In the last episodes, we’ve been talking about using a Canadian Controlled Private Corporation to invest. However, the main reason why corporations exist is to run businesses through. As a small business owner, it is important to know how to pay yourself from your business. Whether incorporated, or as a sole proprietor.
Compensating yourself can take multiple forms. For example: salary, dividends, taxable benefits, pensions, gifts, and health benefits. How you choose to pay yourself has different advantages, potential pitfalls, and nuances to be aware of. Use this knowledge to reward yourself optimally for your work while staying out of trouble. It is like a table saw. You don’t want to leave money on the table, buy you don’t want to stick out like a sore thumb either.
[0:00:17] BF: Welcome to episode 12 of the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We’re hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital and Dr. Mark Soth, aka The Loonie Doctor.
[0:00:30] MS: In the last couple of episodes, we have talked about investing using a corporation. A corporation is a separate legal entity that we can use to conduct business and/or to passively invest. The most common potential advantage of that is using pre-personal tax dollars to invest. You pay a low corporate tax rate upfront, invest money that you don’t need personally within the corporation, and then later on, you can take it out and pay tax at some time in the future, hopefully at a lower personal tax rate.
This setup makes sense from a policy perspective to promote reinvestment within small business corporations to help them grow their business. However, recent rule changes have been in place to try to disincentivize the accumulation of a whole bunch of passive investments with inside one of these corporations.
[0:01:15] BF: We also started talking about taxes within the corporation in those episodes, and we’ll come back to that again today. Corporate taxes are impacted by the active business income, business expenses, investment income, and how you compensate yourself as an owner of the business.
[0:01:28] MS: That issue of how we pay ourselves personally from a corporation is where we’re going to hone in on today. The way a corporation works, really, a corporation can regulate how your income flows to you. It’s like a big dam with all the business income flowing into the reservoir, and the money is then released by opening up different floodgates, salary or different types of dividends that allows that money to flow it into your personal hands, at which point, it usually triggers personal tax.
[0:01:54] BF: The dam analogy is so good. You can use a corporation to smooth out the income that flows out to you personally, and that lets you manage your tax brackets. Over time, knowing which levers to pull to keep the money flowing efficiently when you consider both your personal and corporate taxes is also really important. It changes as the sources of income in your corporation changes, and also, the planning that you do to compensate yourself today personally affects the financial planning options that you’re going to have later. Setting up an RRSP account, or an individual pension plan, which you can only do in the future if you’ve been paying yourself with a salary in the past.
[0:02:27] MS: I think we’ve got the money scope ready to dive in, and we are going to come and cover some familiar territory, but it always looks different when you’re entering in from the other end. We’re going to do that, plus, we’re going to be looking into a lot of nooks and crannies that we haven’t looked into at all yet. Here we go.
[0:02:42] BF: To kick this discussion off, we want to throw at a disclaimer, and I think this is really important. Anytime we’re talking about taxes, the specific fact pattern of the situation can affect the relevance of various tax planning ideas for that situation. Let’s just be mindful of that as we’re talking here. In addition to that, there are exceptions to many of the things that we’re going to talk about. Based on the specific fact pattern, there may be an exception to any of the tax related ideas that we talked about today.
We’ve done our best to be thorough covering these topics, but when it comes to tax planning, it’s always sensible to get professional advice. Don’t run off and take some of the stuff we talk about and try and do some crazy tax planning strategy without first getting advice. We do also want to mention that given the complexity of today’s topic, and I think Mark, we agreed before we start recording that this is probably our most ambitious episode to date in terms of the content we’re covering.
We wanted more than our own eyeballs on the notes that we prepared for this. We had input on this episode from Ironwood Wealth Management, from an expert in financial planning who I can attest to his expertise, but he wishes to remain anonymous. Then also, from two tax-specialized CPAs, Jacob Milosek and Spencer Brooks at Hendry Warren, which is an accounting firm in Ottawa. We had lots of really valuable input. I think, Mark, you’d agree that the back and forth within that group was – it was something else to be part of.
[0:04:01] MS: It was great. The thing I would say about this is I don’t think anybody has really covered this topic like we’re about to cover up today. We’re going to get into all sorts of things you’re not going to hear commonly discussed. We’ve organized it and we put it into some practical applications that are the common things that hit people up, but you’re not going to read this somewhere on the internet. I mean, there’s nowhere you’re going to pick the brain trust like we’ve picked for this one.
[0:04:23] BF: No, you saw it as that group of people who are all highly qualified and intelligent. Even within that group, there was a lot of discussion and many debates about whether this or that is true, or what we should think about it this way or that way.
[0:04:35] MS: We’ve linked to the CRA interpretive bulletins for some of the other things that are coming up as well, just to make sure we keep our footnotes references going. The other thing I would point out about with this disclaimer is that when you’re consulting a tax professional, knowing about these topics is really important. That’s going to help you get the most out of the interaction with them.
Accountants are great at taking care of what you hand them. However, when you plan to use a corporation, they have to know all the details of your situation, including your goals and your long-term plan to be able to make a strategy to help you with that.
Plus, there’s also some strategies that even accountants don’t readily consider, unless you ask all the right questions and bring up some of the suggestions. Like, as Ben said, there’s stuff that we bounced around that people hadn’t thought of, so it’s really good. We did enlist a lot of others to help us with this, and some of it’s pretty wild.
[0:05:24] BF: Any errors in the episode are our own. We own the errors, even though we had all this input, we take ownership of any errors if they exist. However, we were very thorough in preparing the notes.
[0:05:37] MS: If we find something, we’ll do an addendum, or we’ll fix it. I think we’ve done as much due diligence as we can. With all that preamble, let’s get right into talking about taxation of active business income. When you earn business income, you can do that as an individual, which could be referred to as a sole proprietor, or you could incorporate, which creates this separate legal entity from you to run the business through.
In the case of a small business in Canada, that’s called a Canadian controlled private company or a CCPC, and you’ll hear it called that. They also come in a bunch of different flavours. For example, a profession, like a physician may have what was called a professional corporation, or in the case of a physician, an MPC, medical professional corporation. In general, corporations may provide some liability protection for some businesses, but that doesn’t usually do that for professional corporations.
Now from a tax standpoint, one of the main pillars of our tax code in Canada is this idea of tax integration. What that is, we talked about it before, is that it aims to make people indifferent about whether they earn business income directly as an individual taxpayer, or whether they flow that income through a corporation into their hands.
Now, practically speaking, integration means that when you add up the corporate taxes, plus the personal tax on the dividends that are paid out from what’s left over, it should be approximately the same as if you just earned that income as a sole proprietor. Now this is relevant today’s episode, because tax integration is not perfect, and it works differently depending on whether you pay yourself salary, or dividends.
There’s also some funny nuances that can actually break tax integration pretty substantially in certain cases. The other important detail is that with a corporation, you can choose not to take all of your income personally in one shot, and that’s the biggest difference.
Even though as it flows through, integration should make it roughly the same. The ability to defer some of that personal income into the future gives you that partial tax deferral. That’s where the dam analogy comes in. The corporation holds your pre-personal tax money, which is going to be more, obviously, until you choose to open the floodgates down the road and release it. You can use that money to invest along the way.
Now, whether incorporated or not, the taxable income portion of your business income is net of business expenses. It’s not just what you make, it’s what you spend to run your business. Revenue minus active business expenses.
Now we talked about passive income in episode 10, it’s taxed a bit differently. But what counts as active income is pretty straightforward. It’s generally any income other than the income that’s earned from passive investments.
Now we are going to spend some time to talk about how the business deductions work. The income coming in is pretty easy, but subtracting those deductions for what is considered a business expense is much more convoluted.
[0:08:27] BF: One of the common myths is that corporations get special business deductions. I think Seinfeld had a bit about this, “Just write it off.” They generally don’t, in Canada at least. There are some exceptions though.
Health spending accounts are one. Those can be set up for incorporated businesses with a single employee, but an unincorporated business requires more than one employee, so that’s an exception where corporations get slightly different treatment than a sole proprietorship.
Another one is a defined benefit pension option, which is available to people with corporations. These are called IPPs. We’ll talk a little bit about them later. Those also offer certain deductions that are not available to an individual taxpayer with a sole proprietorship business.
Other than those exceptions, and maybe some others that I’m not thinking of, or we’re not thinking of. Individual or non-incorporated business, a sole proprietorship, can deduct the same business expenses as a corporation, or an incorporated business.
Expenses are really important, because they’re deducted dollar for dollar against active income, and that reduces your tax bill. The net income after deductions is what you pay tax on. Spending some money on something in the corporation, in the business that is deductible, is essentially buying that thing with pre-tax dollars, which can be a big deal.
In general, most business expenses are deductible in some form, if they meet three important criteria:
1) They’re incurred to earn business income.
2) They’re not disallowed by the Income Tax Act. Now the Income Tax Act specifically disallows certain things.
3) They’re reasonable in the circumstances.
[0:09:54] MS: That third one about reasonableness of it is open to interpretation. One thing that’s important to realize is that CRA’s interpretation is what matters. Yes, you can argue with them, but to argue with them will cost you money to defend yourself. Even if you’re ultimately right, it can cost a lot to show that you are.
It’s important to talk with your accountant when considering business expenses that may fall into a grey area before you spend the money. They’ll either be aware of relevant interpretive bulletins that CRA has issued. Or if there isn’t one, they’ll probably have a sense of what raises flags through their experience with their clients. That’s probably one of the reasons why it’s important to have an accountant that has experience with the type of business that you’re running, so they can get that sense of what other business owners are doing and what gets flagged and what doesn’t.
You don’t want to leave money on the table, because you’re afraid of CRA for what is actually a legitimate expense. You also don’t want to stick out a sore thumb for the CRA buzzsaw. Even if you’re ultimately right, it’s an expensive road to get there.
There are a few exceptions where people do tend to get themselves into trouble due to the rules and interpretations around reasonableness, and we’re going to talk about some of that specifically. But vehicles, entertainment, golf is particularly in there, and vacation style conferences would be examples.
Another example is using a home office, which has some nuances to consider that could come out when you eventually go to sell your home by affecting your principal residence exemption. That’s the exemption that allows you to sell your house tax-free in Canada. If you’re balancing some of these things, you’re not sure, definitely discuss that with your accountant. It’s also important to have a basic idea of how expenses get deducted and when.
[0:11:37] BF: In terms of common business expenses, payroll is the most common recurring expense that includes salary income paid to employees, plus the employer portion of employment insurance premiums for arm’s length employees, which we’ll dig into later, and also, Canada pension plan contributions.
One important nuance with deducting salary as an expense is that it must be deducted against active business income. For someone who’s in retirement, and if their corporation becomes a holding company with investment income only and no active business income, using salary is not typically going to make sense, because the deduction’s not going to be useful.
You’d likely be mostly using dividends in that case anyway, by that point, to keep your corporation’s investment income tax-efficient, which we’ve covered in past episodes. We’ll also talk more about why that is later. We know this is a common question, because one of our listeners has already asked about it before we recorded this episode.
The other common question here is when you have an active business income, you’re lower than your usual salary. If you usually earn some amount of money and pay yourself some amount of salary, if you have a year where your business income is lower than that, what does that mean? For example, if you take a parental leave and the business income hit because you’re no longer earning active income in the corporation, that goes with the parental leave happens. What happens to your salary deduction if it exceeds your business income?
You can actually carry some salary deduction backwards to apply against active income from a previous year as long as the salary is reasonable. Fun little nuance there.
Office expenses and other operating costs for the business are also going to be deductible against income.
Some expenses, like meals and entertainment are 50% deductible, and they’ve also got to be considered reasonable.
