A common tax strategy for owner-managers is to pay themselves salary to reduce their corporation’s income to the $500,000 level eligible for the small business deduction (low corporate tax rate). Also, owner-managers may inquire whether the corporation should pay them a salary in order to give themselves the maximum RRSP contribution ($23,820 for 2013, which requires a salary of at least $132,333). The strategies of "bonusing" income down to the small business deduction level, and providing enough salary to maximize RRSP deductions have been common planning techniques for many years. However, decreasing corporate tax rates (including the tax rates for business income over $500,000) now make these strategies less attractive.
If the owner-manager does not require a salary of $132,333 to fund personal living needs, or if a year-end bonus is not required to clear draws taken out by the owner during the year, the owner should consider retaining the profit and having it taxed within the company. With corporate tax rates in most provinces ranging from 11% - 14% for income up to $500,000 and 25% - 29% or so on the excess, a substantial tax deferral can be realized by retaining profits and accumulating corporate wealth.
If active business income is earned in a corporation and later paid out as a dividend, the combined tax rate is more or less the same total tax rate as receiving the income directly as a salary or bonus. As a result, deferring income through a corporation is now often the preferred option. Deferring the payment can eliminate personal tax on salary of, say, 46% (depending on the province) in exchange for corporate tax of, say, 26%. The ability to retain this extra 20% of income for reinvestment in the business or in passive investments provides a compelling argument to stray from the old rule of thumb of "bonusing out" income. Note also that if the funds are not paid out until years later when the owner has retired, the ultimate total tax rate could be much lower.
Consider the example of paying a salary of $132,333 to maximize the RRSP contribution, versus paying a salary of only $82,333. The $50,000 differential increases RRSP room by $9,000; however this leaves $41,000 taxable at personal rates. The tax on this amount would be in the range of $15,000 - $19,000, depending on the province of residence. This leaves the shareholder with only $31,000 - $35,000 or so for re-investment in aggregate. Contrast this with after tax funds of $43,000 ($50,000 less corporate tax) or so available within the company. The difference is $8,000 - $12,000 more to invest. If payroll taxes would apply to the salary (such as in Manitoba and Ontario) the difference will be even greater.
When considering this strategy, it is important to consider the ability for creditors to access the funds or the effect the funds may have on eligibility for the capital gains exemption.
The benefit of this strategy is in the use of the excess funds from business (this strategy does not apply to passive income) in the corporation to pay down debt or invest. Once the $43,000 mentioned above is distributed to the owner-manager, the tax on the resulting dividend will eliminate the excess funds.
Owner-managers should consider this strategy as an effective way to accumulate capital for retirement, as opposed to maximizing their RRSPs or bonusing out surplus funds.
Your TSG representative would be happy to discuss this concept with you.
TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.