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Building your Financial
Success
With Alain Aube
Tax Planning
Salary versus dividends - what mix is right for you?
As the owner-manager of a
Canadian-controlled small business corporation, this question will loom
ever larger as the tax year shortens: What mix of salary and/or
dividends provides the best tax-savings option for you? That's an
important and complex question - because the answer you select can have
a significant financial impact not only in this taxation year but also
down the road, when you're counting up your money for retirement.
Often, a privately-held corporation
enjoys a reduced tax bite up to a threshold limit, after which your
company moves out of the 'small business' category for tax purposes -
and those calculations are simple and straightforward. The complexity
comes from your need to calculate the best mix of salary and dividends
for your particular situation.
Among other things, your decision will
depend on your cash flow needs, your ability to make the maximum
possible Registered Retirement Savings Plan (RRSP) contributions for
yourself and any family members your company has employed, and whether
or not you want to maintain the option of 'carrying back' business
losses from potential downturns in future years. Here's a simple
example:
- The first $225,000 of active business
income earned by a Canadian-controlled small business corporation is
eligible for a federal tax rate (including surtax) of 13.1%. Income
between $225,000 and $300,000 will be subject to federal tax of 22.1%.
(The $225,000 small business income threshold will be increased by
$25,000 a year starting in 2004 and will be fixed at $300,000 in
2006). If your business income is subject to the full small business
deduction, paying yourself through salary or dividends is relatively
immaterial as the tax rates are nearly equal.
- But if your business income exceeds
the threshold limit, you may conclude that the best strategy is to pay
enough salary to reduce your corporation's net income to $225,000 (for
2003), thus benefiting from the lower small business tax rate.
Alternatively, you could decide to benefit from the tax deferral
available if you leave profits in the corporation - however, you will
likely pay a higher combined personal and corporate tax rate if you
take the amount out in a later year.
- You should also take into account the
potential impact of your salary/dividend decisions on your retirement.
Although dividends are tax-preferred and salary isn't, dividends do
not count toward your RRSP room. So, if you don't pay yourself
sufficient salary dollars to allow for the maximum possible
contribution to your RRSP, you could end up shortchanging your
lifestyle come retirement.
- If yours is a 'variable' business -
good years interspersed with not-so-good years - paying yourself a
large salary can also cause taxation headaches by preventing you from
carrying back a loss in future years. For example, if your business
earns $500,000 this year, and you pay yourself a $400,000 salary, your
company's net income is $100,000. If your business loses $500,000 next
year, you have no way of carrying back that loss against your personal
income. Had you left that $400,000 in the business and paid yourself
via dividends, you would be able to carry back your 2004 loss, totally
negating your company's 2003 corporate tax and providing you with a
tax refund for that year.
There are a number of business planning
tools to aid in the complicated salary/dividend decision process. But
the services of a financial planning expert can help ensure your
'executive compensation' decisions are less taxing today and more
rewarding tomorrow.
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