When to pay yourself extra from your corporation

The main benefit to most high-income professionals using a corporation is tax-deferred investing. In keeping with that, it is common advice to only take out the minimum from your corporation. Just enough to fund your personal spending and investments. That leaves more partially-taxed capital in the corporation to grow. You pay the rest of the tax later when you access it, but the money pile may be bigger. However, there are several situations when it may make sense to pay yourself extra money from your corporation. Even if you don’t need the money right now. What to Do With Excess Personal Cash Before considering whether to shift some money out of a corporation, you must consider where it is going to go. This post is about using opportunities to take money out of your corporation efficiently and put it to better use elsewhere. Here are a few ideas. Read: Pension basics for self-employed professionals and business owners Planned Upcoming Splurges Taking extra cash from the corporation that you don’t need this year sometimes makes financial sense. If you are planning a major spend in the next few years, and are not normally in the top tax bracket, then you could spread out the withdrawal over several years. That income smoothing helps to keep you in lower personal tax brackets. The excess personal cash could be parked in a number of ways until the big spend. If you do earn interest leading up to spending the cash. Then, tax integration of interest favors personal income versus flowing it through a corporation anyway. So, less tax getting it out and less tax on interest while waiting. Read: No overhead, less autonomy: CPSA releases guide for contract physicians Repaying Personal Debt If you have excess personal cash, then paying off personal debt like a line of credit is a good use. It is a risk-free tax-free return. It feels good. Plus, it gives your more financial wiggle room to deal with emergencies. If your mortgage is bothering you, then making a lump sum payment may be a good idea. First, make sure that you are allowed to make additional payments and that it reduces your interest paid. Also, be sure that it is not money you are going to need again soon. Generally, taking out extra money from a corporation just to repay personal debt is mathematically suboptimal. The interest rate must be very high (like >8%) to make up for the loss of tax-deferred investment growth. However, it is close and the mathematically optimal solution is very sensitive to future market returns, interest rates, and other unpredictable variables. So, I would personally go with what makes me most comfortable. However, if taking money out of the corporation anyway to keep it tax efficient, that is different. If efficiently moving money out, then this is a good use for it. Tax-Sheltered Investment Accounts If you have excess personal cash and your debt is at a comfortable level, then catching up on unused tax-sheltered investment accounts is a great use for it. An RRSP or FHSA can mean a fat tax refund while in a high personal tax bracket. A TFSA has tax-free growth and withdrawals. Both have no Canadian tax on investment income while corporate investment income is taxed. So, the growth rate of tax-sheltered investments will outpace investing through a corporation in the long run. The problem with those registered accounts is the limited contribution room. You have to have paid a salary for the RRSP room, but the contribution is functionally pre-tax due to the deduction. A TFSA requires after-tax personal cash and the contributions are limited. However, if you have room and money to invest – it is a no-brainer. Spending on something now instead of later. The preceding usages of excess cash are the most financially optimal. However, money is for spending. Either now or in the future. If your future security is well taken care of, then consider how you could spend the money now. There are ways to spend money that are more likely to bring you lasting happiness and satisfaction. It takes effort and skill to spend intentionally. If you don’t practice, it is often something that savers often struggle with later. Otherwise, donating money is an option too. Giving effectively has both mental and financial rewards. When To Pay Extra Dividends If your corporation has been making income on its investments, then it has also paid tax on that. Paid upfront and at high tax rates. Fortunately, some of that tax money collected is also tracked by corporate notional accounts. The money in those accounts is released by paying out dividends to shareholders. Like yourself. Most of the time, you will require enough money to live on that you’ll pay enough dividends to keep your corporation efficient at the same time. However, if you have a large corporate investment income and a low personal cost of living, then it can make sense to pay extra dividends. Tax-Free Opportunity To Move Money Out For realized capital gains, your corporation gets half of the gain added to its capital dividend account (CDA) balance. You can use a positive CDA balance to pay yourself a tax-free dividend after filing a special election. You wouldn’t want to harvest capital gains when you don’t need the money personally. However, if you have a CDA balance due to selling an asset, rebalancing your portfolio, or donating appreciated stock, then don’t let it go to waste sitting there. The main reason to not pay a capital dividend is if all of the corporate cash is tied up in investments that you would not want to hold personally or have a high transaction cost to sell and then re-buy personally. For example, real estate. The other possible reason to delay is if the CDA balance is too small to justify the accountant fees for filing a special election. Release More Tax Than You Pay The tax collected on dividend income received by the corporation is tracked in the refundable dividend tax on hand (RDTOH) accounts. For eligible dividends, all of the tax collected (eRDTOH) is refunded to the corporation when you pay enough eligible dividends. The personal taxable income level below which the corp refund is more than the personal tax is shown for each province below. Only part of the tax is refundable from paying enough ineligible dividends to release nRDTOH due to corporate interest or foreign dividend income. Either way, if the refund to the corporation is more than the personal taxes paid on the dividend. Then, it often makes sense to pay the dividend. Release the Buying-Power Before It Erodes The net of the corporate refund minus personal dividend tax means less net tax in the current year below the above personal income levels. Plus, the buying power of the money tracked by those notional accounts erodes with inflation. So, taking advantage of them now is better than later. That is why my algorithm for paying salary vs dividends prioritizes clearing these accounts out before salary. Salary When You Don’t Need The Money The complexity of the decision