With just a couple of months to go before year-end, now is a great time to reach out to your incorporated business-owner clients to see if they’ve had their year-end compensation discussions yet with their tax advisors.
The issue arises because, as an incorporated business, there is flexibility in how a business owner can be remunerated. The same holds true if they’re a professional, such as a doctor, lawyer or accountant, who has incorporated their practice using a professional corporation. This flexibility stems from how a corporation distributes its income to a 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 (which is also the employer) can claim an income tax deduction for the salary (and applicable payroll taxes such as CPP and EI), which reduces its taxable income. The business owner then includes the salary in their taxable income and pays tax on that income at personal graduated tax rates.
As an alternative to distributing income as salary, a corporation can pay tax on its corporate income in the year the income is earned. In that year or a future year, the corporation can distribute its after-tax corporate income to the owner as dividends. The owner will pay a lower tax rate (as compared to salary) on eligible and non-eligible dividends due to the dividend tax credit, which is meant to compensate for taxes paid by the corporation.
Let’s take Marlon, an incorporated physician, whose professional corporation is expected to earn $100,000 of taxable income in 2023, after all expenses and overhead. If Marlon resides in Ontario, and assuming the corporation qualifies for the small business rate of 12.2% on active business income, the corporation would pay $12,200 in corporate income tax for 2023. The net amount, or $87,800, can be left in his corporation and invested, or be paid out currently or in a future year.
If the $87,800 is paid out, it will be taxed as a non-eligible dividend, and if Marlon is in the top Ontario marginal tax bracket in 2023 (due to other income), he would pay approximately $41,920 on this dividend, netting him $45,880 after-tax. The net result is that on $100,000 of net income, Marlon will have paid total tax of $54,120 for an effective integrated combined tax rate of 54.12%.
What’s interesting to note is that this rate is only slightly higher (0.6%) than the top Ontario personal tax rate of 53.53% on salary income. This means that if Marlon had instead decided to pay himself a salary of $100,000, his professional corporation would claim a tax deduction for the salary expenses, and have no net income and thus pay no corporate income tax. Marlon would pay personal tax on that $100,000 salary at his marginal rate, which if he had significant other income, could be as high as $53,530. Contrast that with the $54,120 total tax paid on the dividend compensation method above, and the difference in total tax payable is a mere $600.
Of course, what the rate comparison fails to acknowledge is the tax deferral advantage of leaving funds in a corporation. Suppose Marlon didn’t need any of the corporate income to live on because he has other sources of income, and he could afford to leave all of it in his corporation. The corporation would pay a bit of income tax currently ($12,200), leaving $87,800 in the corporation where it can be invested for years, if not decades. The deferral advantage is simply the difference between the top rate (53.53%) and the small business rate (12.2%), or 41.33%.
So be sure to reach out to your business-owner clients in the weeks before year-end to make sure they’re on top of their 2023 compensation planning.
Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the Managing Director, Tax & Estate Planning with CIBC Private Wealth in Toronto.