Reasonableness is something that we’re going to come back to many times throughout this episode. As we alluded to in the previous section, there are some expenses that are explicitly disallowed, like golf green fees and membership dues.
[0:13:25] MS: I was wondering about Taylor Swift tickets. We actually got some. I think if we were to use those as a deduction, we could probably net drop our net income down to zero.
[0:13:34] BF: Yeah, it’s doubtful that that one would be allowed. Unless, you’re recruiting patients there.
[0:13:38] MS: Maybe an Elton John concert or something to get the demographic that I go after.
[0:13:43] BF: The other thing to be aware of when you’re spending corporate dollars is that the expense may not be all deductible at once. For example, when you buy durable business equipment, like machinery or something like that, the cost is not usually going to be completely deducted against your business income upfront in that year, because the equipment has durable value, but depreciates over time.
Only the depreciation of the asset is deductible in a given tax year, and that’s called the capital cost allowance, and there are different categories for different types of equipment based on how quickly they’re expected to depreciate to prescribe how fast their cost can be deducted over time.
[0:14:20] MS: Yeah, so it’s not going to be all at once. That’s the important thing you remember with that when you spend that big chunk of money, is you’re not going to save the taxes on it right away. The other thing that it’s important to understand is that if you get personal benefit from the business assets, then that’s usually not a free lunch either. It could be a free lunch for a 50% deductible lunch if it’s for business purposes. Other than that, probably not.
In general, if there’s personal use of company assets for non-business purposes, or even access for personal use, then that can be considered another form of compensation that comes from the company, even though it’s not salary per se. The personal benefit portion could be considered a taxable benefit when it is like that, and subject to personal tax, just like it was regular income, the value of that. Some common areas where people get entangled with this are company vehicles and recreational properties.
For example, if you own a cottage through your corporation, anytime it’s available for personal use is a taxable benefit equal to the market value of had to rent it for that time period. This is important to understand, because this is, I think where people get mixed up is this means that technically, let’s say the cottage is rented out for business purposes for four months, and it’s not meant to rent it out for eight months. Even if you use it for one of those eight months, the taxable benefit would be calculated for the eight months that it was available for use.
[0:15:46] BF: That one’s crazy. I personally didn’t know that one. That came up in our brain trust discussion with the accountants that if it’s available for use, it’s as if you’re getting a taxable benefit of using it. I thought you had to actually be using it for the taxable benefit. That’s pretty scary.
This question of, can I buy a cottage in my corporation? That’s come up for my clients many, many times. Because you see this big pile of money in the corporation, it’s like, “Wow, I could buy a cottage. But only if I use my pre personal tax dollars. Can I buy it in the corporation?”
Technically, yes, you can, but it can get very messy with taxable benefits. Generally, we say, it’s probably not worthwhile. Again, that’s one of those things where generally, it’s not worthwhile, but every case has to be evaluated. You can get yourself into even bigger trouble than what we were just talking about with a regular taxable benefit, if you go crazy and buy something really expensive that doesn’t have an active rental market. Because the deemed benefit of the cottage that we talked about, it’s effectively the amount of rent that you would have paid to have access to that cottage.
If something doesn’t have a rental market, what do you do? Well, this has been tested in court. If something doesn’t have an active rental market, like a luxury property, for example, where the fair market rent, because the property is so luxurious that they aren’t available for rent. If the fair market rent does not provide for a reasonable return on the value, or cost of the property, that’s what ends up being the benefit is that reasonable return.
This one court case specifically, the court deemed that the benefit was greater than the market value of rent. Instead, it was deemed equal to the return the corporation could have earned on the invested capital, plus the operating costs of the property, which could end up being way more than rent.
[0:17:23] MS: Especially if it’s an aircraft, or a private yacht. Unfortunately, that principle applies to private aircrafts and yachts, too. They specifically mentioned that. Sorry to crush all the dreams out there, and we’ll put the CRA interpret bulletin into the footnotes.1
Anyways, the other thing that we can get is a vehicle and recreational property costs are pretty easy to quantify in a side business versus personal usage. However, there are all sorts of other expenses that are pretty hard to track, or identify. More than what we could possibly cover today.
We just wanted to highlight some of the issues that non-monetary compensation can actually count as taxable income for you personally. Be sure to discuss those types of expenses with your accountant if you’re not sure.
[0:18:04] BF: I mentioned it earlier, but those pre-personal tax corporate dollars, they burn a hole in people’s pockets.
[0:18:08] MS: They’re exciting.
[0:18:10] BF: It’s this big pile of money. But then when you think about, “Well, we’ll have to pay, whatever, 50% in tax. So, I don’t have that much money actually. But if I could only buy it in the corporation.” But then, you start thinking about the costs in terms of taxable benefits and the complexity of accounting for all of that stuff in the long run, I don’t think that can be underestimated.
[0:18:27] MS: Yeah, it’s a buzzkill.
The other thing that comes up, and I see this one come up every December, and again, around Valentine’s Day is that an employer can give gifts, awards, and rewards. You made gifts for special occasions, awards for specific achievements, or rewards for performance. This probably gets especially dicey when you’re talking about a spouse, probably for many reasons.
The gifts and rewards are generally considered to be taxable benefits by CRA.2 That includes non-cash, or cash amounts. Those that are under $500 in value are often excluded. But not always. There’s a lot of rules around this. There’s no way to easily summarize this for a podcast. Of course, the general rule of having that principle of reasonableness applies.
A common issue that comes up is when benefits for shareholder employees are different from benefits from all employees. If your corporation hire has more than one employee and you treat them differently, if a shareholder employee gets benefits that the non-shareholder employee does not, then that’s going to be deemed to be a shareholder benefit.
[0:19:32] BF: Let’s talk about how net active income is taxed. When you take the business income from operations, your active business income and deduct expenses, that’s your net active business income. Similar to personal taxes, that amount is subject to corporate tax rates. Unlike personal income tax though, where there are many tax brackets that are progressive with increasing income, there are only two main effective tax rates for corporations. That is the small business deduction rate, or the SBD rate, and the general corporate tax rate.
Tax rates on active corporate income can be very low if the SBD applies. Generally, that low rate applies for the first $500,000 of net income. I said generally. There’s various ways that there can be exceptions to that. We’ll talk more about that. Then there are also some nuances to the SBD threshold. That’s what we’ll cover in some detail later on.
The combined federal and provincial SBD rate varies from as low as 9% in Manitoba to 12% in Ontario and Quebec, and most provinces for the SBD rate are in the 11% to 12% range.
That is a lot lower than the general corporate tax rate, which ranges from as low as 23% in Alberta to around 30% in the maritime provinces. Ontario and Quebec have 26.5% as their general business tax rate. BC, Manitoba and Saskatchewan are at 27%. It varies across provinces, but on average, 27% to 28%.
[0:20:56] MS: The next thing to understand is that that’s how it gets taxed into the corporation, but then you have to flow that out as dividends. That business tax and active income is the first part of the journey of your income passing into the corporation. Money that is left over after you pay that tax, and that money that’s left over after the expenses and the taxes have been paid is called retained earnings.
What you can do with those retained earnings? Well, your corporation could invest those retained earnings in stocks, or bonds, or in various investment funds that we’ve talked about. They could save that money for an upcoming business expenditure, or other investments that are coming up, or they could pay that retained earning money out as dividends to the shareholders. They make that decision just like any other company.
Now, when you do eventually pay money out of the corporation’s dividends to spend it personally, those dividends are then taxed at your personal tax rates. There’s some accounting gymnastics about how that actually happens, because it’s trying to account for the fact the corporation has already paid some of the tax on it. This is that tax integration at work.
In Canada, we have a system of dividend gross-up and credits to account for those taxes paid by the corporation when they flow out to an individual. We did touch on this in episode nine for dividends from publicly traded companies. However, there are some extra wrinkles for private corporations.
We’ll start by comparing income that was taxed at this small business deduction rate, and then we’ll talk about income taxed at the general corporate tax rate, because they’re treated differently.
[0:22:24] BF: That’s going to be talking about regular, or non-eligible dividends to start. Income tax at the small business rate gets dispensed as what are called non-eligible dividends. For determining the personal income tax on a dividend, there’s that gross up and credit system that you mentioned.
First, there’s a dividend gross up. For a non-eligible dividend, that means the dividend is multiplied by 1.15. This means that a $100,000 dividend that you’ve received personally would count as $115,000 of taxable income. That gross up is meant to approximate what the income was before corporate taxes were paid. You’re approximating pre-tax corporate dollars. Then the gross up amount is taxed along with whatever other income you have through your marginal tax brackets.
Then after your taxes are calculated and the order matters. After your taxes are calculated, a dividend tax credit is then applied to reduce the amount of tax that you owe overall. The credit is meant to account for the taxes that the corporation has already paid. The actual credit is going to vary from province to province, since the provincial portion of the small business tax rates are variable across provinces. The combined federal Ontario tax credit for non-eligible dividends is 12.0164% of the grossed-up dividend amount. Very specific.
[0:23:40] MS: Yeah, lots of significant figures.
[0:23:43] BF: To take that to an example, if an Ontario corporation earns $100,000 tax at the small business rate of 12.2%, that leaves $87,800 of $87,000.8 of retained earnings in the corporation. That can then be paid out as a non-eligible dividend. For personal taxes, that $87,000.8 would be grossed up by 1.15. That grossed up amount ends up being $100,970. Now notably, that’s a bit more than the actual pre-tax corporate earnings, because we know we’re following the example with $100,000 to start.
At the top personal marginal rate in Ontario, which is 53.53% at the time of recording, that ends up being $54,049 in tax. But there’s also going to be a tax credit to reduce that amount owing.
Again, the combined federal Ontario tax credit for regular dividends is 12.0164% of the grossed-up amount of the dividend, which is notably a little bit less than the actual corporate taxes paid. That is a $12,133 tax credit, reducing the net personal tax to $41,916.
In this case, the combined corporate and personal tax rate on the dividend is going to be 54.12%. Now compare that to the 53.53% for having earned the income personally. We can see that there’s a little bit of a tax integration inefficiency.
That number, the 54.12% on total taxes between the corporation and the individual is really important, because looking at only the personal side of the dividend, which many people do, can lead to quite a bit of confusion around the relative tax efficiency of dividends.
[0:25:23] MS: That happens all the time. I literally answered an email about that yesterday, where someone was talking about how they’re going to pay such a low tax rate, because they were just going to give themselves dividends. But, they were totally ignoring the fact that the corporation paid tax on it. This is one of the ways people get confused to think dividends are better than salary. But as you just showed with your example, it’s not.
I mean, it’s a complicated process, so it’s no wonder people get confused. But people forget to take both sides. That tax rate on the $87,000 and $87,800 non-eligible dividend is 47.74%. That’s the number you’ll see when you look online about what different tax rates are for dividends. You’ll see that 47.74% for the example we gave, which is less than the rate that you’d see for salary, but that’s not accounting for the corporate taxes. When you put the corporate taxes in there, it’s going to be actually a little bit more. People are tempted to think that dividends are more efficient.
Now, tax integration, we did gave one specific example at the top tax bracket in Ontario. But if you look across the country, tax integration generally does not favour dividends over salary when all of the money flows through.
Now, the0re are still some exceptions. For example, at the top marginal rate in Saskatchewan, where dividends have a slight advantage, 0.4%, it’s going to be 0.1% as of July 2024.3 It’s going to be almost exactly the same.
There’s also some exceptions where various tax brackets in some provinces will favour dividends and others won’t. Historically, dividends were favoured at the top tax rate until relatively recently over the last number of years, and that maybe explain why some people still hold on to this belief that dividends are more tax efficient. They were at one point, but when the rules changed, then that changes as well.
