Two happy carpenters shaking hands with senior customer after successful agreement in a workshop.

As we approach the end of the calendar year, it may be worth taking some time before Dec. 31 to review the compensation plans of your small business owner clients. After all, clients who own a business through a corporation — whether retail, manufacturing, operating or consulting — have tremendous flexibility in how they choose to remunerate themselves. The same holds true for professionals who have incorporated their practices, such as doctors, lawyers and accountants.

This flexibility stems from how a corporation distributes its income to the shareholder who is also an employee: either as salary or dividends.

If corporate business income is paid to the owner as salary (or bonus), the corporation (employer) can claim an income tax deduction for the salary (and applicable payroll taxes), which reduces its taxable income. The owner then includes the salary in their taxable income and pays tax at personal graduated tax rates.

As an alternative to distributing income as salary, the corporation can pay tax on its corporate income. In the year the income is earned or a future year, the corporation can then distribute its after-tax corporate income to the owner as dividends. The owner will then pay a lower tax rate (than for salary) on eligible and non-eligible dividends due to the dividend tax credit, which is meant to compensate for taxes paid by the corporation.

So, how can we help clients, many of whom have corporations with Dec. 31 year-ends, decide between salary and dividends?

As a general rule-of-thumb, if the owner needs to withdraw funds from their corporation, perhaps to pay personal expenses, they should consider withdrawing salary to create RRSP contribution room. Receiving salary of up to $171,000 in 2022 would create RRSP contribution room in 2023 of up to $30,780 (the 2023 maximum).

If, on the other hand, they do not need to withdraw funds from their corporation, they may still wish to withdraw sufficient funds to maximize contributions to their TFSAs. The TFSA can provide a tax-free rate of return on investments. (I describe this in detail in my report Just do it: The case for tax-free investing.)

Finally, it may be worth reminding clients to consider leaving any remaining funds in their corporation to benefit from the significant tax deferral, which may provide more investment income in the long run than personal investing in non-registered plans. They can then distribute the company’s income as dividends in a future year, perhaps even into retirement. For 2022, the tax deferral advantage among the provinces ranges from a low of 37% in Alberta (because of its relatively low top marginal rate) to as high as 43% in Newfoundland and Labrador on income eligible for the small business rate. (My report Bye Bye Bonus! discusses this compensation decision in greater detail.)

Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the Managing Director, Tax & Estate Planning with CIBC Private Wealth in Toronto.