IMPORTANT NOTICE: Professional medical corporation information on MD’s web site is based on existing incorporation rules which may be impacted by proposals announced in the Department of Finance’s policy paper entitled “Tax Planning Using Private Corporations.” MD is monitoring these proposals and we will update our tax planning strategies accordingly should rules change. For more details, please read MD’s blog Tax Planning Using Private Corporations, What’s Next: A Summary of Finance Announcements.
One of the challenges for incorporated physicians is deciding whether to be compensated by salary, dividends or a combination of both. In the past, most physicians chose the salary option, supplemented by dividends.
However, a number of physicians use dividends as their primary compensation method. The following information will help you decide which strategy works best for you.
To help you determine whether salary and/or dividends may be the right choice for you, consider the following six factors:
- Current tax: Our tax system aims for “integration,” meaning the total tax payable should be the same regardless of whether you draw salary or dividends. However, integration is not always perfect and there can be a minor tax advantage or cost to earning income through a corporation (both for income from your medical practice and for investment income).
- Investment tax: There can be gaps between the tax a corporation pays on investment income and the tax that would be paid by an individual earning investment income directly at the top tax bracket, especially if the individual’s investment income is no longer tax sheltered.
- Tax upon withdrawal: No active business income effectively equals no salary. Even if there is still some active business income, the most effective mechanism for the withdrawal of retained earnings from prior years and/or investment income is dividends.
- Factoring in additional provincial variations: Typically, physicians use their professional corporation as a savings vehicle, and the current and investment tax gaps can both have an impact on its tax efficiency. This varies considerably by province. Read more about provincial variations.
- Adjusting for personal preferences: Every financial situation is unique and requires unique advice. There are many personal factors—purpose, time frame, need for income, capacity for risk—that can significantly impact the chances that either salary or dividends are the better option.
- Lifestyle and risk management considerations: Salary comes with extra diversification “benefits” like RRSP room and access to the Canada Pension Plan. However, since these take up cash flow greater than their tax savings, sometimes minimizing current tax can have lifestyle consequences if you don’t have access to enough cash. If short-term needs require you to withdraw all your savings, this could negatively impact your retirement plan. In addition, from a risk management perspective, it would be better to leave enough money to allow for reasonable debt levels and ensure that you have adequate insurance coverage.
Additional information and guidelines
Preferences often evolve: Typically, a physician who is just starting to save money in a corporation cares most about current tax, while someone who has already accumulated substantial corporate savings is more concerned about investment tax.
Accumulation and withdrawal phases: Even where there is an orientation to salary while accumulating funds, dividends are often used to supplement income, especially where corporate investment income creates refundable corporate tax or low-tax payment options. If you have no active business income, then typically there’s no salary. If some active business income remains, dividends are still the most effective way to withdraw retained earnings from prior years or investment income. Dividends are often the only good choice in retirement, and may be the only choice if the owner/shareholder is not performing company-related services that would reasonably warrant a salary.
Income splitting: Income splitting is a current tax strategy that further complicates the decision related to salary versus dividends. There is a reasonableness test to income split using salary, which Canada Revenue Agency enacts to ensure the income splitting of salary is not intended to evade taxation, that does not apply to dividends. Converting compensation received by the physician to dividends received by the spouse (who must be a shareholder in the corporation) could result in significant tax savings. Income splitting can be ideal to enhance corporate savings or reduce future tax; it should not be done, however, at the expense of risk management or retirement planning considerations.
Current lifestyle: Dividends do not create RRSP room nor do they allow you to pay into pensions like the CPP or QPP. For 2017, maximum RRSP room is $26,010, and employer and employee CPP/QPP contributions are capped at $5,128.20 and $5,594.40 respectively. If the focus is spending more now, eliminating RRSPs and CPP/QPP through a dividend strategy can add significantly to the current lifestyle. Add a spouse to the equation and the ramifications likely increase.
Remember, drawing down your savings can have a negative impact on your retirement, so manage your spending and debt levels carefully. For most physicians, a reduction in CPP/QPP contributions would reduce CPP/QPP benefits.
Tax exempt beats integration: Neither RRSP nor CPP/QPP contributions are subject to current tax or investment tax prior to withdrawal. This creates an advantage even more favourable than retaining and investing all surplus funds within the corporation.
Timing considerations caused by a combination of salary, RRSP and dividends: While the mechanisms are different for corporate assets derived from active income and passive income, in both cases credit is given for tax already paid by the corporation when it is paid out personally. With active income, dividend tax credits reduce personal tax. With passive income, both dividend tax credits and notional account refunds are in play. Generally speaking, drawing from your corporation in retirement results in less tax than drawing funds from your RRSP because the corporate portion of the tax has already been paid.
This strategy often rightly results in drawing from one’s corporation first and delaying RRSP withdrawals. Having only corporate savings isn’t necessarily better from a future tax perspective. Dividends can result in greater problems with Old Age Security (OAS) clawback as they must be grossed up when included in taxable income, and the higher amount impacts OAS clawback thresholds. It is possible for an RRSP to get “too big”; in other words, saving a little bit of current tax can result in paying more future tax and/or OAS clawback.
Your MD Advisor can work with you to develop and review various scenarios, looking at the pros and cons for each strategy.