Veronika asked:

My husband has an incorporated business in British Columbia. We have been recently working with a financial advisor who suggested that instead of taking his income in dividends (appr $45,000/yr), he take it as a salary to benefit from CPP earnings when he retires (my husband is now 45 years). Our accountant advised that this was not a popular strategy as he would be paying both portions of the CPP contribution.

What is your advice?

Mario Cywinski answered:

For this question, we decided to ask two different experts. One from a Chartered Accountants (CA) firm, and the other from a Financial Planner for a Credit Union.

Financial Planner

Our Financial Planner is Terry-Lynn Mann from Meridian Credit Union. We posed Veronika's question to Terry-Lynn, and this was her response:

It is great that you have both an advisor and an accountant working with you. They will each be looking at your financial situation from a different angle. I see a couple of reasons why your accountant would prefer to pay your husband in dividends. Let's start with CPP. Your accountant is correct....Canada Pension plan contributions are split equally between the employer and the employee. Since your husband is both the employer and employee, he would have to contribute both portions. Contributions are based on salary, so he could find himself paying up to $3821 (in 2006). Your CPP retirement pension is based on how much, and for how long, you contributed to the Plan. The age at which you choose to retire also affects the amount you receive. The maximum monthly benefit in 2006 is $844.58.

The pension is designed to replace about 25 percent of the earnings on which a person's contributions were based. So let's assume after 20 years of contributions your husband qualifies for $10,000 per year at age 65. (You would need CPP office to calculate accurate figures for you) Alternatively, let's say you were to save $3821 per year into a tax efficient non registered investment vehicle instead of paying CPP. You increase your contribution by 1% each year, and assume an annual rate of return of 7%. At age 65 you would have $161,000. Starting at age 65 you could withdraw $10,000 per year, indexed at 1% per year. Your money would run out around age 85.

Comparatively, CPP will pay out his benefit for the rest of his life. Other benefits of the CPP plan to consider are the survivors benefit payable to the spouse upon death of the contributor, children's benefit if you have dependent children, disability benefits, and death benefit.

Taxation - Canada Revenue Agency treats dividend income and salary differently. Salary is 100% taxable, whereas a tax credit is applied to dividend income, making dividend income more tax friendly. This is likely one of the reasons your accountant is structuring his compensation as dividends.

Saving for retirement - paying your husband a salary would earn him RRSP contribution room. This would give him the opportunity to save for retirement in a tax deferred investment. The benefits of RRSPs versus non registered is another topic that should be explored in depth. Regardless of how his compensation is structured, he needs to be saving for retirement.

So in conclusion, deciding to pay your husband dividends or salary needs to take into consideration a number of factors. It is important for your accountant and your advisor to work together to help you find a balance between tax efficiency and securing your retirement dreams.

Chartered Accountant

To provide a bit of background, income earned at the corporate level is subject to both corporate income tax and upon distribution as a dividend to individuals, personal income tax. Once an individual receives a dividend, the personal tax system provides relief from corporate taxes already paid by Canadian corporations through the gross-up and dividend tax credit mechanism. This system of "integration" was designed to ensure that there would be little or no difference in the amount of taxes paid between a company paying out a salary to its individual shareholder versus paying out a dividend from corporate retained earnings.

Prior to new dividend legislation being introduced, the integration system worked well when corporate income tax was paid at the small business rate (available on Canadian active business income up to $400,000), but for corporate income that was not eligible for the small business rate, the system resulted in more tax paid through dividend distribution than if the income was earned by the individual directly.

Legislation proposed last fall which increases the gross up and dividend tax credit on eligible dividends (dividends paid on income that is not subject to the small business deduction) has helped to alleviate this issue.

Based on the information below and assuming that the company is taxed at the small business rate, the husband may be slightly better off paying a dividend versus salary based on corporate and personal income tax rates today. Conclusions on this particular topic are often difficult to make as there are a number of considerations and assumptions that have to be taken into account . The answer will also depend on your province of residence as tax rates vary by province and income level.

We note that apart from minimizing the combined corporate and personal taxes, the challenge will be to weigh in other considerations that may affect the decision to pay out a salary versus making a dividend distribution . Drawing a dividend alone does not provide earned income for RRSP purposes nor does it contribute to the Canada Pension Plan (CPP). Dividends may also affect the availability of other deductions that rely on having earned income (e.g. child care expense deductions).

As the reader suggests, it is important to sit down with your advisor and work through different scenarios based on an individual's particular fact pattern - for example, one must consider the cost of CPP contributions when paying out a salary versus a reduced future pension income if a dividend is paid.

Furthermore, as the company continues to grow in the future, the decision of what the appropriate mix of dividends versus salary or bonus is will become more complex and will need to be revisited each year.

About the author

Mario Cywinski was the Assistant Editor of Canadaone.com and a graduate of Humber College's Journalism Program. Mario is currently the Managing Editor for Canadian Automotive Fleet and Fleet Vans and Trucks magazines, and is a member of AJAC. He has also worked for Trajan Publishing Corporation as a copy editor, and interned at ABC News, OMNI Television and Global TV.

 
Click here to go back to Ask-an-Expert index page.