Are dividends or a salary better for small business owners?
Tax planning should be a year-round event. But, for small business owners, important decisions have to be made before year-end.
The upside of running your own business is that you have considerably more options when it comes to retirement savings than do salaried employees. The downside, however, is that too few small business owners take advantage of them.
You probably know, for instance, that the tax rules allow you to deduct costs of doing business from your gross income. What you're left with is your net business profit — the amount that gets taxed.
But getting hold of that money can be an issue since small business owners often have trouble separating personal wealth from the cash that's in the business. How you withdraw money from your business is important, though.
If you're a solo operator, you're limited to setting December 31st as the year-end of the business. An incorporated business, however, can set a year-end at any time during the year.
If you do own an incorporated business, there are essentially three ways to pay yourself: salary, dividends, or a combination of the two. If you opt for the former, the company gets to deduct the expense but the money received will be taxed in your hands.
Alternatively, you can leave the money in your corporation to be taxed at a much lower small business corporate tax rate and then pay the after-tax earnings out to yourself or through a family trust to other family members as dividends.
Your company doesn't get a deduction in this instance and the dividends will still be taxed in your hands, but at a much lower tax rate than a salary.
But the tax rate advantage is only half the story if you don't need all the cash personally.
For example, where you have other sources of income to help fund your personal living expenses, there's nothing to say that you have to extract any funds from the corporation at all.
By simply choosing to have the business income taxed in the corporation at the preferential rate, you can enjoy a generous tax deferral by reinvesting your money inside the company rather than taking it as higher-taxed salary.
Realistically though, most people need something to live on.
In this instance, the conventional wisdom has generally been that you should take a salary from the business to at least maximize RRSP contributions, and then consider a different combination after that.
That would mean, for example, taking a salary of at least $124,722 if you want to be able to contribute the maximum amount to an RRSP ($22,450) for 2011.
But, according to a new report by Jamie Golombek, CIBC's managing director of tax and estate planning, most business owners should think twice about this RRSP strategy and instead consider sticking with dividends, leaving the excess cash in the company.
In fact, although the actual tax savings vary depending on which province you live in, this strategy left business owners with more after-tax cash in every province other than Quebec.
By leaving funds in the company, and investing them as you would inside an RRSP, you can build up a significantly larger investment portfolio that can later be tapped at retirement by paying out a dividend, he maintains.
His calculations take into account the Canada Pension Plan benefits you won't see as well.
While paying enough salary to maximize CPP entitlements is often touted as one of the benefits of salary over dividends, Golembek believes taking those foregone premiums and investing them in a diversified portfolio would likely produce a larger pension income in the long run.
And, since RRSP contributions must eventually find their way into an RRIF in which withdrawals begin at a set age, dividends afford more control over when you actually receive — and pay tax on — your savings.
Other potential benefits of paying out dividends as opposed to a salary are that so-called "payroll taxes" such as CPP contributions, EI premiums and other provincial payroll deductions are not applicable when it comes to dividends, Golembek notes.
For example, business owners who pay a salary must contribute both the employer and employee portions of the CPP, which works out to a total of about $4,326 in 2010.
Since incorporating is going to cost you at least $1,500 a year in legal and accounting fees, the structure you choose for your business and which way you take money out of the company often rests on how much revenue and profit you have.
But incorporating is still worth thinking about.
Before you do anything, of course, be sure to read Golombek's report (pdf) in detail and then talk things over with your own tax advisor.
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