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Sunday, December 12, 2010

Tax and Estate Planning: Should you pay yourself salary or dividends?

Tax and Estate Planning

Should you pay yourself salary or dividends?

By Jamie Golombek
You need to do the math before making a decision

If you’re an incorporated small-business owner, chances are you’ve probably been advised at one point to pay yourself at least enough salary from your corporation to allow you to contribute the maximum to an RRSP. That’s because the ability to contribute to an RRSP is based on 18% of the prior year’s “earned income,” which includes salary but does not include dividends. For 2010, you would have to pay yourself a salary of at least $124,722 to be able to contribute the 2011 RRSP maximum of $22,450.

The problem with this general rule, at least for corporations with a taxable income (pre-salary or bonus) below $500,000 (the federal small-business limit), is twofold and has its origins in the theory of integration. Integration tries to ensure that individuals pay the same amount of tax regardless of whether income is earned personally or through a corporation. If your corporation earns $125,000 of corporate net income and pays it all out to you via a salary or bonus, that remuneration is tax deductible to the corporation and taxable to you based on your personal tax rates. The corporation pays no corporate tax since its taxable income after deducting your compensation is zero.

Alternatively, if the corporation chose not to pay you a tax-deductible salary, its corporate net income would be $125,000 which would be taxed inside the corporation at the small-business rate. The after-tax amount would then be paid to you as a dividend and taxed in your hands personally at the dividend rate. In every province other than Quebec, the tax you pay on salary you withdraw is actually higher than the combined corporate small-business tax paid by the corporation and the personal tax you pay on the dividends. The tax savings by paying dividends instead of salary runs from a negligible 0.3% in P.E.I. to a high of 3.6% in Nova Scotia.

But that’s only half the story because by choosing to have corporate income taxed and reinvested inside the company, a tax deferral ranging from a low of 25% in Alberta to a high of over 35% in P.E.I. can be enjoyed.

 Jamie Golombek is Managing Director of Tax and Estate Planning, CIBC Private Wealth Management. You can read the complete version of his report here.