While a corporation can introduce benefits into a business owner’s life — hello lower corporate tax rates and liability protection — it also introduces additional complexities.
There is one complexity in particular that each corporate owner must deal with annually — how are they going to get paid? There are three options: salary, dividends or a combination of the two.
Before I dive into the differences, which largely relate to how these amounts are taxed, I want to briefly review the concept of tax integration so you can understand the logic behind the tax differences.
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At its most basic level, tax integration aims to ensure that if you earn a certain type of income in a corporation (where it is taxed) and then pay that income out to yourself personally (where it will also be taxed), the combined corporate and personal level tax is the same as if you had just earned that income personally.
Tax integration is not perfect in Canada, nor can it be. Because taxation of income comprises a federal rate and a provincial rate, the rates of tax paid on any particular type of income vary by province, and provincial rates often change.
As such, some types of income in some provinces are typically integrated, while in others there will be a small tax leakage in favour of either earning income individually or corporately. (And don’t even get started on how the new proposed capital gains tax rules affect integration.)
With tax integration in the back of your mind, let’s first review how a salary is taxed.
When a corporation pays a salary to an individual, that individual is going to pay a higher personal tax rate than they would on dividends. However, the corporation is entitled to a deduction from its income for the salary paid.
So, in this case we have a higher personal tax rate but a lower corporate tax rate. However, in order for the corporation to be entitled to that deduction, the salary paid must be “reasonable.”
The general test for reasonableness that I suggest to business owners is to ask themselves: “would you pay that salary to an employee who is not related to you for completing the same tasks?” If the answer is no, it’s probably not reasonable and you risk the Canada Revenue Agency denying the corporate deduction. The test for reasonableness is more nuanced, but this is a good “gut check” to start.
Now let’s consider dividends. As a starting point, you have to own shares in the corporation or be a beneficiary of a trust that owns shares in the corporation in order to receive dividends.
Dividends attract a lower personal tax rate but do not allow for a corporate level deduction. With that, you can probably see how tax integration is being achieved.
With a salary, you have a higher personal tax rate but a lower corporate tax rate, while with dividends you have a lower personal tax rate but higher corporate tax rate.
To take this a step further, there are different kinds of dividends. I want to touch on two: ordinary dividends and eligible dividends.
Eligible dividends allow for an even lower individual tax rate than ordinary dividends. However, in order to be able to pay eligible dividends, a corporation must have a corresponding balance in its general rate income pool (GRIP).
So, how does a corporation get a GRIP balance? It does it by paying a higher level of corporate tax.
Each small business corporation is entitled to a preferential tax rate on the first $500,000 of income in a year, which is currently 10 per cent in Saskatchewan. However, any income over $500,000 is taxed at the general corporate rate, which is currently 27 per cent in Saskatchewan.
A corporation adds to its GRIP when it pays tax at the (higher) general corporate rate. This all goes back to integration — a higher corporate rate allows for a lower individual rate.
In the same way that salaries must be reasonable, there are also requirements to be met to receive dividends in a tax efficient manner.
The rules for this are complex, but at a very high level, the person receiving dividends must not only be a shareholder of the corporation or a beneficiary of a trust that is a shareholder, but they must also be older than 17, active in the business or otherwise fall into a prescribed exception. If they do not, those dividends will be taxed to the individual at the highest marginal tax rate.
When determining how to take compensation, there are factors to consider other than the net tax rate. For example, a salary will create contribution room in your RRSP but can also attract other payroll remittance obligations. Your long-term objectives for your business and retirement should also be considered, and your compensation package might look different from year to year based on those considerations.
So, how can you ensure your compensation package is both tax efficient and achieving your goals? The best advice I can give is to engage the services of a good accountant who is going to review compensation with you annually to ensure you stay on track.
Stephanie Maszko is a lawyer with Stevenson Hood Thornton Beaubier LLP in Saskatoon. She can be contacted at smaszko@shtb-law.com. This article is provided for general informational purposes only and does not constitute legal or other professional advice and does not replace independent legal or tax advice.
