Be Happy On Pay Day; After Incorporation, Pay Yourself With Dividends And Soften The Tax Man's Bite
INCORPORATING YOUR BUSINESS offers tax advantages, but it also makes tax management more complex -- especially when it comes to paying yourself. While it may appear that you could end up paying tax on your earnings twice -- once inside your corporation and again when you withdraw it as income -- that's actually not the case. Canadian tax law addresses this problem, but it's import to be aware of the details. This is one instance where you need to know how the system works for you.
The Income Tax Act has created a system called "integration," which tries to ensure that individuals pay the same amount of tax regardless of whether income is earned personally or through a corporation.
Here's how it works: Say you are a consultant in the highest marginal tax bracket, about 45% (on average) in Canada. You have just incorporated. Before incorporation, say you earned $1,000 personally. In the top 45% bracket, you would have paid $450 of combined federal and provincial tax and be left with $550 in after-tax income. Now that you've incorporated, it's your corporation that earns the $1,000. Assuming a combined federal and provincial small business tax rate of 20%, your company would be left with $800 after it paid its $200 of corporate tax. To get the money into your hands without double tax, your corporation pays you a dividend of the remaining $800. This dividend is eligible for tax credits that, ultimately, will ensure you pay the same tax on the $1,000 that you would have paid if you had earned the money directly as income.
At tax time, you "gross up" the $800 value of the dividend -- that is, add 25% to its value, as per federal rules -- and report it as $1,000 of dividend income on your personal return. You thus owe $450 at your top marginal tax rate, but now you get to claim the dividend tax credit. This credit would theoretically be worth 13.3% of the grossed-up amount federally ($133) and an additional 6.7% provincially ($67) for a total credit against taxes payable of $200. Deducting this $200 federal and provincial dividend tax credit from the $450 of tax otherwise owing will result in a net personal tax payable of $250. That would leave you $550 of after-tax cash -- the same amount of after-tax cash that you would have had before incorporating.
Canada's integration system, while not perfect, works pretty well, but it's not the only way to take to take funds out of your corporation. I'll write more on that subject next month.