balancing GRIP, dividends, and salary is why I built the CCPC Income Dispenser to automate it. It uses the algorithm shown below. Early on in your career, it is likely that you will have very little investment income in your corporation and require very small dividends to release all of the RDTOH. That means salary to make up the difference. Those who didn’t get their brains scrambled by trying to decipher the above decision tree may have noticed that there may also be situations when it makes sense to pay some salary from a corporation when you don’t need the personal money. Down at the very bottom. That could be a salary to the owner and/or a low-income spouse. Most commonly, it would be to a low-income spouse. It is only at very low personal income levels that personal taxes are lower than corporate. The higher-income spouse in a corporation will likely need to take some dividends, bumping their taxable income. Income-splitting using dividends with a spouse is also tougher to meet the criteria for. So, some salary and dividends to the active owner and then salary to a lower-income inactive shareholder spouse would be the most common situation. However, it could also be efficient to pay out more money than you currently need if you have a very low cost of living or a high corporate tax rate. Corporate active income above the small business threshold is taxed at the higher general corporate tax rate. For either situation, paying some extra salary if the personal marginal tax rate is less than the corporate tax rate. Even if you don’t need the personal cash. This often confuses people. In fact, I made some mistakes with it in the original version of this post and corrected them after some feedback on Financial Wisdom Forum. There are some really knowledge people on there and I appreciate their quality control. Even after working with this stuff for several years, I still make the occasional rookie mistake. When Personal Tax is Less Than Corporate The combined Federal and provincial corporate tax rates are shown in the table below. As you can see, they range from 9% in Manitoba to 17% in Quebec for corporations with access to the small business deduction. When paying excess salary means less tax than leaving it in a small business. Those small business rates are lower than the lowest tax marginal tax rate. One of the errors that I made when first thinking about this is neglecting the spousal tax credit. Even if you have a spouse with no personal income, giving them a salary would reduce the spousal tax credit for the higher-income spouse. So, beyond the basic personal amount ($15K), it would be at a ~20% tax rate for each new dollar. It is pretty hard to have a realistic situation where the personal tax rate is lower and you don’t use at least that minimum personal amount to live on. When Tax on Salary Is Less Than The General Corporate Tax Rate Just to be clear, the algorithm earlier in the article prioritizes paying enough dividends to release the money in the most valuable corporate notional accounts (CDA & RDTOH) first. Then some salary, or sometimes eligible dividends if there is leftover GRIP, to make up to meet spending needs. This nuance of personal versus corporate tax would only come into play as a consideration if you (or a spouse employed by the corporation) have a low taxable income after doing that. The general corporate tax rate is higher than some personal marginal tax rates. For Ontario, it is 26.5%. It is as high as 31% in some provinces. For most provinces, the personal tax rate is lower up to incomes of ~$53K. Again, it could make sense to pay that personal tax and move that money out of the corporation at that income level. There are a few exceptions to the $53K estimate based on the province’s corp and personal rates. Alberta actually has a general corporate rate below their lowest personal rate! Could that really happen? These situations are not common. However, they are common enough that I have been asked about them. So, I know they exist. This could be a useful way to income split in a corporation that has income over the SBD limits if both spouses are active enough in the corporation to get moderate market rate salaries. Some dividends could be used to clear out the RDTOH and then equal salaries to make the taxable incomes $54K for each partner. That may be more money than a low-spending couple needs. However, it is more tax efficient than leaving money in the corporation. Both in terms of lower current-year taxes and growing a smaller tax liability in the corporation for later. It could also be useful for a business owner without access to the small business deduction and a low cost of living. For example, Quebec has extra hoops to jump through for the SBD and other professionals may have to share their SBD with other partners in a group practice. If they only need $60-70K to live on, they may still want to take money out of the corporation as long as their personal tax rate is less than the general corporate rate. Another time where this could come into play is if there is high corporate investment income, but no dividend splitting with a spouse. The spouse may work for the corporation, but not pass the 20h/wk test. In that case, it is possible that the dividends that the high-income spouse needs to take to clear the corporate notional accounts are enough to cover their cost of living. However, paying the low-income spouse a salary may still be a lower tax rate than the corporate rate. They could then invest their income to earn more investment income at their low personal rate moving forward. Without running afoul of the attribution rules. Summary Rules of thumb are attractive because they are simple and easy. However, optimally using a corporation is complex. You are hopefully using a good accountant to help you. Even then, you must know some of what is happening to make sure that you get your money’s worth. The best plan for you rather than the rules of thumb. For compensating yourself, paying enough dividends to release refundable taxes, then salary to make up a personal cash shortfall is a good rule of thumb. So is taking advantage of corporate tax deferral by not taking out extra. However, this post describes times when you may want to take out some extra money from your corporation. Plus, ideas of how to better deploy it. Hopefully, if these situations apply to you, then you can bring them up with your accountant. Even this post is general in nature and there are nuances. If you don’t know, then it is a sign that you should find out. The Loonie Doctor is a Canadian physician. The content in this article is for general illustrative and entertainment purposes only. The Loonie Doctor tries to be accurate and complete, but cannot provide a guarantee or warranty to that effect. It is recommended that you seek professional help if needed for your individual financial decisions.

When to pay yourself extra from your corporation

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