[0:27:10] BF: Even though we’re saying that integration slightly favours salary, the potential advantage of dividends is that you delay taking them until some point in the future. If you do that, you’re benefiting from a deferral on the personal portion of your tax bill, which can be useful.
It basically means that you can invest your pre-personal tax corporate retained earnings inside of the corporation, deferring the personal portion of tax. That can very well work out better than salary in the long run if you can grow that capital more tax efficiently inside the corporation than you could personally.
However, it may not be better compared to tax-sheltered accounts, or even personal accounts at low personal tax rates, if those are available to you. For someone who’s personally taxed at the highest rate, maybe not so interesting to pay salary and invest personally. But if someone has a very low personal tax rate, or a family member with a low personal tax rate, or if they’re tax-sheltered accounts available – that was one of the first papers I ever did on this type of tax planning was, does it make sense to take money out of the corporation to invest in the RRSP and the TFSA?4 I found that, generally, it does if you have a longtime horizon.
[0:28:16] MS: Not even that long, actually, for some of them.
[0:28:18] BF: Yeah. For RRSPs, it makes sense, because you can defer the personal tax still by paying yourself out some salary to put in the RRSP. The TFSA, you’re potentially taking a big tax hit upfront, so you’ve got to have a little bit of runway for it to make sense if you have a high personal tax rate.
[0:28:34] MS: I would make two comments on that. As one, I think it was around 10 years, or less for reasonable variables. The thing I think people need to remember is that your investing timeframe is actually when you die. It’s going to be most likely more than 10 years. I would certainly hope for most people. Generally, especially during your working years, it’s going to make sense, because hopefully, you’re going to live more than 10 years in retirement.
[0:28:57] BF: Total digression. But that, people framing their time horizon as the data at which they will retire, I think is such a problem in financial planning. It comes up in asset allocation discussions, too. Well, my time horizon is only five years, because I’m going to retire. Well, I don’t think you’re going to die in five years.
[0:29:11] MS: I brought it up, just because I know this RRSP-TFSA question still comes up. You’ve found that answer, I’ve found that answer. Jamie Golombek’s found the same answer.5 6 It’s been shown repeatedly by many people using different methodology, but it still comes up all the time.
[0:29:26] BF: It’s one of those things that research changes one death at a time. It’s the same idea. There’s this notion that dividends are really tax efficient and everything should stay in the corporation, and I think things like that commonly held wisdom like that just changes very slowly.
The other thing is, digression here, but there are ways to get money out of a corporation relatively tax efficiently, like realizing a capital gain, the corporation using a capital dividend account, funding a TFSA that way, there’s no runway, if you can get money out through the capital dividend account.
[0:29:51] MS: Yeah, it’s easy. The other thing that comes up is people have this giant unused RRSP contribution room that’s sitting there unused, and they have all this money sitting in their corporation. They could move that into their RRSP, which is tax-sheltered from the tax exposed account with no cost.
I mean, there’s no corporate cost, because you pay this salary. It’s a deduction for the corporation. You put it in the RRSP, it’s a deduction against your personal income. A 100% shift over to a tax-sheltered account. I know a lot of people that have this big RRSP contribution room that’s not used, and they have all this money in their corporation. It’s one of the most common things I see when I help people out.
[0:30:25] BF: Which is crazy. We talked about tax drag in a past episode. You have way more tax drag in the corporation than you do in the RRSP, or the TFSA.
The other way that tax deferral using the corporation can become a major tax savings is if you take dividends out in a future year when your tax rate is lower, than if you took the money out now.
If you’re going to take a dividend out now and you’re going to pay tax at a very high personal tax rate, whereas in the future you expect your income tax bracket to be lower, because you’re not maybe earning as much income, or your expenses aren’t as high, then taking money out in the future at a lower tax rate can make retaining in the corporation investing and paying dividends later increasingly attractive. That’s another big one.
Now that’s going to depend on what your future withdrawals from the corporation are going to look like and other sources of income. That’s going to depend on how much you need to spend and also, how much you need to take out of the corporation to keep the refundable taxes on investment income flowing efficiently. A lot of different variables there that are going to influence what your future tax bracket is.
Then it’s also important to keep in mind that future tax rates can change. That can present tax planning opportunities if there are years where tax rates become more advantageous. It also presents a risk, where if tax rates go up and you’ve left all your money inside the corporation, then it can actually make you a little bit worse off, than if you’ve taken the money out earlier at the lower tax rates. This is an interesting point.
That depends not only on personal tax brackets, but it can also show up tax rate changes that can be detrimental, or beneficial, I guess. Well, yeah, definitely, either way. That can show up through changes in personal tax rates, personal tax brackets, but it can also show up through changes in the federal SBD rate.
That’s because the dividend tax credit is based on the corporate SDB rate at the time that a dividend is paid, not the tax rate actually paid on the active business income when it was earned. If the government reduces the corporate SBD rate, they’re generally going to modify the gross up and tax credit to reflect the lower corporate tax rate paid on retained earnings.
[0:32:20] MS: Yeah. Just to explain that a little bit more is basically, so if the corporate tax rate dropped over time, you would have paid corporate taxes at a higher rate previously. Then now when you’re sending the money out and the corporate tax rate is lower, you’re not going to get as much credit for that as you would have in the past if you’d floated through right away. When corporate tax rates are dropping over time and you’re holding on to money, it can be a disadvantage.
If corporate tax rates rise over time, then it could be potentially an advantage, because you’ll get a bigger credit down the road than what you actually paid the tax on. That’s a bit mind-bending. Problem is no one can actually predict which way tax rates are going to move in the future, although it’s hard to imagine corporate tax rates, specifically the small business deduction rate getting any lower over time. It’s pretty low. If there is a risk, they are probably to the upside, but no one knows that.
The other thing that’s common advice is to take the minimal amount of personal income that you possibly can, which as you mentioned, usually is dividends, because then, you’re going to leave more tax-deferred money invested within the corporation than if you moved it out dollar for dollar, or salary.
However, the optimal answer on how and how much to flow to the corporation actually requires more consideration and planning than that. Dividends also impact how tax efficient the corporate investing is due to their relationship with the refundable dividend taxes on hand. We’ll come back to that in the next section, or the next episode when we talk about planning for the optimal salary and dividend mix. There’s other interactions that go on there.
Some of the answer also depends on the corporate income tax to the general rate, because corporate tax to the income check of the general rate is going to generate what’s called GRIP. That gives the corporation the ability to pay out eligible dividends personally, which also enters the picture.
All or most of the income that a corporation pays at the higher general corporate tax rate, that was around 27%-28% across the country, that gets passed through to shareholders as eligible dividends. In provinces with the corporate tax rate over 28%, all of the retained earnings from active income tax to that rate can be paid out as eligible dividends. That would be all of Atlantic Canada, for example. In provinces with lower tax rates, it is partial, because the GRIP is calculated not dollar for dollar.
GRIP, which stands for general rate income pool is one of these notional accounts that we’ve talked about before. They exist only on paper for tax tracking purposes. Basically, the GRIP balance is how much money a corporation is allowed to pay out as eligible dividends. It’s going to be how much you generate, minus how many eligible dividends you pay out. That’s the basic calculation.
In episode 10, we talked about that with investment income, or a dollar of eligible income, eligible dividend income is received by the corporation that generates $1 of GRIP. Then your corporation has the ability then to pay that $1 out as an eligible dividend to you personally, and that passes through quite efficiently.
Now, in contrast with active income, GRIP is determined by multiplying the net active income by 0.72. That’s why I said 28% earlier, because only 72%, or 0.72 of the active income tax to the general corporate rate allows you to have this GRIP. So, it’s going to be less.
[0:35:46] BF: I’m going to take us through a quick example. A lot of numbers here, but I’ll try to illustrate how GRIP works with active income. If we start with a corporation that has a $100,000 of net income taxed at the general rate, we’re going to get $72,000 of GRIP based on that multiplier.
If this was an Alberta corporation, the general corporate tax rate is only 23%. There’d be $77,000 of retained earnings. Of that, 72,000 could be dispensed as eligible dividends and the remaining $5,000 as non-eligible dividends. We’ll follow that Alberta example by flowing all of the money through to a shareholder.
The $72,000 of retained earnings is dispensed as eligible dividends and it’s going to get grossed up by 1.38 to give $99,360 of personal taxable income. It’s pretty close to simulating that original $100,000 of corporate income, but not quite perfect.
The top marginal tax rate in Alberta is 48% personally, which gives $47,692 in tax on that $99,000 of personal income. But then, that’s not quite the end of the story. Eligible dividends come with an enhanced dividend tax credit. For Alberta, that reduces taxes owing by 23.1398% of the grossed-up amount to give a $22,992 credit. That makes the net tax on the $72,000 eligible dividend come out to $24,700, or an eligible dividend tax rate of 34.31%.
The $5,000 non-eligible dividend would pass through using the 1.15 gross up and regular credit, or non-eligible credit for a net tax of $2,116.
When you add up the corporate tax paid, plus the taxes paid on the non-eligible and eligible dividends, the total tax on $100,000 of corporate income comes out to $49,816. So, a 49.82% total tax rate corporate and personal combined. That’s higher than the top Alberta personal tax bracket of 48% for salary income.
In this case, tax integration does not currently favour corporations if all the money is just flowed through, compared to top personal rates. Flowed through as dividends. The main exception, at the time of recording anyway, is New Brunswick, where tax integration favours dividends by 0.5% for general corporate tax.
[0:38:03] MS: It’s pretty close, but people get messed up with this, because they see that 34.31% eligible dividend tax rate on the internet and they’re like, “Wow, I’m going to give myself eligible dividends. It’s awesome.” But if you factor in all of the active income tax that was there, it’s actually more than personal.
As we have alluded to, tax integration for these dividends is imperfect and it really does vary by province and even by tax bracket. It tends to favour salary over dividends in most jurisdictions when you’re looking at the top personal tax brackets.
However, the magnitude also varies when you move down through the tax brackets into lower income levels, even within a given province. In very low tax brackets, the dividend tax credit may sometimes even be lower than the tax is owing. This is especially true for eligible dividends.
That brings up an important issue and that’s that this dividend and enhanced dividend tax credit is a non-refundable tax credit. You’d want to make sure that even if you’re using dividends and getting this low, or even negative effective tax rate, you have to pay enough personal taxable income to actually use that tax credit, because it only offsets tax that you owe. If you don’t use it, then you’re going to lose it. You won’t actually get that negative effective tax rate, unless you pay enough income to be actually paying some tax.
We’ll come back to that and some other practical nuances in episode 13, when we talk about optimizing our salary and dividend mix, but it’s worth hearing it more than once, because it confuses a lot of people. You can usually see calculations on the internet and other places that are pretty much always done at top personal tax rates. Now, some of us do spend money and take money in top personal tax rates, but a lot of people and probably the majority of people actually do not.
When you look at that, it’s important to think about what happens at lower tax rates for tax integration. What actually does happen, I’ve gone through this, is that the tax integration becomes tighter. There’s less of a penalty for flowing active income through a corporation as you move down to lower tax brackets. If you’re talking about small business deduction income going through non-eligible dividends, it becomes very minuscule. The tax integration functions really, really well at lower tax brackets and there’s often a bit of a penalty at the top tax brackets.
