Just rewards

Written by Camilla Cornell

How do you pay yourself? Salary, with the occasional bonus for good measure? Dividends? A mixture of all three? Your choice is likely driven by a desire to minimize taxes. After all, you work hard for your money, so it only makes sense to keep more of it in your pocket.

Indeed, not all compensation packages should be created equally. But given recent changes to the taxation of dividends, now may be a good time to revisit how you earn personal income. “However you’ve done it in the past, start over,” suggests Kurt Rosentreter, a senior financial advisor with Toronto-based Berkshire Securities Inc. and the author of Wealthbuilding. “The rules have changed in the last 18 months.”

Last November, the federal Department of Finance reduced the tax rate on eligible dividends for the 2006 taxation year. It was a long-awaited change intended primarily to address the inequitable tax treatment of distributions from income trusts versus public corporations. Many provinces promptly followed suit. (So, for instance, the combined federal/provincial taxes on dividends in Ontario fell from 31% to 21%.) Those changes have made dividends much more appealing, and may alter your optimal salary/dividend mix.

Previously, your company’s income was effectively taxed twice, first at the corporate level and then again at the individual level. Say you were the sole shareholder of a business based in Ontario with $100 in net income. If you paid the top corporate tax rate, you would have $65 left over, explains Dave Loewen, a tax partner with PricewaterhouseCoopers in Winnipeg. If you took that balance as a dividend, you’d pay another $20 to $25 in personal taxes. “So,” says Loewen, “of the original $100, only about $40 to $45 actually ended up in the shareholder’s hands.”

That’s why experts formally recommended that entrepreneurs pay out money due to be taxed at the high corporate rate in the form of a bonus — a tactic commonly referred to as “bonusing down.” “At least it was only subjected to tax once, in the shareholder’s hands,” explains Loewen. Given the same $100, even at the top marginal tax rate of 46% (in Ontario), you would end up with $54.

The new dividend regime attempts to equalize the taxes paid on a dollar, regardless of how you earned the income. “Many entrepreneurs should reconsider the traditional strategy of a salary and bonus to now consider paying eligible dividends in light of lower taxation,” points out Rosentreter. “Remuneration in the form of dividends has suddenly become more attractive.” And as the federal taxation rate on dividends continues to drop, in the long run you should end up with that $54 in your pocket — no matter how you take your compensation.

“The biggest consideration typically is what produces the minimum amount of tax and that will vary depending on the circumstances,” says Loewen. Still, there may be other advantages to taking dividends rather than bonusing down. You won’t pay CPP and employment insurance on dividends. On top of that, notes Loewen, several provinces levy provincial payroll taxes such as health care and post-secondary education premiums. “If an owner/manager is being compensated by large bonuses, that payment creates extra payroll taxes. With a dividend payment, you can avoid that.”

You can even receive dividends tax-free, as long as the payment streams from a capital gain and your company has a balance in its capital dividend account. “If a corporation realizes a capital gain, only half of the capital gain is taxed,” explains Loewen. “The half that is not taxed can be distributed as a tax-free dividend to the shareholders.”

To determine the compensation strategy that’s best for you, enlist the help of your accountant and financial advisor. Furthermore, as your company grows, you’ll want to determine the optimal mix of dividends versus salary annually.

Originally appeared on PROFITguide.com