credit Rates as a % of Grossed-up Taxable Dividends

Year	Gross-up	Federal	AB	BC	MB	NB	NL	NS	NT	NU	ON	PE	QC	SK (1)	YT(2)
2012	25%	13.33%	3.5%	3.4%	1.75%	5.3%	5%	7.7%	6%	4%	4.5%	1%	8%	4%	4.51%

Small Business Dividend Tax Credit Rates as a % of Actual Dividends

Year	Gross-up	Federal	AB	BC	MB	NB	NL	NS	NT	NU	ON	PE	QC	SK (1)	YT(2)
2012	25%	16.67%	4.38%	4.25%	2.19%	6.63%	6.25%	9.63%	7.5%	5%	5.63%	1.25%	10%	5.00%	5.64%

(1) SK rates reduced (SK 2011 Budget) for 2011/2012 in conjunction with the reduction in the small business corporate income tax rate.

(2) YT rates as per Bill 92 passed December 10, 2010. Dependent on corporate income tax rates.

Source: TaxTips.ca

Budget 2013 limits dividend payouts

The budget document says:

“Income earned by corporations is subject to corporate income tax and personal income tax. The result is dividends received by Canadian taxpayers are taxed at both levels. The dividend tax credit compensates a taxable individual for corporate taxes…paid.

“The current credit and gross-up factor applicable to non-eligible dividends—those not taxed at the general, corporate rate— overcompensate [owners] for income taxes presumed to have been paid at the corporate level…[they’re] in a better tax position than if [they] earned the income directly.”

The new proposal aims for “appropriate tax treatment of dividend income [by] adjust[ing] the gross-up factor [for] non-eligible dividends [down] from 25% to 18%.” It’s also reducing the tax credit rate from 13 1/3% of the grossed-up dividend to 11%, and from 16 2/3% of the actual dividend to 13%.