Another exception here, Nova Scotia and dividends may be more efficient than salary at incomes less than $112,000 here, but they actually have a 0.23% advantage in the highest tax bracket there. You can see within Nova Scotia, if you move through the tax brackets, it can be an advantage in some tax brackets and then a disadvantage in other tax brackets. We really actually mean it when we’re saying to consult your accountant for your specific situation, because it really does actually depend on how much you’re paying yourself and your province.
Now, I do know some accountants will say, “Yeah, I know it’s all just so close enough. Don’t even bother to worry about it. We’re talking little bits here and there.” But if you are talking about a substantial amount, it can make a big difference over time. Now, I’ll just give an example of that for general corporate income. Tax integration between salary versus dividends is huge. For example, in Newfoundland, the cost of flowing income through a corporation as eligible dividends, instead of salary, can be over 7% difference. It can be over 8% in the lowest tax brackets there in Newfoundland. That’s pretty big and substantial. That’s a big difference.
For most provinces, it’s about 2% efficiency, which doesn’t sound a lot. We would get really upset if we were paying a 2% management fee on our investments. Well, we’re paying a 2% management fee to the government on our income. You might want to think about that. Now, there are some exceptions, BC, Northwest Territories, Yukon, they have less than a half percent of inefficiency. It’s so close there that it’s probably not worth worrying about at all.
While I was preparing for this episode, I actually made a tax table calculator that shows tax integration for active corporate income and the difference with provinces and across the different tax brackets, just so people could look and see that on their own if they want to, for their own situation.7 Now of course, you’d want to consult an accountant, but it’s more than just the top tax bracket stuff that you usually see. I’ll put a link to that on the episode page, which will be on moneyscope.ca.
Now, one interesting piece that I don’t think we mentioned in our episode on corporate investment taxation that we did is that the tax integration cost of flowing interest, or foreign dividend investment income worsens as you go, and you look at lower personal tax brackets. We ran through that at the highest personal tax bracket, like everybody else does. But with this calculator, I did it through all the different tax brackets and that cost of flowing it through gets worse as you’re in a lower personal income. Corporation is best actually if you’re in a high-income tax rate for that investment income.
I mentioned that, because a lot of studies that look at corporate investing just look at the top tax bracket and real life may actually be less favorable towards the corporation if you have foreign investments in the mix there. That routine earning and spending can plop yourself into different tax brackets. Now, if your alternative to the corporation is investing via low-income spouse, which we’ll talk about later, that could be part of the tax planning that you do instead, if you’re in some of those lower tax brackets.
[0:43:10] BF: The impact of paying dividends to a lower income spouse, or when drawing a very low income yourself in the corporation can be pretty significant. In some situations, the grossed-up taxable income is what’s used for income tests and benefits. I mentioned earlier that the order of the calculation of the gross-up your full tax blanket and then later the credit, the order matters and the order matters, because one of the reasons it matters is that the grossed-up portion of taxable income is what’s used for calculating your entitlement to income-tested benefits, like the Canada child benefit, or old age security.
Dividends could effectively bump your net taxes, versus benefits disproportionately if those end up getting clawed back. The marginal effective tax rate when you account for benefit clawbacks can be very, very high. Dividends are going to be worse for that than salary, because of the gross-up.
[0:43:59] MS: That gross-up would basically make it for a non-eligible dividend you paying, the clawback would be 15% faster. Then for an eligible dividend, be 38% faster on what is already a pretty aggressive clawback rate.
[0:44:12] BF: You combine the clawback with your actual taxes based on the regular tax brackets and your effective tax rate can be incredibly high if you’re in those brackets, or if you’re at an income level where those benefits matter. That’s one of the other misconceptions generally, about dividend income being more efficient is that the fact that the gross-up can really affect your entitlement to benefits more aggressively than salary would.
On the other side of the ledger, RRSP contributions with their deductions can also reduce taxable income and can reduce that clawback. Making an RRSP contribution to reduce your taxable income, the effective benefit of that, or I guess the opposite, instead of having a huge effective tax rate, you’re saving at a huge effective rate by reducing your taxable income using RRSP contributions. That could tip the scales further toward salary in some situations, because it generates that RRSP room. The effective tax rates in those clawback situations, I can’t emphasize enough, can be just astronomical.
I think the take home message though is that there are differences in tax integration between provinces and across tax brackets. While we can say that generally, salary is overall more efficient from an integration perspective, you do also need to consider your own specific situation. Rules of thumb, like salaries better, or salaries more efficient may not always work out in your specific situation.
We do also need to cover this interesting idea of broken tax integration. We were just talking about integration inefficiencies. Where when you flow all the income through, salary can be a little bit more favourable, generally speaking, than dividends, although there are exceptions. There are some special cases where tax integration is straight up broken. It’s not even an inefficiency. It’s stuff’s not working the way that it was supposed to.
Tax integration works on the assumption that the federal and provincial governments are going to treat the small business deduction the same way. There are a couple of cases where they don’t and that causes breaks in tax integration that can really favour, or penalize corporate owners depending on their specific situation.
Saskatchewan, in that province, the provincial SBD limit is $600,000. The federal, as we mentioned earlier is still $500,000. Saskatchewan decides they want their SBD to be $600,000. Great, but that doesn’t affect the federal SBD for someone living in Saskatchewan. As of July 1st, 2024, income below $500,000 is taxed at 11%. That’s 9% federal and 2% provincial tax at the SBD rate.
Income between $500,000 and $600,000 has a hybrid rate of 17%, where the higher general federal corporate tax rate of 15% is applied, plus the 2% provincial SBD rate. Over $600,000, we’re back to the normal 27%.
There’s this funny transition range that has a different situation. That also creates a break in tax integration. Income above $500,000 and below $600,000, the corporation is paying tax at a lower rate than the national average general corporate tax rate of around 28%. That 28% is why the GRIP calculation is 72% of the original income.
But the GRIP is generated based on the federal tax rate. In that hybrid, or transition range of federal general rate and provincial SBD rate, the corp pays a lower hybrid tax rate on active income. The shareholder gets some eligible dividends through GRIP, because of the federal portion of the tax being paid at the general corporate rate.
The net result is that the personal tax savings from the eligible dividend, from paying eligible dividends is 5% to 7% in that range, compared to salary. This type of beneficial anomaly from broken tax integration was also created in Ontario and New Brunswick when the passive income rules were put in place.
[0:47:51] MS: It caused a big break there as well. It’s really quite interesting. I mean, Ontario and New Brunswick, there was this beneficial anomaly created when the federal government sought to penalize too much passive income in corporations. The intent with that was that for the small business deduction threshold, that it would get reduced for passive incomes over $50,000 a year. We talked about that in episode 10.
But just to review it quickly, the usual $500,000 small business deduction threshold shrinks at a rate of five to one. When the passive income is over $50,000 per year, the active income that gets that favourable rate is reduced at a rate of five to one. Grinds it down really, really quickly.
Now, just to give that an example of some numbers. Let’s say, I have $100,000 of passive income. That’s $50,000 over that $50,000 limit. Due to the passive income rules and the following fiscal year, the SBD threshold is going to shrink by $250,000, because it’s that five to one clip from the $500,000 that it usually would be. Any net active income that’s over $250,000 is going to get taxed at the general corporate tax rate. What was intended with that was a bump of the general corporate tax and income over $250,000 to jump up from 12% to 27%. A big jump right there. That’s 15%, and occurring at a five-to-one clip. Five times 15%, massive income tax jump.
However, with that shrinking SBD also comes the ability to pay out eligible dividends, instead of non-eligible dividends. As we went through, there were some personal tax savings due to the enhanced dividend tax credit. That helps to offset some of that big corporate tax jump by having lower personal taxes as long as you flow that money through the corporation yourself as dividends and use up the GRIP that was generated.
What happened in Ontario and New Brunswick is that the provinces didn’t follow the federal government lead on this passive income tax change to grind down the SBD. What happens is the federal corporate tax rate jumps when the SBD grinds down, but the provincial tax rate stays at that very low SBD rate for that first $500,000 of net income. Now you can potentially have a $500,000 transition zone, where you get this blended tax rate that’s going to be a blend of the federal general rate at the higher amount and the small SBD rate.
I’m just going to give an example with that, too. Let’s say, you have an Ontario corporation that has this $100,000 of passive income last year. It has $400,000 of active income this year. The SBD rate was reduced to that $250,000 that we talked about. That gets taxed at 12.2%. Now the next $150,000 that’s over that gets taxed at this hybrid rate of 18.2%. That’s 15% from the federal rate, plus 3.2% from the Ontario rate. That’s 18.2%. Now if they had an income over $500,000, that income above $500K is going to be taxed at the usual federal and provincial rate of 26.5%. So, closer to that national average.
Now, there is this big window between the SBD level that’s got shrunken down from $500,000 where you get this blended rate. Again, the GRIP is calculated off the federal rate, which is what took that big jump. The corporate income in that hybrid rate zone is 18.2%, but the corporation can dispense eligible dividends as if it had been taxed at that full rate of 26.5%. This is how tax integration is broken in favour of the owner. It was designed around that 26.5%, but the corporation is only paying 18%. Then you get to pay out those eligible dividends, have a lower personal tax rate.
When you add up the blended corporate rate and the lower personal tax rate flowing all that money through is about 2.2% less total tax in the top Ontario tax bracket. When you look at it through lower tax brackets, the break in tax integration actually gets bigger and bigger. It’s more like a 5% advantage when you’re in the lowest tax brackets. If you go through that exercise I just went through in New Brunswick, it’s a massive advantage. It’s like in the 7% to 10% range in New Brunswick.
[0:52:03] BF: Tax code is super complicated. That’s a big issue. But whenever changes are made like this, there’s a pretty significant risk of unintended consequences, which is exactly what we see there.
[0:52:13] MS: I’ve written about this a couple of times in my blog. I think meddling with the tax code is like a Jurassic Park episode. They have this great idea about how they’re going to meddle with the genome and predictably, bad stuff happens. I also wrote about it, this anomaly in particular, and a Doc from New Brunswick piped in that finally, their government was doing something to attract physicians. By having broken tax integration so badly.
We actually did go. We went and checked out Fredericton when we were thinking about where we wanted to move to. We ended up staying on Ontario. We’ve actually used this anomaly a few times now at this point. It can be a good way to flow through eligible dividends to personal money. Now, the important thing with that is if you aren’t flowing the money out of the corporation as eligible dividends, then you have paid more tax upfront due to the loss of the federal SBD. You don’t get that benefit of the broken integration, unless you pay out dividends.
Now, if that’s many years later, then the value of those savings from the GRIP account does erode with inflation because the grip account is priced in nominal dollars. The value that represents with tax savings is going to get smaller and smaller as time goes by. People don’t appreciate that.
Even though tax integration was broken here, favouring corporate owners, it actually still does accomplish this task of incentivizing people to move money out of their corporation. That was actually what the intent of the legislation was – is to move money out of your corporations and not just keep it invested there. But I think, they didn’t mean it for it to be a carrot. They wanted it to be a big stick instead. But instead, we got a carrot.
[0:53:40] BF: Yeah, those changes caused such a big fuss. I remember at first, people thought that they were paying more tax. Then slowly, people realized they’re just losing some tax deferral. Maybe it’s not as big of a deal. Then later, people started to figure out that this break in integration actually makes things potentially more efficient in these certain cases. It was interesting to see people go from panic to maybe not so bad.
[0:54:00] MS: Well, I think their initial proposal was draconian.
[0:54:03] BF: The initial one, yeah.
[0:54:04] MS: That broke tax integration so badly against corporate owners that just wouldn’t stand, I think. Then they came up with this compromise that preserved it mostly.
[0:54:13] BF: The initial proposal, that would have been a disaster.
