Business owners should use dividends

Traditionally, Canadian business owners have been advised to pay themselves a salary or bonus, rather than dividends, in an attempt to bring their income down to the small business deduction (SBD) limit ($500,000 or $400,000, depending on the province) and ensure no income above that threshold remains in the company to be taxed at higher rates. But in the current tax environment, depending on your province of residence, dividends may be the best strategy.

The mechanics driving this decision is the tax theory of integration. When integration works perfectly, there should be no difference between taking salary or dividends because the same amount of tax will be paid either way. The reality is perfect integration rarely exists due to varying provincial corporate and personal tax rates.

Case study

Eligible income for the small business deduction

When income below the SBD threshold is taxed in the corporation and then paid out as a dividend, the result is a tax rate advantage through combined corporate and personal tax savings in nearly all provinces. The savings range from 0.6% in Manitoba to about 4% in Nova Scotia.

If you don’t need cash immediately and can leave after-tax SBD income to be reinvested inside the company, a tax deferral advantage can also be realized. Deferrable tax ranges from 25% in Alberta to more than 35% in P.E.I. and Manitoba.

By paying dividends rather than bonuses, the deferred tax amount can be reinvested in the corporation until the dividend is actually paid. Over time, the income earned on the deferred amount can off set a tax rate disadvantage.

For example, if such income is retained in the corporation and invested at 5%, immediate savings will be realized by paying a dividend in all provinces other than Quebec and P.E.I. In Quebec, income has to stay inside the corporation until the second year, and in P.E.I. until the third year. After that, the income earned on the deferred amount would off set the tax rate disadvantage.

It is generally advisable for SBD income to be taxed initially inside the corporation, due to the tax rate advantage. If you don’t need the money to fund current lifestyle, after-tax SBD income can be re-invested in the corporation. This makes the most of the tax deferral advantage.

Ineligible active business income

When corporate income is above the SBD threshold, there is generally a tax rate disadvantage (from 1% to 7% depending on the province) but there are still significant tax deferral advantages when active business income (ABI) is left in the company. This deferral advantage ranges from 12% to 20% depending on the province.

When after-tax ABI is reinvested at 5%, the time funds must be retained in the corporation for the tax deferral advantage to off set the tax rate disadvantage ranges from four to 38 years, depending on which province you live in. If income is to be distributed by way of a dividend prior to those times, it may be better to pay a bonus from ABI now rather than pay a dividend later.

Although dependent on the long-term rate of return, it may still be advisable for ABI to be initially taxed inside the corporation despite the slightly higher taxes, and to retain and invest the after-tax ABI in the corporation to enjoy the tax deferral.

This article originally appeared in Canadian Capital.