As a small Canadian business owner, you may be paying unnecessary additional tax on business income.
Your corporation earns income and may distribute dividends, if it is profitable, to its shareholders (including you), which you then have to pay individual tax on, creating a double taxation problem. You pay tax twice on the same income; once at the corporate flat rate, and again at the progressive individual rate.
Recognizing the problem, the government created specific mechanisms and schemes that you can take advantage of through strategic tax planning to effectively help you avoid double taxation, save money, and reduce unnecessary tax burdens.
Taking advantage of these mechanisms, such as paying yourself in dividends rather than by salary or retained earnings, can help you save money long term, especially if you are a small Canadian business owner.
What is Double Taxation?
Shareholders are taxed at an individual level based on progressive tax rates set out by the federal and provincial governments.
Progressive tax rates rely on a "bracket system" which divides income into portions, and each portion is taxed at a specific rate, similar to climbing stairs. As your income increases, each new portion is taxed at a higher rate, but the lower rate still applies to the earlier portions. For example, federally, the first $57,375 of your income will be taxed at 14.5%. The next portion, income between $57,375 and $114,750, is taxed at 20.5%. The brackets keep rising on any income earned above that threshold, up to $253,414.
Conversely, as a small Canadian business owner, when your corporation earns income, it is taxed on that income at a corporate flat rate. Subsequently, when you distribute the net profits as dividends to yourself as the sole shareholder, those dividends will be subject to your individual progressive tax rate. The same income is being taxed twice. This is referred to as "Double Taxation".
To demonstrate how double taxation operates, assume you own a corporation that earns $1,000, you are the sole shareholder of the corporation, the corporation is taxed at a flat rate of 20%, you are personally taxed 19.55% for any amounts $52,886 or less, and this is your sole source of income.
The full amount of $1,000 will be declared as income by the corporation, meaning 20% will be paid in corporate tax, leaving the corporation with $800. This $800 is referred to as retained earnings or "after-tax dollars". If the $800 is distributed as salary, you, as the shareholder, now have to pay 19.55% tax on the $800 you receive, leaving you with a net profit of $643.60 and a $156.40 tax liability.
The same income of $1,000 is getting taxed twice; once at the corporate level for 20%, and then again at the individual level at 19.55%. You, as both an individual and shareholder, have paid a total of $356.40 in taxes on income of $1,000.
If, however, you were operating the business as a sole proprietorship and not through a corporation, that same $1,000 would be taxed at 19.55%, leaving you with $804.50 profit.
Double taxation, therefore, disincentivizes individuals from creating and operating Canadian small businesses because it results in a higher tax burden, making it more financially attractive to earn income personally than to earn it through a corporation.
The government has various policy interests in encouraging individuals to start corporations, including economic growth. Thus, in response, the government created a compensation scheme between individuals and corporations to integrate their taxes at the corporate and individual level so that the taxes paid would equal what an individual alone would pay ("Integration").
Small Canadian-owned businesses, formally called Canadian Controlled Private Corporations ("CCPC"), particularly benefit from the Integration scheme because they are offered significantly lower corporate flat rates and small business deductions, tax-free dividends, and other mechanisms that result in maximum after-tax income.
Integration – The Government's Scheme to Prevent Double Taxation
Integration involves a 3-step process to ensure that double taxation is prevented.
First, when a corporation distributes its after-tax dollars as dividends, the shareholder will declare a "gross-up" on those dividends. A gross-up is an artificial increase in the amount of a dividend to approximate what the corporation earned before taxation. For a CCPC, the gross up, according to the Income Tax Act, is 15%. Any dividend you receive will be increased by 15% to determine how much your dividend needs to be "grossed up" or boosted. This is purely for calculation purposes and does not reflect the amount actually earned from a dividend.
Second, the shareholder pays taxes on the grossed-up amount at their progressive federal and provincial rate.
Third, the shareholder will be entitled to a dividend tax credit, equal to the gross-up amount, which reverses the artificial increase and ensures that the personal tax owed reflects the corporate tax that was paid.
Following our previous example, if the corporation had $800 to distribute as dividends, following the 20% corporate tax taken off from the $1,000 income, you, as the shareholder, would report $920 on your personal tax return, not $800. The dividend has been "grossed up" by $120 to mimic the corporation's pre-tax earnings. At a personal tax rate of 19.55% for any amounts $52,886 or less, $179.86 in taxes is owed.
However, the dividend tax credit (equal to the gross-up of $120) reduces personal tax liability and reverses the artificial increase the gross-up caused. Ultimately, $59.86 will be taxed.
Altogether, the Integration scheme results in the shareholder paying $59.86 in tax, as opposed to $156.40 without the Integration scheme. The tax payable will be lower than what an individual is likely to pay personally, thereby addressing the problem of double taxation and making incorporation a more enticing option for small Canadian business owners.
The Benefits of Paying Yourself through Dividends
Depending on the state of your business, paying yourself in dividends rather than by salary can help reduce your overall tax burden and leave more after-tax dollars in your pocket.
In addition to tax savings and reduced administrative burdens on your corporation, dividends can also be the most flexible option when withdrawing income from your business, if you have any profits.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
