By John Nicola, CFP, CLU, CHFC, Phill Tippetts-Aylmer, CFP, CIM, & Dr. Arv Sooch, DMD, BSc (Pharm).
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IN THIS ISSUE: SUMMARY
Dentists are business owners and, consequently, have a unique opportunity to restructure their compensation. In this article, we discuss how a dividend compensation strategy can help build wealth more effectively.
Let me twll you how it will be.
There is one for you, nineteen for me,
’cause I’m the TAXMAN…– George Harrison
George Harrison wrote these lyrics during a period of time when the highest marginal rate of tax in England was 95%. Perhaps if he had John Maynard Keynes as a financial advisor, he would have fared better and complained less. It was, after all, Keynes who wrote: “The avoidance of taxes is the only intellectual pursuit that still carries any reward.”
For over 20 years, self-employed business owners and professionals have been able to incorporate their businesses and practices. Certain “rules” about how one takes his or her compensation and splits income with other family members have become ingrained in our thinking. For example:
- Take a large enough salary to maximize your RRSP contribution ($140,945 in 2016 with a contribution maximum of $25,370 with contribution levels being indexed going forward).
- Split income with low-income spouse if possible and pay them a “reasonable” salary.
- Distribute after-tax corporate earnings by way of a dividend to a discretionary family trust (limitations apply to beneficiaries under the age of 18).
- If you earn more than $500,000 after expenses, you should “bonus down” and pay personal taxes on that income rather than the high-rate corporate income (which is currently 26% for 2016).
- Taxes on investments held inside a company are higher than when those investments are held personally.
What if some of these “rules” are outdated or, while correct, only reveal half the story? What if these rules are costing you more in taxes and lost retirement savings than other compensation approaches that are both safer and simpler?
A few years ago the General Rate Income Pool (GRIP) was created to track active income earned or eligible Canadian dividends received that have been taxed at the higher Canadian corporate rates. Dividends paid out of this GRIP account are taxed at a lower personal rate of up to a maximum of 31.3%, rather than the regular rate of 40.61% on regular or ineligible dividends.Even with the recent tax changes resulting from the most recent Liberal government budget, in this article we will make a case for the following:
- Incorporated business owner / professionals earning less than $500,000 per year should not take any salary. That also means no RRSP or IPP contributions. The same would be true for paying salaries to low-income spouses.
- Ideally, all income would be paid (in the above scenario) as dividends and structured to make total taxable incomes for a husband and wife equal.
- Continuing to pay dividends to a family trust for children over 18 still makes sense under the right circumstances.
- Future retirement savings would occur at the corporate level (perhaps in a holding company). If the asset mix is combined with the right compensation approach, then the tax on corporate investments can be reduced from its initial rate of 49.67% to as little as 0% (we realize this is a huge difference, so please see the following example.)
- For practitioners earning more than $500,000 per year, the latest tax law presents a number of outcomes; however, in general, income would be taken in a combination of ways:
- No “bonus down” to $500,000.
- Salary – only to the extent that RRSP/IPP contributions can be maximized (approximately $140,945).
- Dividends – for the balance of income required; ideally through a trust or to other shareholders with lower tax rates.
Let’s first look at the following case study:
A TALE OF TWO DENTISTS
Scenario One: TRADITIONAL SALARY
Assume John Wilson is a dentist who makes $500,000 after expenses, but before tax, in his incorporated practice. He is married to Mary who earns income only from the practice. They need about $200,000 per year to live on and they want to maximize their RRSP contributions as well. In this case, we’ll further assume that Mary receives an income of $40,000 per year as a salary and he receives $300,000 (before taxes, RRSP deductions, and CPP premiums). The table below shows the net result for 2016.*
*We have used 2016 tax rates and CPP premiums. Income based on $380,000 paid in salaries and the balance of $120,000 earned is assumed to be retained in the company and tax paid at the small business rate of 13% in 2016.
