The expert
Wilmot George Jr., CFP, TEP, CHS, director of tax and estate planning at Mackenzie Investments, Toronto
Client profile
Roshni Mehta, 29, owns a driving range and mini-putt facility in Brantford, Ont. Three years ago, she added a high-tech indoor swing analysis and club fitting centre to attract golfers during the winter. The added profit has pushed her into the highest tax bracket.
She wants to pull an additional $10,000 per year from her business to fund a lifestyle upgrade, but doesn’t know how to avoid a tax hit. Should she take dividends in lieu of salary or bonus? She read about Budget 2013’s changes to the small business dividend tax credit and is wondering how they’ll affect her.
In 2013, it was generally more tax-efficient to earn business income as non-eligible corporate dividends everywhere but Quebec and P.E.I.
After the proposed changes, however, it will be more tax-efficient to earn business income as regular income in six out of 10 Canadian provinces.
7
Degree of difficulty
7 out of 10. George suggests advisors leave the number crunching to accountants. Instead, your key role is to help a client decide whether to go with dividends or a bonus by explaining the implications and tradeoffs for CPP benefits and income-splitting options.
The issues
Corporate income gets taxed twice: when it’s earned by the business, and again when it’s paid out as a dividend to an employee. “The purpose of the dividend tax credit (DTC) is to compensate the taxpayer for this double hit. The government’s trying to put her in the same position she’d be in had she earned the income without using a corporate structure,” explains Wilmot George, director of tax and estate planning at Mackenzie Investments in Toronto.
But “because of decreasing corporate tax rates, the DTC and gross-up factor currently applicable to small businesses, (non-eligible) dividends actually overcompensate some taxpayers,” he says.
Budget 2013 closes the gap. Effective 2014, the federal gross-up factor for non-eligible dividends falls from 25% to 18%; and the corresponding DTC will go from 13.33% to 11%. “The result is a 1.6% federal tax increase,” adds George.
Here’s how the change breaks down federally for a $10,000 dividend:
| Table 1 | 2013 | 2014 |
|---|---|---|
| Non-eligible dividend | $10,000 | $10,000 |
| Gross-up | $2,500 | $1,800 |
| Taxable dividend | $12,500 | $11,800 |
| Federal tax (29%) | $3,625 | $3,422 |
| Dividend tax credit | ($1,666) | ($1,298) |
| Net federal tax | $1,959 | $2,124 |
| After-tax proceeds | $8,041 | $7,876 |
| Top federal marginal tax rate | 19.6% | 21.2% |
Regardless of province, non-eligible dividends will be more expensive next year. So does it make sense for Roshni to draw a salary and bonus instead?
Pros of salaries: There’s less OAS clawback. And, it creates RRSP contribution room and allows for advanced retirement planning strategies, including Individual Pension Plans and Retirement Compensation Arrangements. Further, George explains, clients who want CPP benefits need to pay premiums, and this can only be done through the salary option.
Pros of dividends: Not having to pay CPP premiums and the income-splitting opportunities are both selling points.
“Shareholding family members who don’t work for the company can be paid dividends,” George notes. “[But] to receive a salary, they would have to be employees.”
Also, gross-up on dividends bumps up net income, which allows clients to donate more to charity. Finally, in some provinces, including Ontario, additional payroll taxes come off salaries, which Roshni could avoid.
Client acceptance
9/10
Roshni is pleased the math favours dividends because she likes the other benefits. She isn’t keen on giving the government CPP premiums to invest on her behalf. She also likes the income-splitting options, which may prove useful when she starts a family. Roshni also supports many local causes, so dividends will allow her to maximize her charitable giving and enjoy tax benefits.
The solution
From a tax perspective, dividends win for Roshni, even with next year’s reduced DTC.
On the federal level, Roshni’s $10,000 bonus is subject to the top marginal rate of 29%, leaving her with $7,100.
Here’s how her net cash flow after federal tax on $10,000 of dividends, both pre- and post-Budget 2013, breaks down:
| Table 2 | Non-eligible dividend, pre- Budget 2013 (federal) |
Non-eligible dividend, 2014 (federal) |
|---|---|---|
| Corporate active business income (ABI) | $10,0001 | $10,0001 |
| Bonus paid | – | – |
| Taxable income (corporation) | $10,000 | $10,000 |
| Small business corporate tax rate | 11% | 11% |
| Corporate tax | $1,100 | $1,100 |
| After-tax profit available for dividend | $8,900 | $8,900 |
| Top non-eligible dividend marginal tax rate | 19.6% | 21.2% |
| Personal tax on non-eligible dividend | $1,744 | $1,887 |
| Net cash flow | $7,156 | $7,013 |
1 Eligible for small business tax rate
On the federal level, in 2014 dividends will cost $87 more than a bonus ($7,013 minus $7,100), compared to a savings of $56 pre-budget ($7,156 minus $7,100). But once Ontario tax is factored in, dividends are the right choice.
Roshni’s $10,000 bonus is taxed at a combined federal and provincial rate of 46.4%, leaving a net cash flow of $5,360.
Here’s how net cash flow breaks down for dividends under both levels of taxation:
| Table 3 | Non-eligible dividend (pre-change – federal/Ontario) |
Non-eligible dividend (post-change – federal/Ontario) |
|---|---|---|
| Corporate active business income (ABI) | $10,0001 | $10,0001 |
| Bonus paid | – | – |
| Taxable income (corporation) | $10,000 | $10,000 |
| Small business corporate tax rate | 15.5% | 15.5% |
| Corporate tax | $1,550 | $1,550 |
| After-tax profit available for dividend | $8,450 | $8,450 |
| Top non-eligible dividend marginal tax rate | 32.6%2 | 34.9%2 |
| Personal tax on non-eligible dividend | $2,755 | $2,949 |
| Net cash flow | $5,695 | $5,501 |
1 Eligible for small business tax rate
2 Ignores Ontario top marginal tax rate for income beyond $509,000
Pre-budget, dividends offered a savings of $335, or 3.4% over a bonus ($5,695 minus $5,360). Post-budget, there’s a savings of $141, or 1.4% ($5,501 minus $5,360). So Roshni still saves by taking dividends in 2014.
Dean DiSpalatro is the senior editor of Advisor Group.