Salary vs Dividends - a false debate

When it comes to BUSINESS OWNERS, there is no debate between whether to take compensation in the form of Salary versus Dividends, unless one is over the age of 71 or so poor as to not even own a house.

While this opinion may seem extreme and totally counter to what almost everyone else says, I am of the strongest belief that a successful business owner in Canada should take some of the take home compensation in the form of a salary, and if additional funds are needed, a dividend can then (and only then) be contemplated.

The simple reason is that by advocating a 100% dividend strategy, financial advisors and accountants are doing a considerable disservice to their business clientele for a variety of reasons set out below.

Since dividend income is a right of being a shareholder (and not an employee), a 100% dividend strategy precludes the possibility of setting up a Personal Pension Plan (PPP). In other words, here is what happens:

1) You face immediate taxation at the corporate level (12.2% in Ontario if under $500,000, 26.5% on taxable revenues above $500,000, more if the Tax On Passive Income kicks in, and 44.5% if a personal service corporation). That means you are already starting with a handicap.

2) Retained earnings kept in the business or even transferred to a HOLDCO will now grow passively and continually face potentially very high rates of taxation (especially on interest income or foreign dividend income). Sure, you can buy and hold stocks and never sell them to avoid this ongoing taxation, but surely few are like Warren Buffett and know which stocks to pick and hold on for 30+ years. Beware of the Morneau measures and the Tax On Passive Income, since once you earn more than $50,000, for every additional dollar of passive income one loses 5$ of the company's $500,000 small business deduction limit. In other words, the corporate tax rate more than DOUBLES from 12.2% to 26.5% on each dollar caught by this 2018 tax measure!

3) When you decide to retire and you do need money to live, the corporation that invested passively must generally pay you a dividend personally, and that's when you have to include that income into personal income through the dividend tax gross up and deduction system. So for a third time, the CRA has its hand extended waiting for their share.

4) if you die and the value of your passive corporate investments are part of the value of the shares of your company, we now have a 'deemed disposition' and immediate taxation. We cannot rollover that value to children without exposing it to taxation. We may even have to worry about provincial probate fees in certain provinces depending on the monetary amounts in question.

So while we did not have to make any CPP contributions, the overall picture is one of constant taxation and the risk of large tax on death (or if one becomes a non-resident of Canada - under the 'departure tax').

Now, let's look at what happens if some of the compensation is paid via Salary and the corporation sets up a PPP:

a) Contributions made to the PPP by the corporation are fully tax-deductible.

b) Such contributions include:

• Past Service buy backs
• Special Payments
• RRSP double dip
• Pension adjustment offset amount
• Terminal Funding
• Higher annual contributions than permitted under RRSPs

c) Moreover, some additional amounts are also tax-deductible:

• Investment management fees
• Interest paid to a lender on borrowings to contribute to the plan (corporate write off)
• Interest paid to a lender if cash was invested in the company (personal write off)
• HST pension entity rebate
• $2,000 annual non refundable pension amount credit

d) In effect, instead of starting with a deficit, we utilize pre-tax corporate dollars to build up a pension plan that will grow for many years in an account not subjected to ongoing taxation.

e) And even at the end, during the de-cumulation phase, the PPP provides many ways to further reduce the tax burden:

1. At any age, a pension is eligible for 'pension income splitting' treatment with a spouse that might have no income of his own.
2. Both parties in the couple can claim the $2000 per annum pension amount credit, such that the first $4000 of pension paid annually is very lightly taxed.
3. Non residents in a country that has a tax treaty with Canada typically only pay 15% Part XIII Income Tax Act (Canada) withholding tax on the monthly pension amount paid out.
4. The capital inside of the PPP is considered an 'exempt asset' which means that the 'departure tax' (deemed disposition when one becomes a non-resident) does not apply at all to the pension fund.
5. Charitable giving can further reduce personal taxation for those that are philanthropic in old age.

BUT BY FAR, the biggest disservice of the "All Dividends" camp is the failure to allow families to pass wealth from one generation to the next tax effectively through the use of the PPP set up for that family.

If multiple folks in a family business all join the single family PPP (since all are eligible on account of receiving a salary), should the parents pass away while in receipt of their pension, the balance of the capital that was not spent during retirement transforms into what we pension lawyers call "pension surplus". This surplus is such because the pension plan has discharged its promised obligations: it paid a pension to the member, and would have paid a survivor pension had there been a survivor spouse to pay it to. Any monies left behind is simply classified as surplus.

Where the PPP allows multiple family members to save for retirement and some pass away, the surplus is not subjected to a "deemed disposition". Instead it continues to operate, free of tax, within the confines of the pension plan. The surviving children that are still plan members in effect get to control that untaxed surplus. Some simply let it grow for many more decades free of tax to create a massive safety buffer. Others return some of the surplus back to the corporation, especially if the corporation has carried forward tax losses it has yet to utilize. Finally some declare a surplus distribution of some or all of the surplus. That surplus distribution is either taxable or non taxable depending on the recipient of the surplus. If a registered charity is a beneficiary of the PPP, it is exempt from tax, even on receiving surplus from the PPP.

None of this powerful tax planning is possible if one opts for 100% dividends.

Oh! and don't get me started on the CPP and how it is such a waste of money and won't exist etc. Salary implies having to contribute to the Canada Pension Plan. Many think that they could do better than the CPP Investment Board in investing the employer and employee premiums ($3499.80 x 2) over long periods of time. It turns out when you get an actuary to crunch the numbers that in order to match the CPP Investment Board and generate an annual flow of retirement income from say an RRSP, you would have to find a risk-free GIC-like bond that pays 4.6% consistently for 30 years in a row in the open market.

The bottom line is that unless you are ready to take risks including the risk of losing it all, it is virtually impossible to match the stream of pension income paid out of the CPP on your own for someone that has a normal life expectancy. And for those who still think that the CPP is about to go bankrupt, the Chief Actuary has reported that it is viable for at least the next 75 years. The last time people though the CPP was going bankrupt was back in 1997 and this was before the CPP Investment Board was created and the provinces worked together to amend the CPP Act to put this plan on a solid financial footing. Their doomsday information is 25 year old and getting a bit dated.

Don't be guided by slogans and facile thinking. Finance is not easy but it is worth spending time learning about how the laws of this country work.