If you’re like many entrepreneurs and business owners, you were focused on growing the business at first. When your hard work paid off, you were able to take funds out of the business. This is the stage when business owners can benefit from a tax-balanced strategy to meet these personal goals, while keeping personal and corporate income tax to a minimum.
We will explore common issues in owner-manager remuneration and the accompanying tax issues. We’ve assumed that you’re the controlling shareholder and manager of a Canadian corporation and you live in Canada. As such, the corporation will be a Canadian-controlled private corporation (CCPC) and both you and the corporation will be subject to Canadian tax on taxable income you receive.
Salary or dividends
As an owner-manager you can pay yourself a salary from the company, in which case the company will be entitled to a deduction in determining taxable income for that salary. Or you can leave the funds in the company to be taxed as corporate profits and the directors can declare a dividend to you as a shareholder, which will be taxable to you.
The Canadian tax system is designed such that where business profits are taxed in a CCPC and the net amount after tax is paid as a dividend to you, the total tax should be equal to the tax that you would pay if you had earned the same income as a salary paid from your company. This concept is called integration. Because of integration, if you need to take funds out of the company, either as salary or dividends, in theory the decision is tax neutral. However, integration isn’t perfect, and the degree to which tax is integrated varies by province and territory due to differing provincial and territorial tax rates.
Special tax status of CCPCs
CCPCs enjoy a special tax status in that the first $500,000 of net business profits earned are subject to a lower rate of tax than general business profits because of the small business deduction. The general corporate federal tax rate on business profits is 15% while the small business federal corporate tax rate (applicable on the first $500,000 of taxable income) is 9%. When funds can be retained in the company, this allows an additional 6% of taxable income to be kept in the company for reinvestment. Each of the provinces and territories also have lower tax rates for small business income.
When dividends are paid from a CCPC, the rate of tax on the dividend to the individual recipient will differ depending on whether the profits are paid from income that has been subject to the general corporate tax rate or has been taxed at the small business tax rate. Dividends paid from general business profits are known as eligible dividends. All other dividends are known as ineligible dividends. The difference in tax rates of dividends for individuals is designed to compensate for the different corporate tax rates so that integration is maintained no matter if the profits are subject to the small business or the general corporate tax rate.
The charts in the appendix (with 2023 tax rates) illustrate the total taxes, deferral, and integration costs when profits are taxed at the small business rate and paid as ineligible dividends as well as when profits are taxed at the general business rate and paid as eligible dividends to an individual at the top marginal tax rates.
There is no requirement to pay a salary to an owner-manager. Currently, there is a small income tax savings to paying a salary from business income compared to dividends in most provinces before factoring in Canada Pension Plan (CPP) contributions. This savings is based on the assumption that dividends will be paid in the same year that the profits are earned, similar to salaries. Accordingly, this does not consider the benefit of the deferral of tax where profits are retained in the company and paid out as dividends years later.
The charts in the appendix also show the deferral achieved when earning either small business income or general business income in a CCPC. The time value of money and the rate of return on money re-invested in the business must be considered to properly measure benefit of the deferral of tax.
Considerations for salary
The decision to pay a salary or dividend from the company will be based on a few factors including whether you have any other sources of personal income, as this affects the tax rate on salary or dividends, and what funds you need from the company for your personal expenses.
If you want to make contributions to a registered retirement savings plan (RRSP) and the CPP, you will need to pay yourself a salary. In 2023, the salary required to maximize CPP contributions is $66,600. This would create the need for you to pay an employee contribution into CPP of $3,754.45, and your company would need to pay an equal contribution for a total expenditure between you and your company of $7,508.90. CPP contribution limits on pensionable earnings are indexed to inflation and will rise accordingly in 2024. Also in 2024, a new additional component to the CPP will come into effect, affecting those at higher income levels.
You must have salary (earned income) in the previous taxation year to contribute to an RRSP. To make a maximum RRSP contribution in 2023 of $30,780, it would’ve been necessary for you to have earned a salary (or have other earned income) of $171,000 in 2022. To make a maximum RRSP contribution in 2024 of $31,560, it will be necessary for you to earn a salary of the $175,333 in 2023.
If you are paying child care expenses and are the lower-income spouse or common law partner in your relationship, paying salaries also makes sense because child care expenses are not deductible if dividend income is your only source of income. In general, child care expenses are only deductible if they are paid to enable a taxpayer or a supporting person to be employed or to carry on business. Special rules are provided where the parent is attending a post-secondary institution.
A similar consideration exists if you use your personal vehicle for business purposes and want to deduct expenses related to using such vehicle on your personal tax return, as employment expenses are only deductible against employment income.
There are other considerations as to whether payment by way of salary or dividend is the most beneficial in each situation. Your BDO advisor can help assess the best option depending on your personal circumstances. Many owner-managers will take a base salary from their company to allow for CPP and RRSP contributions and pay a bonus if the business is profitable enough and if further funds are required. There is generally no limit to the amount of bonus that can be paid from the annual profits to an owner-manager, but salaries to family members are limited to what would reasonably be paid to an arm’s length person performing the same services.
In some provinces, a payroll tax can apply and can increase the overall cost of paying or receiving a salary. These payroll taxes are summarized on page 11 of the BDO Tax Facts publication.
Paying personal expenses in the company
As the corporation is a separate legal entity from you as a person, it’s important to pay personal expenses personally and keep corporate expenses in the company. However, if company funds are used to pay personal expenses on occasion, this will create an amount owing by you to the company (a due from shareholder loan).
If this loan is not repaid within a year of the end of your company’s taxation year, the amount of the loan will be considered taxable income to you as a shareholder. If a dividend is declared, it can be used to repay this loan. If your preference is to have earned a salary from the company, a portion of the salary can be used to repay this loan. If the loan balance is not repaid before it is included in taxable income, a deduction from income can be claimed if the loan is subsequently repaid.
The bottom line
A balanced compensation strategy should be reviewed each year as personal and corporate circumstances change. In future articles, we will look at additional factors that impact owner-manager remuneration, including investing excess corporate funds outside the business and factors for an owner-manager to consider when planning for retirement.