Scenario One: So how might this have worked if they had received sufficient dividends from the company to provide them with the same after-tax spendable income, saving for retirement within the company instead of personally through RRSPs?As in the chart above, we assumed that corporate income above the amount necessary to pay dividends was retained in the company and tax was paid at the small business tax rate of 13%.
So how do these two approaches compare?
- With dividends, total taxes for John and Mary are over $54,000 per year less as a result of three major factors: CPP does not have to be paid, the reduced corporate tax rate, and the total income being split more evenly as opposed to when taking salary. There are tax savings achieved here due to the new high tax rate bracket of 47.7% imposed on the salary of $300,000.
- Savings are now entirely in the company and about $55,000 more than a combination of corporate and RRSP savings.
- When they retire, John and Mary will pay about 10% less tax on dividends taken from their company than withdrawals from their RRSPs.
- There is less risk of a tax reassessment for Mary with dividends vs. salary and in addition, with no RRSP’s there are no minimum withdrawal amounts imposed each year after age 72, which could impact eligibility for OAS.
- While they do lose future CPP benefits (but not benefits accrued so far), in most cases the amount they will lose is considerably less than the premiums they will have to pay. (See our newsletter on this and other related topics at www.nicolawealth.com)
For the majority of dentists earning less than $500,000 per year, dividends are a more effective and safer way to take compensation.
So that leaves TWO big questions:
- What do business owners and professionals who earn more than $500,000 per year do, and2.
- How can one reduce the taxes one has to pay on investment earnings inside a company?
The first question was made slightly more complicated by the new dividend rules that came out in early 2007. It is best for individuals in this category to review with their accountants, as early in the year as possible, what approach is best for them. Below are some guidelines:
- Salary should not be more than the amount required to maximize your RRSP/IPP contributions. For 2016, that will be approximately $140,945.
- If you have investment income in your company and have accrued RDTOH (Refundable Dividend Tax on Hand), you should take sufficient dividends to get it back. This can lower your tax on investment income by more than 50%.
- Income split as much as possible and if you have a family trust (with beneficiaries who turn 18 years of age or older in a given year), then review with your accountant how best to use it. The current tax rules have rendered the option of taking dividends as one’s income as good, if not slightly better, than salary at many income levels, for many individuals. We have developed an analysis tool to assist our clients and their accountants in determining the right mix of salaries and dividends for different situations. (You can call us for a copy of this analysis tool)
To answer the second question, a quick primer on corporate tax rates on investment income is necessary. If you are going to take the dividend approach, you will be investing corporately. Companies have to pay a high tax on investment income that is subject to tax credits. Space does not permit us to go into this in great detail, but the following table will help. We can make two key observations from this table:
- It is much better to pay taxes after we have received back the refundable taxes available (RDTOH). This will happen automatically if we take our compensation in the form of dividends.
- The lowest tax rates for a company are on capital gains and dividends from Canadian companies. That means we should focus on holding long-term appreciating assets and dividend-paying stocks in our company portfolio, and move interest-bearing assets and income trusts to our registered plans (RRSPs and IPPs). If we do this well, we can possibly reduce our long-term corporate tax rate on investment income to less than 6% (the average of the dividend and capital gain rate after RDTOH).
The table below shows how the tax rate can get to such a low level.
So for small business owners such as incorporated dentists, it seems that while it might not be the absolute “best of times.”…it is certainly still a pretty attractive time from a tax point of view.
There is one caveat: in order to receive back RDTOH you need to ensure that the dividends you receive come from a company that has RDTOH (this would typically be the “location” of the investment assets {i.e. a holding company}). If you have both a holding company and an operating company, you may find that all of your RDTOH is in the holding company.
If that is the case, then taking dividends from your operating company will not trigger any refunds of taxes and will be far less effective. Review with your accountant how best to integrate this compensation structure into your tax planning.
We don’t all need to have the intellect of John Maynard Keynes to reduce our taxes. We simply need a better understanding of how the rules work and be flexible in which approach to adopt when they change.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. NWM is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions.
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