As the owner and active employee of an incorporated small business one of challenges you face is how to get the (most amount of) money out of the company and into your pocket or bank account by paying the least amount of tax possible.   After all, whatever is left after the government takes its share is yours – so if you can reduce the amount the government takes, you increase the amount the amount that remains for you.

Basically, there are two ways in which you can receive money from your company.  Most small business owners simply pay themselves a salary.  Another alternative, though less utilized, is to pay a dividend.  In fact, you could combine the two — you can receive both a salary and dividends.

Hard as it may be to believe, there is actually a theory underlying the Canadian income tax system.  Lawyers and accountants call it the theory of integration.  Our tax system was designed and is periodically tweaked in such a way so that business owners should be indifferent between taking a salary or dividends from their company.   In an environment where tax integration works perfectly the same amount of taxes will be paid regardless of whether the business owner receives salary or dividends.

Of course, our tax system isn’t perfectly integrated – in large part because the tax rates on personal and corporate taxes vary significantly depending on what province you are in.  As my practice is located in and restricted to the province of Ontario I will use Ontario tax rates in my example.

Consider the case of Mike Kilpatrick.  He is the sole shareholder of a company called Small Co.  He also works full-time in the business along with several other employees.   It is mid December and Small Co has a December 31st year end.  Mr. Kilpatrick is confident that at the end of 2010 the company will have $100,000 in profit.  Mr. Kilpatrick has not taken any salary and wants to know what combination of salary and dividends will provide him with the largest amount of after tax personal income.  Or to put it another way what combination of salary and dividends will result in the smallest amount of combined personal and corporate tax.

Let’s consider the two alternatives using the amounts from the table below. 

The salary alternative

If Mr. Kilpatrick were to take all the profits as salary he could take $97,837.  As an employer the company needs to match Mr. Kilpatrick`s CPP contribution and pay that amount –  $2,163 to CRA [Canada Revenue Agency].

The salary paid to Mr. Kilpatrick and the amount paid to CRA as its  CPP contribution total $100,000.  This expense  exactly matches the profit of $100,000 so that the company has neither a profit nor a loss and no corporate income taxes are owed.

On his salary of $97,837, Mr. Kilpatrick will have deducted the maximum CPP of $2,163 and combined federal and Ontario income taxes of $26,813.  This leaves him with an after tax amount of $68,861.  This is how much money Mr. Kilpatrick will ultimately end up with out of the $100,000 company profit.

The dividend alternative

What if, instead of paying Mr. Kilpatrick a salary, he was paid as much as possible,  all in dividends.  Dividends paid to shareholders are not tax deductible.  Therefore, the company will have to pay corporate income taxes on the profits of $100,000.   A small business corporation, otherwise known as a Canadian Controlled Private Corporation or CCPC for short with a  December 31st year end will have a tax rate of approximately 16% in 2010. This means the company will have to pay $16,000 in income tax on $100,000 profits, leaving $84,000 to be paid to Mr. Kilpatrick as a dividend.

Mr. Kilpatrick will have to pay $9,875 of personal income tax on that dividend payment.  The total amount of tax paid by both the company and Mr. Kilpatrick is $25,875 — almost $1,000 less than the $26,813 Mr. Kilpatrick would have owed had he taken all salary.

But there is more.  Dividends do not attract CPP payments.  The bad news is because Mr. Kilpatrick is not making a contribution to his CPP, the payments he will receive upon retirement will be lower.  The good news is that he gets an extra $4,326 because he doesn`t have to pay $2,163 to his CPP and the company doesn`t have to match that amount.   But in order to keep the comparison between salary and dividend alternative equal lets assume that Mr. Kilpatrick takes what would have been his CPP contribution and puts it in a Tax Free Savings Account – sort of a self administered pension plan.  Not a bad alternative!  You, not the government, get to control your retirement investments.

But the company doesn`t have to pay any CPP contribution because there is no matching CPP for Mr. Kilpatrick.  From the company`s perspective this is like another form of tax that in the case of paying dividends doesn`t have to be paid.

The upshot of all of this is that if Mr. Kipatrick is paid the maximum amount possible in dividends he will  end up with an after tax amount of $71,962.  This is how much money Mr. Kilpatrick will ultimately end up with out of the $100,000 company profit.

Note that Mr. Kilpatrick ends up with more than $3,000 more cash – $71,962 vs. $68,861 — if he takes dividends instead of salary.

Of course it will be a little less than that after you pay your accountant for having come up with such a great tax saving idea!!