Jim asked:

I started my business as a sole proprietorship but I am interested in finding out more about incorporation. Specifically, when taking a salary from the business or taking it as dividends, which receives preferential tax treatment? Does the lower tax rate of corporations make it more beneficial to have the company pay the lower rate and my salary be taxed higher?

Lorn Kutner answered:

Editor's Note: Lorn has answered the two specific questions you have asked; however, as the decision to incorporate in not a simple one and a number of issues beyond the two discussed below need to be considered when making a decision, it is advisable to get expert advice specific to your circumstances before proceeding.

1. When taking a salary from the business or taking it as dividends which receives preferential tax treatment?

Dividends are a distribution of a company's profit to its shareholder(s) and as such the dividend is not tax deductible to the corporation.A salary, on the other hand, is deductible to the corporation. Generally, all expenses (including salaries) must be reasonable in order for the company to deduct it for tax purposes. However, the administrative practice of Canada Customs and Revenue Agency ("Revenue Canada") is not to question the quantum of the salary, regardless of how large it might be, if the salary is paid to the owner/manager.

Salary is taxable to the recipient as employment income and simply is added onto the employee's (owner's) income and subjected to tax based on the marginal tax rates. Dividends received are grossed-up by one-quarter and are eligible for a dividend tax credit worth approximately the same amount. Subject to my comments in #2 below,the end result is that if the company earns business income, pays tax and then pays its after-tax profits as a dividend to the shareholder, the combined corporate and personal tax should be about the same as if the shareholder earned the business income personally. This is referred to as integration in our tax system.

Careful analysis is required when deciding on the appropriate salary/dividend mix. The decision depends on the individual's income level, the corporation's income level, the cash flow needs, whether the shareholder needs earned income for RRSP or childcare purposes, etc.

 
2. Does the lower tax rate of corporations make it more beneficial to have the company pay the lower rate and my salary to be taxed higher?

The combined federal and Ontario tax rate for Canadian controlled private corporations is about 20% on the first $200,000 of active business income. The combined rate increases to about 36.5% on active business income between $200,000 and $300,000 and then tops out at about 42-43% on active business income in excess of $300,000.

Double taxation can occur if more than $200,000 of taxable income from an active business is left in the company.

As a result, the best strategy in many instances is to pay enough salary/bonus to reduce the company's taxable income to $200,000. This maximizes the amount of corporate income that is taxed at the lowest small business tax rate. By leaving $200,000 of corporate taxable income to be taxed at the low rate, a maximum tax deferral of about 27% (difference between the top personal tax rate of about 47% and the 20% low corporate rate) is achieved. Once the after-corporate tax profits are paid out as a dividend,then integration "equalizes" the tax. The longer the after-corporate taxes can be left in the company, the longer the tax deferral.

About the author

Lorn Kutner MBA, C.A., is a tax partner and heads up the tax department at the Toronto-based accounting and consulting firm of Mintz & Partners. He has practiced exclusively in the income tax field since 1981; estate planning, tax planning for high net-worth individuals and corporate tax structuring are among his specialties. Lorn can be reached at 416-644-4328 or at lorn_kutner@mintzca.com.

 
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