Business owners who benefit from the small-business deduction will lose the tax advantage gained by choosing to pay themselves in dividends instead of salaries, beginning Jan. 1, 2014.

The change was announced in the March 2013 federal budget and will result in a smaller gap between the rate of taxation on dividends and on wages paid by small corporations. Currently, there is an advantage of 2%-3% associated with paying dividends instead of wages.

Small-business owners eligible for the small-business deduction traditionally have shown a preference for dividends, says Aiman Dally, chartered accountant and CEO of Copia Financial Solutions in Toronto. “They also avoid paying payroll and other source deductions,” Dally says, “which is a personal financial planning decision.”

Canadian-controlled private corporations eligible for the small-business deduction enjoy reduced taxes on active business income of up to $500,000.

The rationale for the change is to improve tax integration. (“Integration” refers to the mechanism used to ensure that business owners do not pay taxes twice on the same amount – once inside the corporation and again when the revenue is distributed.) The current system results in a slight benefit to the taxpayer when remuneration is received as dividends; this result is known as “overintegration.”

Under the new regime, business owners will pay the same amount of taxes, whether their remuneration from their businesses is dividends or salary, says Maria Severino, tax partner with Collins Barrow LLP in Toronto: “We now are moving closer to [full] integration, although not perfect.”

The mechanics of integration rely on the so-called “gross-up” and the dividend tax credit system. Under the new regime, the gross-up factor will be reduced to 18% from 25% and the corresponding federal dividend tax credit on the grossed-up amount will be reduced to 11.02% from 13.3%.

Effectively, the federal income taxes on dividends paid to small-business owners will increase by as much as 1.6%. This will have the effect of eliminating the current tax advantage of taking dividends over wages. Because provincial tax rates on dividends vary, the actual tax increase for taxpayers will vary by province.

Given these changes, how should business owners compensate themselves?

“There really is no ‘one size fits all’ approach when determining the optimal owner-manager remuneration package. It is, essentially, a very holistic decision,” says Henry Korenblum, tax specialist with Crowe Soberman LLP in Toronto. “Given the recent tax measures, there are even more factors that must be considered than previously, requiring owner-managers to consider their specific needs and objectives carefully when determining their overall compensation package.”

However, Severino says, it still makes sense to take compensation as dividends instead of wages in 2013 because the changes begin in 2014.

But next year, the decision becomes more complex. For instance, Dally says, business owners must decide whether they want to create room in their RRSPs or individual pension plans. If so, then it might be prudent to take sufficient salary to maximize the contributions.

But business owners must bear in mind that salaries would attract source deductions, such as Canada Pension Plan contributions. Salaries are also subject to immediate payroll taxes, while taxes on dividends often can be deferred until tax returns are filed.

Severino recommends that small-business owners take only as much compensation out of the corporation as they need, whether salary or dividends. Assets left in the corporation will benefit from tax deferral.

Another consideration that small-business owners must bear in mind relates to passive investment income earned by the corporation from interest, rent, royalties and such. In many instances, these forms of income are not considered active business income and thus are not eligible for the lower small-business corporate tax rate. This disadvantage has almost doubled due to the recent tax changes.

In addition, the method of remuneration can also affect disability insurance coverage, which, Dally adds, typically is tied to an income threshold. Therefore, he cautions: “If you have disability insurance, you must ensure that your coverage is not affected by any change you make to your compensation strategy.”

© 2013 Investment Executive. All rights reserved.