Should business owners avoid CPP by paying themselves dividends?

Incorporated business owners are often skeptical of paying into the Canada Pension Plan (CPP). They believe they’re getting a bad deal by paying both the employer and the employee portion of the contribution, and they think they can do better by retaining funds in their corporations to invest. This leads many business owners to avoid CPP altogether by paying themselves dividends instead of salary. In general, this is a mistake.

Is CPP a tax or an asset?

Before getting into the specifics for business owners, it’s important for readers to understand our view that CPP is an asset rather than a tax. Taxes are paid by an individual to support services that may or may not directly benefit them, while CPP is an entitlement to receive future cash flows from an inflation-indexed annuity.

The CPP benefit protects retirees against major risks that are hedged far more efficiently by a pooled pension plan like CPP than by an individual. CPP hedges the risks of living too long using mortality pooling, it protects against high inflation during retirement, and it smooths out the effects of poor investment returns on financial assets.

The CPP enhancements currently being deployed will bring the income replacement rate to 33% — up from 25% for base CPP — with a higher earnings ceiling than base CPP. The full 33% replacement will apply for people taking the CPP benefit about 40 years from now. Between now and then, contributors will get some combination of basic and enhanced CPP. The maximum combined employer and employee contribution for 2025 is expected to be $8,848.

Do business owners get a bad deal?

There is a common misconception that, while CPP may be a good deal for employees, it is a bad deal for business owners. This is incomplete economic thinking. When employers decide how much to pay employees, they will take the cost of employer CPP contributions into account. In a market with perfectly inelastic labour supply, employees will bear the full cost of CPP contributions.

This perfect market does not exist, but evidence suggests that most of the cost of social benefits contributions are funded by employees. Business owners may be explicitly paying both sides of CPP contributions, but employees are implicitly paying both sides through lower wages. Academic research on CPP views the combined contribution as the cost of CPP, and we will take the same approach here.

CPP and tax integration

A concept that is not well understood in general is the relationship between tax integration and the cost of CPP for business owners — or, alternatively, the amount they will save by avoiding CPP. The total maximum CPP contribution in 2025 will be around $8,848, but this is not the amount that business owners will retain in their corporations by paying themselves dividends instead of salary.

The reasons are that CPP contributions result in a combination of tax deductions and credits, and that tax integration often favours salary over dividends.

The 4.95% base CPP contribution on the employee side results in a tax credit personally. In Ontario, that’s worth 20.05% of base CPP. The additional CPP contribution for the CPP enhancement is a tax deduction at the personal level, the value of which depends on the contributor’s personal marginal tax rate. The employer CPP contributions are a deduction to the corporation — meaning that their value depends on the corporate tax rate — and are not taxable to the employee.

The tax integration inefficiency of dividends — the total tax liability between the corporation and the individual taxpayer is higher for dividends than for salary in most provinces — should also be considered one of the costs of avoiding paying into CPP. All considered, the net savings gained by avoiding CPP is a lot lower than the headline number makes it seem. Or, alternatively, the net cost of paying into CPP is a lot lower than it seems.

In a case study where a business owner at the highest personal tax bracket and the corporate small business rate in Ontario is comparing paying themselves in salary or dividends while holding personal after-tax consumption constant, we find that paying dividends to avoid CPP results in just under $6,000 being retained in the corporation.

Due to the grossed-up amount of dividends being used to calculate benefits like the Canada child benefit, the comparison can get far more extreme in favour of taking salary (and paying into CPP) in some cases.

The punchline is that, while CPP is expected to cost $8,848 in 2025, someone in the highest tax bracket in Ontario would be able to retain only about $6,000 in their corporation by avoiding paying into CPP due to tax deductions and credits, and tax integration slightly favouring salary.

Investing in a corporation versus CPP

Business owners may still wonder whether this $6,000 could be put to better use by investing it in a portfolio of stocks and bonds within their corporations. The real internal rate of return (IRR) on base and additional CPP is around 2.1% at a normal life expectancy for a Canadian, assuming the CPP benefit is taken at age 65 and the person lives to age 85.

Deferring the benefit to age 70 is statistically likely to result in better outcomes, especially for people with high incomes and advanced educations — factors related to longer life expectancy. Taking CPP at 70 and assuming a life expectancy to age 95, the real IRR on CPP is 3.11%.

Matching these IRRs by investing the retained earnings saved by paying dividends instead of salary requires taking on some market risk — a risk with a positive expected return but a highly variable long-term payoff. Another consideration is that having CPP as an asset allows for more risk to be taken with the investments that do remain in the corporation.

Should business owners pay into CPP?

The CPP benefit is one of the only ways for many Canadians to access an inflation-indexed annuity, an extremely valuable asset for retirees. Business owners do not get a bad deal by paying both the employer and employee contribution, and the savings gained by avoiding CPP are much less than the CPP premiums due to tax deductions, tax credits, and tax integration inefficiency favouring salary. We demonstrated this in a case study and did not even take into consideration other benefits of taking salary, like the creation of RRSP room.

Deciding between salary and dividends for incorporated business owners is a complex process, but in our view (acknowledging that there are exceptions beyond the scope of this article), choosing dividends for the purpose of avoiding paying into CPP is generally a mistake.