Benefiting from an SBD
Small-business owners need to figure out if they want a bonus or dividend
As 2011 comes to a close, small-business owners will soon need to make some important decisions as to how they should be compensated for their efforts: bonus or dividends.
A Canadian controlled private corporation (CCPC) pays corporate income tax based on the type of income it earns. The first $500,000 of active business income is eligible for the small business deduction (SBD), which means that this income is taxed initially at low corporate tax rates federally and provincially and is not taxed a second time until the funds are removed from the corporation by way of a dividend to the business owner.
Small-business rates have been decreasing over the past number of years, so there is actually a slight tax rate advantage in all provinces of having funds taxed inside the company at the low SBD rates and then paying the amount out as a dividend, either in the current year or when needed later on. This tax rate advantage ranges from a high of 3.9% savings in Nova Scotia to 0.6% savings in Manitoba. Only Quebec and P.E.I. have a slight tax cost of earning SBD income in a corporation and paying it out as a dividend.
That said, even in those two provinces if the funds are not needed to fund a business owner’s current lifestyle, it’s best to retain and invest the SBD income in the corporation and to pay the after-tax amount out as a dividend to the shareholder, so as to enjoy a significant tax deferral of SBD income within the corporation. This tax deferral advantage ranges from a high of 35.4% in P.E.I. and Manitoba, to a low of 25% in Alberta.
But what about active business income (ABI) above $500,000 that is not eligible for the lower SBD tax rates? For ABI, in nearly all provinces, there is a tax cost associated with a dividend strategy and, therefore, a bonus may be preferred if the funds are needed immediately or in the short term. It may, however, still be beneficial for a CCPC that earns ABI to have it initially taxed inside the corporation at a slightly higher corporate tax rate to retain and invest the ABI in the corporation and gain a valuable tax deferral, which can range between 12% and 20% depending on the province.
For a closer look at some examples of these strategies in action, please see my full report Bye Bye Bonus! Why small business owners may prefer dividends over a bonus, available at cibc.com.