I Want to Get Paid!
One of the basic purposes of any business is to generate a sufficient profit to allow the owner to pay their personal bills. The joy of owning your own business is the ability to control how you take that compensation.
If your business is unincorporated, there is no magic to how you pay yourself. What ever is left over after paying your bills is available to you for your use and to pay your taxes. The simplicity of a proprietorship is that all profits (Sales less Expenses), during the calendar year, are taxable to the owner. You do not pay yourself a salary or designate your draws as other than draws from the business.
Within the calculation of taxes on your personal tax return, is a calculation of the CPP. You pay the employee and employer portion of CPP on the profits of the business. The profits also give you RRSP eligibility, as they are considered to be earned income.
You can pay your spouse or children a salary for work done in the business. You should keep careful record of the work done and pay them only what you would pay an outsider for the same work.
There are actually three ways that corporations can reward those connected with it. The method depends on the role of the individual. Although it may be the same person being rewarded for each role, it is important to distinguish each role and method of payment.
One of the major advantages of a corporation is the ability to select the most tax advantageous way of compensating yourself. It also allows the owner to plan the lowest tax paying strategy between the individual and the corporation and even the timing of payments to maximize tax savings.
If you lend money to a corporation, you are entitled to a reasonable return for your investment. Often in a one-person company, the loans are considered to be interest free, as the interest income to the individual is investment income, not RRSP eligible, and inflexible in the amount paid. (Based on interest rate and amount lent).
The advantage to the corporation is that the interest is a tax-deductible expense.
However, there can be good reasons to pay interest.
- A loan from a relative or friend outside of the ownership group.
- A corporation with multiple owners, but not all equally contributing loans to the company. The interest recognizes the risk and contribution of the lender.
- Rewarding a passive owner of the corporation for monies lent to the company.
Yes, the owner is also an employee of the company, as the company is a separate entity from the individual. As with any employee, the amount of compensation is based on fair reward for work done. As with the proprietorship, this applies to all family members.
There are two methods of paying the owner/employee.
Salary can be paid, with the regular deductions, as with any other employee. The only difference is the owner of more than 40% of the shares is exempt from paying EI.
It is best to put the owner on salary if the company is profitable, the amount paid is regular and especially if the ownership does not all work in the business. This recognizes the work done, versus the investment in the business.
Salary is a tax deduction to the company, and is earned income to the employee, thus allowing the owner to contribute to RRSP and CPP. The decision as to the amount of salary is often, at least partly, driven by RRSP considerations.
Management fees are paid when the amount of compensation is irregular, not known until the year end of the company is done and the decision as to the amount and type of compensation is unknown until the corporate taxes are completed. They too are RRSP eligible, however taxes are paid on filing the personal tax return or through personal quarterly tax instalments. They are often used at the start of a business when cash flow and profitability are unknown.
The owners of the shares of the company are compensated through dividends rather than salary or fees. They are compensated for their investment in the company and not the work done for the company. This is an important distinction and the reason why the structuring of the company is so important. Family members who do no work for the company can still be compensated if they are owners of the company. This can allow the tax adviser to effectively plan for greater tax minimization through effective income splitting.
Dividends are paid from the corporation’s after tax income. (The small business rate in Alberta Corporations is 18%, meaning that profits taxed in the corporation are taxed lower than in the owners hands.) They are therefore not a tax-deductible expense of the company. They are considered to be investment income of the owner and not subject to CPP or RRSP eligibility. However, because they are paid from tax paid income of the corporation, they are subject to a lower tax in the hands of an individual. In fact, they are tax free up to $25,000, IF the individual has no other personal income.
The goal for most owners is to minimize their tax bill, taking into account the corporate tax and personal tax paid. Using the three methods of compensation, business owners can reduce, defer and effectively plan a lower tax environment than proprietors, giving them more money to invest and grow their business and more control over their personal finances and retirement plans.