Quebec is another one that’s probably not so friendly. Goes in the opposite direction of the integration breaks that we’re just talking about. In Quebec, there can be extra criteria to meet depending on the type of business you’re running in order to get the SBD rate. As an example, a professional corporation in Quebec has to have 5,500 hours of employee work per year. That can be no more than 40 hours per week per employee. That translates to about three, or more full-time employees. If they don’t have that, then they don’t get the provincial SBD.
Then to make things more complicated, they do still get the federal small business rate. It’s another case of a province being different from the federal tax system. The tax rate on active income ends up being, again, a hybrid rate between the full general corporate and the full reduction of the SBD rate. That hybrid rate is 9% federal and 11.5% provincial for a total rate of 20.5%. That’s less than the full rate of 26.5%, but it introduces another wrinkle that we’ll talk more about later. The corporation’s ability to dispense lower-taxed eligible dividends is determined off of the federal rate, not the provincial rate.
The Quebec small business owner that doesn’t get the Quebec SBD pays a higher corporate tax rate overall and does not make up for it with a lower personal rate on dividends. In that case, tax integration is broken quite unfavourably for the corporate owner paying themselves dividends in those cases in Quebec.
We’ve covered paying yourself with dividends. The alternative to using dividends to pay money out of a corporation is paying yourself in salary. The corporation is a separate legal entity and it can employ its shareholders, just like it can employ anybody else, just like any business out there. Paying salary is generally favoured by tax integration, as we’ve talked about at this point in time. It has some other potential advantages and disadvantages, depending on how you look at it, so we’re going to dive into that.
[0:56:02] MS: Yeah, we’re going to get into the nuts and bolts of using salary, because there’s actually a lot there. I will say right up front, one of the key limitations of salary is that it must be at a market rate salary. That’s usually not an issue for an active owner. For example, a professional who is a voting shareholder for a professional corporation, they can probably pay them whatever salary they want. It’s going to be considered reasonable. They’re generating the income.
However, it is important when paying a non-arm’s length employee, like a spouse. You cannot pay a higher salary than you would pay someone else to do the job. Still, there’s some low-hanging fruit there that are pretty common, like doing some basic bookkeeping for the corporation, billing, some administrative management.
Some people have asked if they have a spouse that manages their portfolio for them, they could pay them a management fee for the investments that are there. That brings up another important point is that the training and credentials of the spouse are an important factor in determining what’s reasonable.
A spouse with a financial professional designation could be paid at a higher market rate than one without any specific training. A similar example for doctors would be that you could likely pay an RN spouse more for helping around your clinic than one without that qualification.
When we did this for my practice, to find out the market rate, I compared what I pay my wife to billing agent fees. She also does some other administrative tasks. I compared her salary to the pay grid for a unionized admin assistant at the university they work at, and they get paid pretty well. It was pretty easy to find that on the university site.
She also, the other thing to be aware of is when you’re doing that is that if you’re paying your spouse, they may not get extra benefits. In the case when you’re not paying extra benefits, there’s a modifier in lieu of those benefits. In a unionized environment, that can be pretty significant. For us, it was a 30% higher pay rate, because of no benefits. I keep that university contract on file, as well as the job description, just in case I ever need to justify it. I’m pretty careful and diligent about this.
This is also one of these areas that your accountant could probably give you some idea about what’s considered reasonable from their experience with other incorporated clients that are probably in a similar situation to what you’re in.
[0:58:10] BF: Mark, I have an idea. Why don’t you just ask your wife to do the CFA program, so she can manage your investments and you can pay her like you’d pay a portfolio manager?
[0:58:18] MS: Pretty sure I know how that would go down. I think the cost of a better couch in the basement and possibly a divorce would probably outweigh the benefits of any salary bump. She puts up with a lot with me, but I think that’d be crossing the line.
Next thing to talk about, when you’re paying someone as an employee, you have to pay them a payroll, just like you would any other employee. Then this issue of payroll taxes comes up. When you pay a salary, or a bonus, that’s T4 employment income.
That means you must also remit personal income tax deducted as source, just like any other employee would. In this case, the source would be your corporation. People call this payroll taxes, but really, it’s just paying the taxes that are owed already. When someone has a salary, you’re just paying them more frequently, rather than an extra tax.
Now, there is an extra tax. There’s the employer health tax in some provinces, but that’s only for corporations with payrolls that are higher. It’s $500,000 in BC. But for most other provinces, it’s in the one to one and a half million-dollar range of payroll that you might have to pay this extra employer health tax. It won’t affect most professional corporations, but it could impact some other businesses.
For a small operation, though, the easiest way to handle this is to plan your salary for the year when you’re talking with your accountant and you’re deciding what your salary/dividend mix is. Then you can set up automatic payments.
What we do is we set up an automatic payment of our net salary from our corporation to our personal account. So, that’s net of our taxes. At the same time, we would calculate how much tax, EI, if it’s applicable, and CPP, which we all have to pay into to get that calculation, and we set that up as an automatic monthly payment to CRA as well. That way, we don’t forget about it. It just happens automatically. The money moves and it’s very important to not miss deadlines.
If you do miss deadlines, there’s late penalties, which can be pretty significant. There are ways to try to adjust that, but you’re best off avoiding it if you can. Now, if your payroll varies monthly, then you must do it monthly. For most of us, we can probably have something pretty consistent. Those penalties, if you are late, are stiff, because CRA wants its money now and not later. That tighter tax payment timeline compared to quarterly instalments, or annual filing with dividends is one of the disadvantages of salary. You have to pass that tax money on faster.
In contrast, if you do want to do something on short notice, it’s easier to give a dividend on short notice and then sort out the taxes later than it is to adjust your payroll. That would be a consideration for some of those one-off changes.
The other costs that get brought up with payroll taxes aren’t really taxes. Those are employment insurance and CPP. Canada pension plan contributions. Those are actually social benefit contributions. While they’re not taxes, they can behave like taxes in some cases, because not all contributors stand to benefit necessarily the same way. We’ll get some more detail on that one.
[1:01:08] BF: One of the ones I want to talk about is EI employment insurance. It’s often optional for the self-employed and has pros and cons in different situations. Employment insurance isn’t really a tax. It’s a social benefits program. It is insurance, as the name suggests. There’s typically an employer contribution and a matching employee contribution. The main issue with self-employed business owner employees is that they’re non-arm’s length employees, and non-arm’s length employees can’t make claims for termination of employment.
Even unrelated employees could be considered non-arm’s length if they’re not treated the same as other employees or are paid substantially more than market rates. The good news for self-employed, or non-arm’s length employees, EI is an “opt-in” option. It’s not mandatory like it is for regular employees.
Some people still opt in with the intention of taking parental leave, or caregiver leave. It’s funded by EI. I just want to make sure it’s clear that one of the benefits that people often use of EI is if they’re terminated from their employment. You can then collect EI while you’re transitioning to a new job. That specific benefit is not available to self-employed people. Because it’s optional, a lot of people question whether it’s worth it to pay into it at all.
There are other benefits other than the unemployment situation, or the termination of employment situation. That’s parental leave and there are actually quite a few other caregiver leave benefits that can be funded by EI.
The problem, though, is that once you’ve taken an EI claim, you cannot opt out later. It’s an opt-in initially. But once you opt in, if you take a claim, you cannot opt out later. EI parental leave payments count for that purpose. If you start paying into EI with the intention of taking parental leave, and then you take parental leave, you now have to pay in the EI for the rest of your salary taking career as a self-employed person.
It could take multiple parental leaves for the parental benefit that you get from EI to make up for the premiums that you’re going to pay over the course of a career. One of the questions that often comes up is if someone had an EI claim as an employee before they became a self-employed, for example, a resident physician who is being paid a salary by an employer, that situation does not force you into EI later on when you become self-employed. It’s an opt-in when you’re self-employed and then once you take a benefit, you’re stuck.
EI gets written off, in a lot of cases by self-employed people, they’ll just opt out, or won’t opt in by default. I think it’s important to note that self-employed people who opt into EI only pay the employee portion of the EI premium. That means you’re paying about 40% of the cost that an arm’s length employee would pay.
You don’t get the unemployment benefits, like I mentioned, but there are six other types of special benefits available.8 Those include maternity benefits, parental, sickness, family caregiver, and compassionate care benefits. There are all different ways that you can get money out of the EI insurance program.
One thing I want to note here is that when we look at the data, those types of benefits are going to tend to be particularly beneficial for women, who tend to spend more time off work for caring for children, caring for other family members.9 It’s just something to keep in mind. Women tend to lose more of their lifetime earnings due to having and caring for children and other family members than men do. That’s true in Canada and the US.10
The other thing on EI that’s interesting to think about is that you always have the option to switch to paying yourself dividends. If in the future you opted into EI, take in the say, parental leave benefits, and then for whatever reason, you really didn’t want to pay in the EI anymore, you can only switch to dividends. That comes with other trade-offs, but it is always an option.
I think, because the EI is very interesting in the sense that there are potential benefits, but it’s often written off by self-employed people, we’ll cover it in one of our case episodes to walk through a couple of examples, where it may or may not make sense in a given situation.
[1:04:51] MS: It can help in different ways. It’s interesting when we were writing this episode, I had actually written off EI as well. I mean, in retrospect, reconsidering whether that was a great idea or not, because one of the other things that may happen later on in your career is you’re going to end up paying dividends mostly anyways, which we’ll talk about in our compensation episodes.
With the part with the lower premiums, the potential benefits, and then the fact you may switch to dividends at some point anyways really changes the math on this one. We’re going to get into that in a case. It’s going to be cool.
Now, the other thing that causes a lot of consternation is the Canada Pension Plan payments, or CPP. This is deducted from payroll. It’s the CPP contributions.
Some people think of it as a tax, because they’re forced to pay it. In some ways, it looks like a tax. However, according to that logic, I mean, unionized employees can be forced to pay into their pension plan and probably wouldn’t consider that necessarily a tax either. That’s one of those pensions that were probably jealous of. The difference is that this is compulsory, government-mandated contributory pension plan, just like some of those other pension plans.
The fact that it’s related to the government sometimes gives people pause, but it’s actually managed on its own. If you look at it, it’s actually, in fact, a defined benefit pension. It’s indexed to inflation. There’s survivor benefits. There’s disability benefits and a death benefit. This is actually a pretty good pension in terms of the benefits that you’re getting. I would say that it’s important to know that an inflation-indexed pension is one of the few true “risk-free” assets for long-term investors to preserve their buying power and mitigate all the different risks that come over long timeframes.
It’s very hard to find anymore. CPP is one of the few ways that Canadians can actually access this type of asset. It’s the kind of pension that people often get jealous over. I mean, the difference here is that it’s relatively small. It’s government-mandated, which always changes how people think about things sometimes.
[1:06:42] BF: I would say, generally, probably not for good reason that it makes people nervous. I think it is a well-funded and well-run pension. It’s well-regarded around the world in terms of the model that they use to manage the investments. CPP is a huge topic.
It’s important, though, to bring up and I think important to really understand, because it can materially affect the salary versus dividends decision for business owners. I’ve seen many tax advisors, or self-employed people say, “I don’t want to take salary, because I don’t want to pay into CPP”, as if CPP is an additional tax. If you think about it that way as a tax that you’re not going to get any benefit from, then it can make salary look a lot worse than dividends, which I think feeds into that common idea that dividends are better than salary. A big topic. But for now, we just want to leave listeners with a message that CPP is probably not something that you want to avoid paying into, in most cases.
There are some specific situations where it doesn’t make sense to pay into CPP. Generally speaking, it’s actually something that you should want to pay into, because the benefit is very attractive. It’s not a tax. We’re not just going to leave it there permanently and tell you to trust us.
