Salary vs. dividends: What’s best?

Small business owners risk paying too much in income tax by making the wrong decision on whether to withdraw funds from their corporations as salary (bonus) or as dividends, says CIBC’s tax and estate planning expert, Jamie Golombek.

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“Each year, small business owners who run their businesses through corporations can choose to receive compensation from their corporations as either salary or dividends,” he says. “This year, changes such as increases in the highest personal marginal tax rates in several provinces and modifications to taxation of dividends will significantly impact the compensation decision.”

Golombek offers the following tips.

For those who need to withdraw funds in 2013

“The 2013 tax rate advantage is an important factor in the compensation decision. Paying dividends can generate tax savings when there is a tax rate advantage.”

Read: 5 tips for clients with new businesses Paying dividends is generally the best option for SBD Income (which is income up to the small business deduction limit of $500,000 in most provinces) due to the tax rate advantage in most provinces, which ranges from 0.56% to 4.54% in 2013. For ABI (which is active business income above the small business deduction limit), paying salary is generally a better option due to the 2013 tax rate disadvantage in most provinces, ranging from 0.47% to 5.88%.

For those who can afford to leave money in the company

“For small business owners who don’t need to withdraw funds in 2013, it can pay to defer dividends to a future year,” says Golombek.

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Although there will be a tax cost associated with paying dividends after 2013, there is a significant tax deferral advantage that may help to offset this cost.

This year, the tax deferral advantage ranges from 25% to 35.5% across the provinces for SBD Income, and from 13.3% to 23.07% across the provinces for ABI. He adds, “If investing the deferred amount will generate enough income to offset the tax cost, then paying deferred dividends is the better way to go; otherwise, small business owners should still withdraw funds in 2013.”

Tax-sheltering benefits of an RRSP

While paying dividends may be advantageous in many cases, distributing corporate income as salary rather than dividends creates earned income that allows small business owners to contribute to an RRSP. And these clients may wish to consider paying sufficient salary to maximize RRSP contributions, particularly if the RRSP invests in higher rate of return, highly-taxed investments over a long time horizon.

Read: CRA launches online mail for small biz “Taxation rules for businesses are quite complex and can change regularly,” says Golombek. “Business owners should consult with a tax professional and a financial advisor for a complete analysis of all factors in the compensation decision.”

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.