Most of Canada’s incorporated small business owners will end up with more money in their pockets by forgoing the traditional year-end bonus in favour of paying themselves dividends from 2011 business income, finds a new report from CIBC’s tax and estate planning expert, Jamie Golombek.
The report argues against the long-held axiom that Canadian small business owners are better off paying themselves a bonus to reduce their business income so that it is all taxed at the preferred lower small business tax rates.
The report takes a renewed look at the theory of integration, which examines both current corporate income tax rates, as well as the ever-changing personal tax rates on dividends. Golombek found that in many cases, a dividends-only strategy may beat the traditional year-end bonus as the preferred method of remuneration for incorporated small business owners in 2011, provided that the payout is not needed in the near term for consumption by the business owner.
“In most cases, in most provinces, it makes sense to have corporate income, whether eligible for the small business deduction or not, and which is not needed to meet short-term spending needs, taxed inside the corporation rather than paid out as a bonus,” says Golombek.
The Canadian income tax system is designed in such a way that an individual should be indifferent between earning income personally or through a private corporation. In other words, the theory of integration implies that an individual should pay the same amount of total tax on income whether earned personally or earned through a corporation, taxed at the corporate level and then paid out as a dividend to be taxed in the shareholder’s hands.
“The reality is, however, that with varying provincial corporate and personal tax rates, perfect integration is rarely achieved,” notes Golombek. “In particular, the actual tax rates in all provinces are quite different than the tax rates upon which the theory of integration is based. The absence of perfect integration means that in most provinces, an absolute tax savings can be realized by having income that is eligible for the small business deduction (“SBD income”) taxed inside the corporation at the small business tax rate and then paid out as a dividend, rather than having the corporation pay a tax-deductible salary or bonus to be taxed in the hands of the individual.”
In every province other than Quebec and Prince Edward Island, there is “over-integration”. The sum of the corporate small business tax and the personal tax paid by the shareholder on SBD income and paid out as dividends is less than the tax otherwise payable if the corporate income was paid out as a salary and taxed at full marginal tax rates personally. The tax savings in the eight provinces where there is a tax rate advantage ranges from a negligible 0.6 % in Manitoba to a high of 3.9 % in Nova Scotia.
The report goes on to draw two additional conclusions. The first is that an even greater benefit can be achieved by reinvesting SBD income within the company, allowing for a significant tax deferral, although the business owner must ultimately pay tax when dividends are distributed.
This same theory applies to Active Business Income (ABI) that is not eligible for the small business deduction. It may be advisable for small businesses to have ABI taxed within the corporation and then retain the funds for reinvestment purposes, thereby capturing a valuable tax deferral advantage. Again taxes must be paid upon future dividend distributions. Both of the above conclusions are dependent upon the long-term assumed rate of return and taxation at the highest personal marginal tax rate. As well, it further assumes the owner is able to reinvest the funds and does not require them to support current lifestyle needs.
More details, including examples are available in the report, Bye-bye Bonus! Why small business owners should favour dividends over a bonus.