We’ve actually got a whole separate episode solely dedicated to diving into how CPP works for business owners, including the total after-tax cost of contributing, which is a lot lower than people realize, and why it’s beneficial to have this type of asset in your overall retirement mix.
[1:08:03] MS: This episode started out as being an episode and then it blew into us doing different analyses that people hadn’t looked at and into multiple episodes. We’re going to do a whole episode on that when you’ve done some really neat analysis there. There’s all sorts of tax credit nuances that make CPP look an even better deal. It’s going to be a great episode. We will come back to that.
One of the tax credits that I’ll mention now, which is important for when you’re considering the salary versus dividend debate, is the Canada employment tax credit, since we’re talking about all these nuances. This is one of the ways that salary, rather than dividend only compensation strategy helps incorporated business owners. Now, the Canada employment tax credit is small. It’s a 15% tax credit on up to $1,368 of income. It only works out to be about 200 bucks. However, that just further moves things towards favouring salary.
It’s also something that self-employed people who are not incorporated cannot usually access. They’re excluded. If you’re an employee of a corporation, you can use it, even if you own the corporation. I thought that was pretty cool. This was including in the modelling the CPP that you did. We’ll unpack that in that episode. It helps to reduce the cost of contributing to CPP to be less than what we think it is.
Another interesting idea for those that even after they listened to that episode, they’re like, “Oh, I’m never going to contribute to CPP,” you could actually pay $3,500 in salary and not have to make CPP contributions. That’s enough to help you get this employment tax credit. There’s all sorts of little tax ninja moves that you can learn here. I just couldn’t resist giving some of those tidbits, but there’s going to be a whole episode on that.
[1:09:39] BF: I love that stuff. I love the tidbits. I think if we take the employment tax credit example, it doesn’t make CPP less expensive. It sort of does. It’s more like, it makes dividends more expensive. Paying dividends to avoid paying into CPP gets more expensive when you account for stuff like this. It effectively makes CPP cheaper, but it’s happening on both sides. If you compare the two alternatives side by side, CPP is less costly than people tend to think it is, and paying dividends in order to avoid CPP is more costly than people tend to think it is.
[1:10:07] MS: That’s the relevant question.
[1:10:09] BF: Exactly, because that is the alternative. The alternative is you don’t pay into CPP and retain the money in your corporation. How much better or worse is that? We’ll talk about in that episode.
The other thing that’s really important with salary is that it can create other planning benefits. It comes with other planning benefits, financial planning benefits. Having tax-sheltered account room to grow your money and then multiple accounts to plan your draw down in retirement is advantageous. We talked about that in past episodes, diversifying your tax exposures through different account types.
Using salary, paying yourself in salary, instead of dividends, allows for the creation of room in RRSPs and IPPs, individual pension plans. That’s something that you don’t get if you’re only paying yourself in dividends. We talked about this in episode eight, you get 18% of your T4 income as RRSP room each year, up to an annual maximum. Contributions to the RRSP are 100% deductible against personal income. Then salary is deductible to the corporation.
The RRSP offers more tax deferral than retaining earnings in a corporation, since you’re not paying corporate tax, or personal tax upfront. Plus, the invested money in the RRSP account then grows tax-free, which is pretty attractive. Corporate investment income can be pretty tax efficient when you manage the refundable taxes. If you’re not able to recoup those refundable taxes, the corporate tax rate can get pretty high for investments. In either case, there’s less tax drag in an RRSP than there is in even an efficient corporation.
Now, you do eventually pay income tax on the RRSP in retirement as you draw the money out of the RRSP, either as RRSP withdrawals, or when it converts to a riff and you have to start taking withdrawals out of the riff over time. Hopefully, ideally at a lower tax rate than when you contribute it, which results in an additional, what I would call a bonus, an additional benefit, and that’s the difference between the contribution of a withdrawal tax rate.
Now, one potentially important advantage of this type of income compared to using dividends from a corporation is that it’s not grossed up for the purpose of calculating income tested benefits, like OAS and GIS. That’s another. We also mentioned the Canada Child Benefit as well, the CCB. Those clawbacks can be much worse. They happen much more quickly with dividend income than salary due to the gross-ups. That can be a problem that’s at least worth considering. That’s a potentially benefit of salaries is that there’s no gross-up.
[1:12:36] MS: This gets to the point today, yeah, you can look at your taxes one year at a time, but you really need to think about how you’re planning your corporation over your lifetime. Decisions you make now are going to impact what’s going to happen down the road in the future.
Preferably, you’ve thought about that in advance. We’ve talked about RRIFs, but the other option also be an IPP. Either of those actually give you the pension tax credit, which is this 15% tax credit on the first $2,000 a pinch of income each year after the age of 65. Again, there’s another advantage towards edge salary there, even though it’s a few hundred bucks, but just keeps tipping the scales.
I will say also, that after the age of 65, it becomes a little bit less important what you’ve done, because you can pension split, you can dividend split from the corporation. If you do retire earlier than that, having built up a spousal RRSP is another way to help income split. That could help your household plan before the age is 65, but you have to plan that in advance.
Another related option that salary keeps the door open to, as I mentioned, was these IPPs. They accumulate room different from RRSPs. We’re going to talk more about that when we get into pensions in a future episode. Their contribution room depends on having paid salary from your corporation.
There’s an actuarial calculation to determine the contributions that you can make. As you get a bit older, that becomes a way to shelter much more money than you would within RRSP, depending on how that all works out. That’s heavily impacted on how much salary you’ve paid yourself from your corporation, both in the current year, or when you’re starting to contribute to something like an IPP, but also, all the previous years too, because your corporation can buy back those previous years of service based on the salary that’s paid. Not dividends.
Pensions, RRIFs, all those things, credits. They also have some other advantages, like potentially creditor protection, that using a corporation alone to invest may not necessarily provide that to you. There’s lots of ways that these options are favoured.
[1:14:36] BF: To wrap up on this, redirecting some money from the corporation to an RRSP and/or an IPP, if you need salary to live on anyway, can be pretty advantageous. There’s more tax deferral, tax sheltering. There’s no gross-up for determining income-tested benefits, like OAS and GIS. There’s some tax credits specific to salary and potential creditor protection using RRSP and IPP account types that may not exist with a corporation on its own. Then the final point I’d make here about the advantage of taking some salary is that people and institutions understand salary.
This might seem like a funny reason, but it’s a real thing. I’ve seen it happen. Lenders tend to have an easier time understanding salary income, which makes it easier to access financing, like if you want to take out a mortgage. Disability insurance is another one where it’s easier to get disability insurance on salary income. Some insurers will ensure based on corporate income, and likewise, some lenders will ensure based on corporate income, or dividends, if you can show that they’re consistent. In general, insurers and lenders are just happier to see T4 salary income.
[1:15:41] MS: I take that extends to a lot of other things. The average voter understands salary and the benefits that go with it. When there are legislative changes, they’re more likely to target those using dividends, rather than salary. We saw that in COVID. There were payroll subsidies and other rescue measures that were put in place. They were much easier to access if you’d been using a payroll and not just dividends. Initially, it was only payroll for some of them.
We’ve also seen it with the legislative nuances that are already in place, like tax credits, creditor protection. These rules are designed with salary in mind. If you’re thinking about risk for the future and legislation, having paid some salary is probably going to be more protected against that when whatever changes come and having just left everything in a corporation.
Okay, so that’s getting towards some of the other practical planning parts, which are going to bridge us into our next episode.
I did say in the intro to this episode, one of the biggest advantages of a corporation is being able to regulate this cash flow, from your business into your personal hands, like a giant dam. The business income flows into the reservoir. You can decide how to flow it out to salary, or dividends, but you can regulate not only how it flows out. You can regulate the rate at which that money flows out. That regulation of the rate is what we call income smoothing.
Smoothing out that income could be very advantageous. Let’s say, you’re not incorporated in your years of very high income. Much of that will get taxed in very high, or even the highest personal tax bracket. Unfortunately, you don’t make up for that in other years when your income is lower. Tax rates increase dramatically with increasing income, not linearly. Personal income is taxed in the year that it’s received. It can’t be shifted forward and backwards through time, like you can do that with a corporation. It’s like, with the dam analogy, it’s like a river that overflows its banks, and the excess water that overflows those banks is absorbed by the surrounding soil.
In this case, it’s like parched, cracked soil that has this unlimited ability to just permanently absorb money. In droughty years, you can’t get that water back again. It’s a one-way movement into the tax system and then it’s gone.
Now, with a corporation, you can reserve some of that water in your big reservoir. You have excess from the wet years. Instead of having that spill in into the parched dirt, you keep it there. Then you can allow it out to try to irrigate during the dry years. You more efficiently move that money out without overflowing the tax banks of your personal consumption.
Basically, you smooth it out across years using a corporation. It’ll overall keep yourself in lower tax brackets over your lifetime. Not just over the short term, but you want to think about this in the long term. It helps to absorb these fluctuations, not only in chunky income going up and down. But also, big chunky expenses. So, both sides of that equation.
I don’t think I can overemphasize how big the impact of this is in real life. I’ve got this data sheet where I’ve tracked my income and expenses over my entire career. I know we’ve hit some pretty dense material on corporations, but even if you leave your compensation planning completely to your accountant, if you don’t discuss your spending plan and make an income-smoothing plan, you’re going to leave a lot more taxes along the way.
I can tell you, when I started actually paying attention to this, it was only around 2017-ish that I started to pay attention on it. I’m mad I really didn’t pay attention to any of this. When I started paying attention to it, our tax bills dropped pretty dramatically. I’d say, that even my income stayed about the same, and our overall consumption rose. But by understanding this stuff and discussing it with our accountant and making plans, we just cut our tax rates pretty dramatically.
[1:19:26] BF: Super important to think about this stuff in a long-term view. A big ebb and flow of incomes is super common in business. Anyone who’s listening who’s in business and has the corporation is going to understand that there can be booms and there can also be busts. If your business is in a relatively stable industry, like a medical practice, that still can be the case. I’ve seen it with many clients.
Outside of economic cycles, you may also have years of low income for personal reasons. Like, if you take time off due to an illness, or a parental leave, or a sabbatical. So, a corporation can be super useful to smooth out income, regardless of your business type. Because there can be economic, or personal, or non-personal reasons why your income fluctuates. So, it makes it applicable to everyone who has a corporation.
For example, if you make $300,000 one year and no money the next year, with a corporation, you could pay yourself a $150,000 each year. Now, that makes a big difference in the overall taxes paid over those two years, because of the progressive personal tax rate system that we have in Canada. If we take that example in Ontario at 2024 tax rates, if you’re not incorporated, you’d pay about $117,000 in taxes for that high-income year and then no tax for the second year for the no-income year.
If you smooth that income out over two years using a corporation, that $150,000 per year would result in $42,000 of tax each year for a total of $84,000. That is a savings of $33,000 in tax by smoothing the flow of income out over a couple of years.
You can use the same type of planning for big chunky spends. When I mentioned long-term thinking and really having a plan for future spending, it doesn’t really matter if you’re already spending so much that you draw money in top tax bracket every year. This type of planning doesn’t matter. But if you normally consume at a lower level, then planning for big spending in the future can save you a lot on personal taxes by keeping you out of the higher brackets.
[1:21:17] MS: For example, if I were planning a $150,000 luxury item in three years, like a luxury car, or an RV..
[1:21:25] BF: Didn’t you mention Taylor Swift tickets earlier?
[1:21:27] MS: Yeah, that would be a big luxury item, too. It could be a big surprise splurge.
