While the start of the year is associated with the last-minute RRSP contribution blitz, it is also a busy time for many entrepreneurs or incorporated professionals. Since the T5 income tax return must be filed no later than the last day of February, they must wonder about the amount of dividend to be paid based on the company’s results. The closer the fiscal year end date is to the end of the calendar year, the tighter the time frame for making this calculation.
Several reasons motivate the decision to incorporate the activities of a company. First and foremost, the owner’s ability to control and limit his personal taxation. Working with entrepreneurs, I have observed over time that there is a general bias in favor of dividend pay. Still, the dilemma between salary and dividend remains a real mystery for many.
Small business, big questions
When a company becomes mature or reaches a significant size and its profits are substantial, the quest for a certain stability often pushes its management to think about the remuneration of its leaders. The choice between salary and dividend is a dilemma that takes on particular importance among shareholders who manage small businesses. Indeed, since Minister Morneau’s tax reform in 2018, the gradual reduction in corporate tax rates has resulted in a parallel increase in the tax rate on dividends, resulting in a loss of income. once fairly marked advantage in favor of the dividend.
Potentially, dividend compensation may even lead to an unfavorable overtaxation, particularly in the case of companies that are not eligible for the SBD (small business deduction) in Quebec (under the 5,500 hours worked rule), which is the case of many very small businesses or incorporated professionals.
Remember that the salary reduces the company’s taxes, while the dividend is paid out of the net profits. All of these elements combined, it is likely that if your company is taxed at the “average rate” (federal DPE only) and your personal needs are important, the comparative advantage will be in favor of salary.
Even if, in theory, when the company benefits from the DPE, the dividend remains fiscally favorable to the salary in the majority of scenarios, other more subjective elements must be considered in your analysis. The value of the pension projected at the RRQ (Régie des rentes du Québec), the possibility of qualifying for the DPE at the provincial level by increasing the hours worked, the shareholder’s investor profile and his family situation are just a few -some of the other factors that must be considered in addition to the calculations of the companies’ immediate liquidity.
An approach based on cash management
In order to optimize shareholder taxation, a demanding and totally personalized analysis must be carried out to find the best effective marginal tax rate (METR). Remember that with the integration rule, the exercise of business activities under a joint-stock company structure does not make it possible to cancel, as if by magic, taxes, but rather to defer them in time.
All comparison calculations between salary and dividend should therefore incorporate the real needs to finance the cost of living and other income already available, if applicable. Each situation is unique, but the greater the income required, the more the salary option is worth considering. If you haven’t reviewed your compensation method since 2018, maybe it’s time to test your resistance to change?
Moreover, in the case of a company with several shareholders, this exercise must be carried out as part of individual financial planning. It is quite likely that the shareholders do not present the same reality and that the shareholding structure may have to be reviewed in order to use personal management companies.
Cash management is the key to business success. Small, start-up and growing businesses can appreciate the flexibility that dividend compensation provides, as there is no need to worry about withholding taxes. But on the other side of the spectrum, the shareholder’s ability to manage his own cash could well represent a more qualitative than financial criterion for deciding on the remuneration to be retained.
Your accountant won’t jump for joy if you decide to change your dividend declaration on Monday morning, even though in theory it’s still possible to do so. Whether you are newly incorporated or have doubts, the ideal is simply to resort to shareholder advances in the coming months to temporarily cover your needs. This will give you time to do the complete analysis exercise allowing you to decide by the end of your company’s next financial year which formula is the most advantageous. Sometimes it is a mixed recipe.