The way a bonus is paid has a significant effect on corporate and personal after-tax income.
You are an owner-manager and you’ve just had a really good year. Profits are up significantly and you want to reward your employee shareholders with a bonus. But how? Salary or dividends? The answer to this age-old question is not as simple as it seems. It is even possible to receive remuneration that is a combination of salary and dividends. However, because every company and its shareholders have different needs, a “one size fits all” approach to remuneration is not prudent.
Salary and dividends differ with respect to taxation. A dividend is a per-share payout of retained earnings and is therefore not an expense and thus does not reduce pre-tax income. A salary bonus differs from a dividend in that it is an expense and thus reduces pre-tax income. Corporations, trusts, charities and a wide variety of other entities can also receive dividends.
Different Tax Effects
Distributing a salary bonus effectively reduces pre-tax income by the amount paid. Thus, if a company pays out 100% of pre-tax earnings in the form of a salary bonus, the corporation may not be subject to income tax expense. On the other hand, if a company wishes to distribute the same dollar amount of earnings by declaring a dividend, the company must first pay corporate income tax. Assuming after-tax earnings of $100,000 and a tax rate of 15.5%, the cash outlay would be $118,343 (i.e., the distribution of the $100,000 of earnings in the form of a dividend bonus plus the $18,343 in income tax on those earnings in order to net $100,000 for the dividend payment).
Dividends are often cited as the best means of providing remuneration to the owner-manager since they do not attract as much personal income tax as salary. For example, a salary of $100,000 for a single individual would create a combined federal and provincial tax of $26,466 (Ontario), whereas an eligible dividend of $100,000 from an owner-managed business would generate a personal tax of $9,802; personal tax from an other than eligible dividend would be $16,693.
At first blush, an owner may be tempted to simply pay out all profits by dividend because of the significant personal tax savings. However, since dividends are paid from after-tax earnings, the combined tax in the case of an eligible dividend would amount to $28,145 ($18,343 + $9,802) and in the case of an other than eligible dividend the combined tax would be $35,036 ($18,343 + $16,693). Certainly there are other factors that come into play both on a corporate and personal level, but the example establishes that one should carefully consider the approach to be taken.
There are additional considerations that must be factored into the decision as to whether to pay dividends or salary.
- Because dividends are not earned income, they cannot be used to create any RRSP contribution room.
- Because dividends are not earned income, they do not create any requirement for a contribution to the Canada Pension Plan by either the owner-manager or the employee.
- Financial institutions often lend on the basis of earned income believing that salary is the only way to judge an individual’s ability to pay. Attitudes in this area are certainly changing, but income based on corporate dividends may impact your ability to obtain personal mortgages or lines of credit.
- If the employee is unable to work because of an accident or some other event, a wage replacement amount may be difficult to calculate because dividends are not earned income.
- Income splitting that is possible by paying salary to family members employed in the business will be hampered if the family members are not shareholders since dividends are paid to shareholders on a pro rata basis.
- Insurance companies may not be willing to support benefit or disability programs if dividends paid to an organization’s owner cannot be included in their definition of earned income.
- Receipt of dividends instead of salary may nullify other personal income tax deductions such as child care expense.
- Various provincial bodies may include dividends when calculating the employer’s Workplace Safety and Insurance Board (WSIB) or Employer Health Tax liability.
An employee can receive three types of dividends.
Three Types of Dividends
A business must be aware that there are three types of dividends an employee can receive from your corporation:
- “eligible” dividend: (i.e., subject to a dividend gross-up of 38% and a federal dividend tax credit equal to 20.73% of the cash dividend) — as noted above, eligible dividends provide a more beneficial tax rate
- regular dividend: (or an other than eligible dividend) subject to an 18% dividend gross-up and a federal dividend tax credit equal to 13% of the cash dividend — provinces may have their own dividend tax credit rates (Check the rate in your province.)
- capital dividend: (capital dividends are received tax free) — this dividend is paid from the company’s capital dividend account, which includes the non-taxable portion of capital gains, life insurance proceeds, and capital dividends received from other corporations
Eligible dividends cannot exceed the balance in the General Rate Income Pool (GRIP). Excess payments from the GRIP can result in penalties.
Talk to Your CPA
Given the complexity of the decision as to whether salary, dividends or a mix of both is the best way to proceed, astute owners should meet with their CPA to discuss corporate and personal needs before a decision is made.
Your CPA understands the share structure of your company, the company’s viability, and the overall remuneration needs of the shareholders. This insight, plus knowledge of the tax regulations and the tax software that can be used to simulate various scenarios, enables your CPA to assist you in making the right decisions as to the appropriate mix of salary or dividends.
The preceding article is reprinted from the June 2015 newsletter Business Matters with the permission of the Canadian Institute of Chartered Accountants. Business Matters is a bi-monthly newsletter, the full version of which can be obtained on request.
This post deals with a number of complex issues in a concise manner; it is recommended that accounting, legal or other appropriate professional advice should be sought before acting upon any of the information contained therein.
Although every reasonable effort has been made to ensure the accuracy of the information contained in this letter, no individual or organization involved in either the preparation or distribution of this letter accepts any contractual, tortious, or any other form of liability for its contents or for any consequences arising from its use.