Let’s say you have this big splurge of $150,000 and normally, you spend $80,000 a year. I could plan to take a bit of extra money out of the corporation each year and save towards that purchase.,Instead of taking up the minimum for two years and then having this massive amount come out in year three.
Using those numbers in Ontario to fund $80,000 of consumption year, plus $150,000 splurge could look like this roughly. $111,000 a year salary for two years and then in that third year for the splurge, if you didn’t plan $415,000 to have the required after-tax money to fund your usual living, plus whatever exciting thing that you’re going to buy. In total, you’d pay about $247,000 in tax and CPP to do that.
Now in contrast, if you were to smooth that out over three years, so you’re planning this instead, it would be $203,000 a year of salary to fund your $80,000 a year of consumption, plus have $50,000 a year of after-tax money that you’re putting aside for this upcoming expense. This is hard for people to wrap their heads around, because they’re paying a bit more tax upfront. Over the course of those three years, because you’re planning, your total personal tax bill would only be $219,000. That’s a tax savings of $28,000 with the same overall income, overall consumption, but you save $28,000 by planning it.
This really emphasizes why this concept is important. Along with planning for your big spends, even if your accountant is helping you to plan, they may not give you an income smoothing plan if you don’t discuss your future cash flow needs with them. I mean, for some advice is just the default to just leaving money in the corporation, taking out the minimum each year, but that’s not optimal in this case.
Even if they are savvy enough to help you smooth your income, they can’t do that if you don’t talk to them about what your plans are. You have to understand what the importance of this is and try to plan as much as you can.
If you do have unexpected big spends that you didn’t plan for, that’s going to happen. It happens all the time. It happens to us quite a bit. I mean, don’t despair about that. There are other options that you can use to smooth income on short notice, like a shareholder loan would be a good example.
[1:23:43] BF: I will talk about shareholder loans. I do want to just comment on the idea of communicating your spending plan with your accountant. It’s not that accountants don’t do this, and it’s not that individuals can’t do it on their own. I do think that financial planning, specifically as a discipline, has a big focus on identifying what your goals are, looking at your overall assets, looking at your long-term plan, looking at your cash flow needs, and making that type of plan. I think that there is a distinction there in terms of the type of advice that you would expect to get from a financial planner, versus an accountant.
Now again, people can definitely sit down and map that stuff out on their own, but it is something a good financial planner should focus on. In a lot of cases, the way that I’ve thought about it, the way that I’ve observed it, and again, it’s not to say that accountants never do this, but accountants will tend to look at, “How do I optimize things for this tax year? Maybe the next two tax years.” A financial planner is looking over your lifetime, over the next 30, or more years, like we talked with earlier. Your time horizon doesn’t end at retirement.
A financial planner might be looking at a 60, or 70-year time horizon right through to making your estate efficient. That just brings a very different type of thinking than, how do I optimize for this one tax year?
[1:24:50] MS: That’s why this whole series of podcasts is important. You have to have these conversations with the different members of your team to actually get the value that you’re going to lock from them.
[1:24:59] BF: Then a financial planner, you take the concepts from a financial planner, or maybe the financial planner is talking to your accountant. Then together, there’s the combination of the longer-term thinking, and then how do we optimize that in each specific tax year over time? I think that’s where you start to get really significant benefits.
[1:25:14] MS: It compounds, just like everything else.
[1:25:17] BF: Some of it is much harder to do in the future. We talked about creating RRSP room is something that just doesn’t happen later. Also, if you realize right now you have this large expense, it’s hard to fix. Although, shareholder loans, which I’ll talk about now are one way to fix it.
If a shareholder takes money out of a corporation without designating it as salary or a dividend, that is a shareholder loan. A shareholder loan is super quick and flexible way to take money out of a corporation, but it has to be used very carefully. I’ll talk about why. If you use your corporate bank account to make a personal purchase, that’s a shareholder loan. It’s a non-business personal purchase.
A shareholder can take funds out of a corporation without incurring personal taxes, as long as the loan is repaid within one year from the corporation’s year end. That means, if a corporation has a December 31st [2024] year end and you take funds out in June 2024, the loan has to be repaid by December 31st, 2025.
Now, if a loan is not repaid, it can be a bit ugly. This is why I say this is a tool you’ve got to be careful with. Even when you’ve repaid a loan on time, there is a deemed interest benefit at CRA’s prescribed interest rate, which is 6% at the time of recording.
If a shareholder loan is not repaid on time, though, the borrowed funds are then included in personal income and they cannot be deducted. The amount cannot be deducted from corporate income. There’s double tax on those funds. Now there is a personal deduction available when the loan is eventually repaid. But still, still not ideal.
To avoid that nasty tax situation, you can repay the shareholder loan on time, or you can book the amount as salary, or dividend before the loan becomes taxable, and that makes it a little bit better.
The other way that people can get themselves into trouble with shareholder loans is by trying to do this regularly, instead of paying normal compensation. If there’s a pattern of loans and repayments that CRA would view, then CRA would view the original loan as not being repaid on time, and that triggers the double taxation penalty that I mentioned. It can go right back to the start of the original loan, if it’s a “series of loans”, that’s how CRA would view it.11
The classic scenario for this is someone gives himself a shareholder loan, repays it from a line of credit, or personal money just before it’s due, and then takes the money back out as a shareholder loan the following fiscal year. That’s basically a shareholder loan given and then repeated year to avoid paying tax income, but CRA doesn’t like that.
[1:27:32] MS: Bad idea. There are some ways that you can get money out of the corporation quite efficiently that are excellent ideas, and one of those is to use your capital dividend account. This is another way that you can get it out on relatively short notice. It can’t be immediate, because you do have to do some filing and make some arrangements, but you can get a big chunk of money out potentially without having a big personal income tax bump by using your capital dividend account.
We talked a bit about it before, but your corporation, when it realizes capital gains, the excluded half of that capital gains is not subject to tax, and that’s tracked by one of these notional accounts, so just on paper for taxes called the CDA, or the capital dividend account. Now, if your corporation has a positive balance in that CDA, it can pay out a non-taxable capital dividend, so it’s tax-free. It does require filing a special election, so it can take a few weeks to do that. There’s some accounting fees that go with it.
However, you have a positive balance and a personal cashflow need. Then, this can be a great way to move money out and to meet that. If you don’t have a large positive CDA balance, but you’re sitting on a bunch of capital gains in liquid securities, then harvesting some of those gains to get money into the CDA is another strategy that you can consider using on somewhat short notice.
By harvesting, what I mean is sell the security and then you immediately buy it.12 It’s like the mirror image of tax loss selling, except there’s no “superficial gains rule”. So, you can sell it, realize that capital gain by the identical security immediately without a problem. That’s important, because there’s three implications to doing that in a corporation, even though it can take you literally five minutes on a computer with a discount brokerage to execute the trades, but there are implications from that.
First is you shouldn’t miss much time in the markets if you immediately rebuy it. Maybe a few minutes. But there are still going to be some transaction costs, so there’ll be a trading commission, which hopefully is free, or not much money, but there’s also the bid-ask spread, which is hidden in there. If it’s a liquid security, shouldn’t be very big. It should be a fraction of a fraction of a percent. The second implication is that the included half of the capital gain would be considered to be passive income. That’s taxed in the corporation, and it counts towards those passive income limits that we’ve spent a lot of time talking about, which could be good or bad depending on your province. You can have that impact on the act of income.
Then the third thing to be aware of is that you get that excluded half to the CDA, which then is this big benefit that we’ve potentially got to move it out. The personal tax savings of using that tax-free capital dividend instead of regular income, like salary, or taxable dividends could offset those corporate taxes quite easily. The corporate tax on the capital gain should be quite small and the potential tax savings compared to salary or dividends regularly is quite large.
The math usually works out, but you definitely want to discuss this for your specific situation with your accountant. It’s, again, an example where you can help yourself by being an educated client of bringing it up. There’s a lot of times I know people have needed the money and they’ve talked to their accountant about that who hadn’t brought it up, and they usually pause for a second and go, “Yeah, that’s a great idea. Why don’t we do that?” This is one of the things, knowing it and bringing it up can really help you.
I have actually written about this on The Loonie Doctor blog, and we’ll come back to this idea in other episodes, but it’s definitely worth mentioning repeatedly, because it’s very powerful and it’s not a well-known strategy, and it’s very often overlooked. We’ve used to buy an RV, to bridge finance and move. We bought a hot tub after episode one of the podcast on short notice. We’ve used our capital dividend account for all those things.
[1:31:12] BF: The CDA is a big benefit when used well. Before we leave the topic of the CDA, this came up, because we were talking about planning for a splurge and smoothing income for that, but it’s important to know that even if you’re in steady-state spending, if you have a large enough CDA balance to justify the accounting costs, which could be a few hundred thousand dollars, depending on the accountant, the sooner that you use your CDA, the better. We talked about this earlier with refundable taxes, I think, or GRIP as well, but it’s priced in nominal dollars. The buying power that the CDA represents erodes over time.
Even if you don’t have a big splurge, using your CDA and then reducing some of your regular taxable income can also be worth discussing with your accountant as part of your overall compensation plan. It interacts with all kinds of other stuff, because you might want to be taking salary for other reasons, like gaining RRSP room. You might want to be taking taxable dividends for triggering refundable taxes, so it all has to be balanced together. If you have CDA available, it’s definitely, I would say, generally going to be a good idea to use that to take money out of the corporation to a shareholder tax-free.
We will circle back on this and all those trade-offs and how they interact when we do episodes on optimal compensation and tax planning. But the CDA is a really, really valuable account. I know, because I’ve seen it. I know you have too, Mark. There are people sitting on large CDA balances. In some cases, very large and not realizing that their utility is eroding. The more we flag this idea of, hey, if you have a CDA balance, you should use it, the better.
[1:32:39] MS: I think what people don’t realize, too, is because it’s so valuable, it erodes really, really quickly. Out of all the notable accounts, inflation erodes that buying power very fast.
The last point about CDA for real, I mean it, is that in addition for its important for spending, the CDA is twice as powerful for giving and donating to charities. If you donate appreciated securities from a corporation to a registered charity, and not only does that get rid of the tax liability of that capital gain, which you would have at some point, it’s about 25% tax for a corporation, but also, the full donation amount gives the deduction against income.
This could be pretty cool. Depending on your situation, that could even be a deduction against investment income, which is usually taxed at 50%. You remove a half rate tax liability, can apply it against a full rate tax liability. That’s not it. It actually gets better, too.
The whole capital gain, not just the excluded half, the whole capital gain gets credited to your CDA. It doubles the potential amount that you can move out as a tax recapital dividend. Those three features are sometimes called the triple benefit of donating using a corporation. It’s huge.
If you are charitably inclined, then this would be a way to not only give to charity, but either give more to charity, or give some to charity and move money out to yourself more tax efficiently.
The final point I’d make, which just came up recently, is it’s worth mentioning that the new changes to the alternative minimum tax rules, which applied to individuals and actually have some nasty wrinkles in there for really high-income individuals that are donating personally to charity. But it doesn’t apply to corporations. That’s yet another reason why donating appreciate stock via corporation is probably the best way to do it.
[1:34:25] BF: The appreciated stock donation from a corporation, I would say, is generally under appreciated.
The final concept we want to introduce in this episode about paying yourself from a corporation is income splitting. We touched on the concept of income splitting when we talked about spousal RRSPs in episode eight. Again, in this episode, and we talked about the attribution rules and taxable accounts in episode nine. We’ll come back to some of the specific strategies in a more comprehensive way as we do our optimal compensation and tax planning episodes.
