I have taken countless exams over the course of many years of study. Frequently, they use multiple-choice questions. Yet, I’ve never seen the option, “It Depends”—which is often the most accurate response in financial planning.
Take the issue of how to draw income from an incorporated small business. Owners of incorporated small businesses wear two hats: shareholder and employee. As shareholders, they are entitled to dividends, and, as employees, they are entitled to a salary. The dollars are the same, but the tax treatment is very different.
Here are some issues to consider and discuss with your financial planner and/or accountant.
The Canada Pension Plan (CPP)
CPP premiums are made through payroll deductions. Owners of incorporated small business must pay both the employee’s and employer’s share. With premium levels increasing, many business owners are looking for a way to avoid this cost.
Salary levels determine the amount of the CPP premium, so many small business owners opt instead to pay themselves dividends. This way, they bypass the CPP premiums which amounts to a saving of 10.2% up to the contribution limits.
While you may save in the short term, keep in mind that, using your own savings to replace the government pension requires personal savings of at least $250,000, based on a conservative annual investment return.
Also, saving requires personal discipline. The CPP premiums is actually a forced-savings strategy that offers you a defined-benefit, inflation-adjusted pension—and, that’s worth its weight in gold. To optimize your CPP benefits, aim for a minimum salary of $57,400 (2019), with the balance of your compensation paid in the form of dividends.
Corporate tax rates are lower than personal tax rates which is why many corporation owners choose to invest within their corporation. However, research has shown that salary or dividends paid to the owner and taxed once at a higher rate can result in lower taxation than leaving money in the corporation to be taxed at a lower rate, every year.
To optimize your RRSP contribution room, the salary component should be $147,222 (2019, and excluding any room that has been carried forward from the past). I often recommend that clients work with their accountants to keep their taxable income to a rate that is comfortable for them. For example, the 43.40% personal income tax rate begins at income above $95,259 for an individual in Manitoba. Total income of $140,000 could then be structured as: $95,258 in salary plus a direct contribution of $26,500 to the taxpayer’s RRSP and $18,242 in dividends. This strategy could save between $11,000 – $13,000 in taxes depending on the nature of the dividends paid.
Individual Pension Plans
There comes a point where no amount of salary/dividend mix will help you to lower your personal tax rate. Unfortunately, money left in your corporation can be vulnerable to creditors and is limited as a result of the newly-implemented rules on passive investment income. This is the point at which an individual pension plan (IPP) becomes an option.
An IPP is designed to generate retirement income based on a formula not related to investment returns. What makes IPPs (and other defined-benefit pensions) so attractive is that any shortfall in the capital required to generate the pension is the responsibility of the employer. This makes them too pricey for large employers to offer but can be seen as an advantage for incorporated small business owners. The IPP allows you to invest in a manner that is suitable for your risk tolerance and add to the plan if the returns don’t satisfy a triennial actuarial assessment of the amount of capital required to fund the projected pension. The contributions are not restricted to the amount of RRSP contribution limits and are tax-deductible to the corporation, so the strategy satisfies two goals: tax efficiency and retirement planning.
Are any of these strategies suitable for you? It depends! Consult with your financial planner or accountant to decide.