Owner managers are in the unique position to be in control of the amount and type of compensation that they receive annually.
If planned correctly the compensation for the owner manager and their family members who work in the business can be executed In such a way that the overall tax burden of the family is minimized.
The family members who share ownership in the family corporation have the choice in the type of compensation that they are able to receive; salaries/wages and/or dividends. Salaries/wages can only be received by those individuals who actually work in the corporation. Dividends can be declared and received by those individuals that hold shares (representing an ownership interest) in the corporation.
Salaries/wages are income to the individual who receives the payment and a deduction for the corporation in the determination of the corporation’s income taxes payable (included in the computation of the corporation’s taxable income). Hence, the individual who receives the salary/wage is taxed on the gross amount received, while the corporation is able to deduct the salary/wage as an expense when calculating corporate income taxes payable.
On the other hand, dividends paid are not an expense that is deductible in the calculation of a corporation’s taxable income; dividends paid to owners are paid from after tax dollars. Hence, the corporation will pay income tax on the dividends paid to owners. As a result of the corporation paying income taxes at the corporate income tax rate, individuals are given a tax credit on dividends received (dividend tax credit) resulting in a more favourable taxation rate for the individual receiving the dividend than the individual receiving salaries/wages. The dividend tax credit is dependent on the corporate income tax rate paid (e.g. Canadian-controlled private corporations are taxed at 15.5% up to $500,000 of taxable income in Ontario).
Below you will find the advantages of paying salaries/wages and dividends. The advantages of paying salaries/wages are the disadvantages of paying dividends and visa versa.
Advantages of Paying Salaries/Wages
Tax deductible to the corporation;
Opens up the option for individuals to contribute to RRSPs (individuals under the age of 71);
Individuals pay into the Canada Pension Plan;
All personal income tax deductions are available (e.g. child care expenses).
Advantages of Paying Dividends
Individuals are taxed at a lower rate than salaries/wages;
The corporate process is simple, declare a dividend and issue a cheque.
So what compensation arrangement is the best to implement for owner managers and their family members?
The answer is it depends.
The answer differs depending on the facts of the given situation:
Each owner manager and their family members personal financial circumstances;
The Retained Earnings or Deficit of the corporation;
The taxable income of the corporation;
The available cash of the corporation;
Cash flow needs of the family members; and
RRSP room of the family members.
In addition, a corporation cannot pay a dividend to it’s owners that will put the Retained Earnings of the corporation in a Deficit position, or increase the current deficit of the corporation.
In practice, a combination of the payment of salaries/wages and dividends will lead to the goal of lowering overall taxation.
It is advisable to seek professional advice to understand the tax laws that impact your particular situation, and to guide you through the complexities of Canadian Income taxes.
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