Using a corporation is one of the other ways to potentially split income, share the income tax burden across multiple people in a household. The idea behind income splitting is you want to even out the taxable income between spouses, or common law partners, or potentially other family members. In Canada, income is taxed individually. Two households with the same household income and have radically different tax burdens, depending on how that income is distributed across people in the household.
For example, we’ll take an Ontario household with $300,000 of income all earned by one partner. They’re going to pay around $114,000 in tax. They’ve got a $186,000 of after-tax income to spend. If the same household income were split evenly between two partners, the tax bill is a much smaller $83,000. That is a $31,000 difference in household buying power for the same household income, the same pre-tax household income. That’s just achieved by splitting income between two partners. Pretty attractive if you can do it.
There are lots of ways that the government tries to avoid having household split income. But with a corporation, there are a couple of ways that it can be done. The first one that’s available to all business owners, whether they’re incorporated or not, is to hire and pay a spouse, or another family member a market rate salary for work that they do for the business. As we mentioned earlier, it has to be legitimate work and it has to be paid at a rate that you would pay a third party.
Mark, you talked through how you’ve justified the amount that you pay your wife, which I think is really important for people to understand. You can’t just pick a number. If you have a business where you both really contribute materially, it makes income splitting with salary super easy. We’ve seen this with dual physician households, becomes pretty easy to split income in that case, which should be obvious, I guess.
Now, this has the benefit of splitting income, plus all the advantages of salary that we mentioned earlier. The main limitation on salary for income splitting, again, is that it has to be market rate. Unless, you’re going to go and tell your wife to do the CFA program, which I agree, Mark. I would not do that either. It ends up limiting many professionals with a lower income spouse to paying salary for some basic admin work that you could justify as being done without any need for special certifications, or knowledge.
[1:37:08] MS: Before we leave that topic, I would say, there are some advantages to having someone who has skin in the game, double-checking your building and your books. In our medical practice, we routinely bill probably about 10% more than some of my peers that I’ve discussed this with. I think it’s largely because we don’t miss much. My wife’s pretty tenacious about it. She handles it. She’s tenacious to me about it, usually.
The reason why this comes up is as physicians, we often have multiple ways to build for doing exactly the same thing. But the higher paying route usually requires better documentation and information collection, which you should be doing anyways. But there’s that extra layer, which people just don’t bother. It’s good to have that accountability from someone to make sure that you’re doing it.
Then one other practical issue that comes up with hiring a spouse is the payroll, which we’ve talked about. You must actually put them on your payroll and pay them along with CPP and the other remittances, just like any other employee. If your spouse works outside the corporation, that could get into one little wrinkle in that there is a potential for a little bit more employer CPP paid than otherwise would be the case.
You’d be paying some from your corp. Some CPP would be paid from whoever the other employer was. That happens, because individuals get credited for excess CPP payments, but employers do not. There is a potential there, if you have a employee spouse who also works outside of the corporation for someone else that you might have a little bit more of a corporate expense. Although, I think a lot of the benefits still probably outweigh that issue. It does in our case. We actually have pretty good income.
The other thing that gets people in trouble is if you want to try to treat them as a non-employee vendor, people try to do that, because they just don’t want to put them on the payroll. They don’t want to worry about any of the hassle that goes with that. They don’t want to have to pay into CPP and have these issues.
CRA is likely to take offense to that. This is one of the ways that people get themselves in trouble. They’re not going to consider them to be an independent vendor, unless they’re providing either a variety of services, and lots of service to other companies just than yours.13 If the only people that they provide service to is your corporation and not much to anybody else, it’s probably going to be considered to be an employee relationship, and they want to get those payroll remittances.
[1:39:20] BF: That’s income splitting with salary. The other way that a business can income split is using dividends. Now, this one is only available to a corporation. Income splitting with salary can be done without a corporation.
As I mentioned earlier, the family member that you want to dividend split with has to be a shareholder of the corporation. You have to have a corporation in place. The family member receiving dividend income has to be a shareholder. You have to be a shareholder to receive a dividend from a corporation.
For professional corporations, that would usually be as a non-voting shareholder. When the corporation is formed, each family member gets their own class of shares in the company. That way, your corporation can declare a different dividend amount for each shareholder separately to facilitate income splitting. That is the power of dividends.
The amount of the dividend does not have to correlate to anything. Unlike a salary, it doesn’t have to be a market rate. There is no market rate. It’s a dividend. You have a spouse who does some admin work, and that’s worth $20,000 a year. If you were to hire someone at a market rate, you can only pay them $20,000 in salary, but your corporation could give them $100,000, or $200,000 dividend if they wanted to.
The advantage of that, enabling you to perfectly income split using dividends is pretty obvious. It’s so obvious, in fact, that the federal government targeted that type of income splitting with a special tax called tax on split income, or TOSI, the TOSI rules. Those rules punish dividends given to inactive non-voting shareholders by taxing them at the highest personal rates. Theoretically, you could use dividends to income split infinitely, but that theory doesn’t work out because of the TOSI rules.
[1:40:52] MS: Not anymore. Those TOSI rules killed dividend splitting as a strategy for many, many people. However, it is important to note that there are still some important exceptions.14 If exempt, and that’s the language that you use, if exempt, then dividends can be given in any amount and taxed at the usual personal rates.
Now, like most legislation, it’s pretty complicated, and they also used it to specifically target certain groups, which is why it’s so complicated, and they didn’t want to catch up others. The intended target for this was incorporated professionals.
For example, businesses that derive less than 90% of their income from services, and carry an inventory that they sell separate from their services may be exempt from TOSI. That exemption can even fluctuate on a yearly basis.
CRA gives the example of a plumber that provides services, but also sells retail parts. In years when over 10% of the gross income is from selling parts, they can income split the dividends. In other years, when over 90% of the gross income comes from unclogging pipes and toilets and all that stuff, they can’t income split. Services get them into trouble. There could be good years, or crappy years for the plumber to income split. Maybe it’s the other way around.
[1:42:07] BF: It’s definitely complicated. There are more than some plumber cracks in the TOSI rules.
Even though the non-services business exemption is not going to be most professional corporations, there are a couple of common exemptions that may apply. One is if the corporation’s active shareholders over the age of 65, the corporation owners can split income and retirement as similar to how pensioners have that option. That was specifically put in place for that reason, because people with corporations were saying, “You’re blowing up our retirement plan. Why do people who have pensions get to do this when we don’t?” It was allowed. I remember when all that happened.
The other big exemption is if the shareholder spouse plays an active role in the business. The CRA has defined an active role in the business with a bright line test of 20 hours per week of work for the corporation, during the times that it is in operation. The time that it’s in operation is important for companies with a seasonal business, like a landscaping company that takes the winters off, or in the literature, they give the example of a farmer.
[1:43:05] MS: I’m honestly not sure how CRA would interpret businesses that choose to open and close for small blocks of time, like a seasonal business is one thing. I know that where I grew up, many businesses electively shut down during hunting season. The rules are fairly new, and there’s some grey zones that are in there that haven’t been extensively tested yet. I mean, you definitely want to have the time sheet and payroll evidence of employment to show that you exceed the bar. That’s what CRA talks about.
There are some other important nuances there, too. One is that 20-hour per week rule allows for exemption of dividends issued in the same year. That could be important for newer businesses. If you’ve just started up and you meet that rule and it’s your first year, you could meet the threshold.
It could also happen for businesses that have sporadic spouse employee involvement. Some years they work a lot, some years they don’t. It becomes important, because what happens is that you become exempt in perpetuity, once there’s a total of five years of meeting that bright line 20-hour per week test. That’s five years in total, not necessarily continuously sequential.
We just touched on a couple of the TOSI rules. The TOSI rules are very complex, and the specific facts to each situation is really important. It’s definitely one of those areas to get professional tax advice from a CPA who’s well versed in the TOSI rules, before you’re considering some income splitting strategy.
The other thing that is important to be aware of too, is there’s always the issue of the general anti-avoidance rule, which is the big, nasty tiger that CRA keeps chained in its closet to threaten people with.
If you have a strategy that is actually within the rules of TOSI, but they decide that it’s been put in place just for the purpose of income splitting, then they have the threat of unleashing the GAAR tiger, which comes with all sorts of penalties.
[1:44:52] BF: The GAAR just got strengthened in terms of when it can apply, like the new GAAR rules that were just put in place are pretty intimidating. It’s a scary tiger. It really is. Definitely worth being aware of.
I think we got into all the nooks and crannies of different ways that you can compensate yourself from your business. In the next episodes, we’re going to talk about optimizing that, which is a whole other interesting thing to think about. For now, let’s go to our post-op debrief for a recap.
In this episode, we covered some of the nuts and bolts about how to pay yourself using a corporation. A corporation is a powerful tool to smooth out your business cash flow into your personal hands. That helps to decrease the amount lost to Canada’s progressive personal tax system.
[1:45:33] MS: That income smoothing works well in the short term. You can smooth out high-income and low-income years, if your business income fluctuates due to market forces, or personal circumstances. It also works on the consumption side as well. With some planning, you can smooth how you take personal income from the corporation for upcoming big chunky spends. Importantly, that requires you to think ahead and to communicate with your accountant and your financial planners.
[1:45:59] BF: Yeah, definitely. If you get caught unprepared, there could be some shorter notice options, like using a shareholder loan, or a capital gains harvest to get money out. Neither is a substitute for an emergency buffer, like a line of credit, or some savings, because they do require some discussion and planning to execute properly.
[1:46:15] MS: In addition to that short term, regaining cash flow through a corporation can help smooth your income and keep you in lower tax brackets over your lifetime as well. Effectively shifting income and deferring taxes on that from your high earning years to retirement where your income may be lower. That underpins the notion of corporate tax deferred investing that we discussed in episode nine. It’s going to be peppered throughout the future episodes on tax and estate planning.
[1:46:41] BF: In addition to income smoothing, a corporation can help to lower a household’s tax bill through income splitting. That could be using some salary, a strategy available to any business, including a non-incorporated one, or using dividends, which is something that’s only available to an incorporated business. There are rules to prevent too much dividend splitting, called the TOSI rules. The main opportunities for shareholders playing an active role in the business, or when the act of voting shareholder is over 65, in those cases, dividend splitting will be allowed.
[1:47:13] MS: Yeah. We also covered the practical implications of using salary and dividends, the two main ways to pay yourself from a corporation. Salary is generally favoured by tax integration, has the advantage of creating tax-sheltered RRSP, or IPP room, and the advantages that come from being something that most of the voting population gets. There’s implications to that.
[1:47:35] BF: There are also some tax credits and other perks that come with salary. With salary, you have to pay into CPP. That’s often used as a reason to not pay salary by those pushing a dividend-only income strategy. We feel CPP is actually a good deal for anyone who could use a defined benefit pension plan that is indexed to inflation with survivor benefits and a death benefit, which I think is most people, unless they have another pension like that, which I don’t think many Canadians do.
[1:48:03] MS: No, despite all the advantages of salary, using some dividends will be important for most corporate owners to keep their corporate investment income growing tax efficiently by releasing the refundable taxes, like the RDTOH that we’ve talked about previously.
Now, in our next episodes, we are going to dig deeper into the salary versus dividend debate to explore how to optimally compensate yourself with the right mix. It’s not a fixed answer. How that mix changes is going to change as your corporation grows and how the strategy you use will change depending on your province, your corporate investments, and whether you can dividend split or not. There’s a bunch of variables in there that can change the best way to pay yourself.
[1:48:44] BF: That’s the end of our episode on compensating yourself as an incorporated professional. We said at the beginning this was an ambitious episode, so we thank everyone who stuck with us till the end.
