Not every dollar you earn is the same. When taxes are involved, a dollar of income could be worth as little as 50 cents when it reaches your hands. An important factor in determining the amount of cash that reaches your pocket is the type of income you receive. The different types of income include:
Marginal tax rates in highest tax bracket
Salaries 49.53%DividendsNon-eligible 40.13%Eligible 33.82%Capital Gains 24.76%
SalariesSalaries are payments to an employee for services rendered. Your professional corporation (PC) incurs an expense and the employee receives the income. Compared to other types of income, salaries have the highest tax rate in the employee’s hands.
Benefits of salaries:
Income deferral: Corporate taxes can be deferred by declaring a bonus. The PC gets a deduction immediately, while the bonus including payroll deductions do not have to be paid until 179 days later.RRSP Contribution room: RRSP room is created when you have “earned income” which includes salaries but not interest, dividends or capital gains. For 2014, the maximum RRSP contribution room is reached when your previous year’s salary is approximately $140,000.Canada Pension Plan (CPP): CPP is calculated based on pensionable earnings which includes salaries but not interest, dividends or capital gains. If you wish to contribute to CPP and be eligible for CPP benefits in the future, you will need to receive salaries. For 2014, the maximum CPP contribution is reached when your salary is $52,500.$10,000 employee death benefit: As an employee, you can designate family members to receive $10,000 from the PC tax-free upon your deathChild care expenses: Deductions for child care expenses can only be claimed if you have earned income and you are the lower income spouse.
Caveats of salaries:
Payroll deductions are required to be withheld from every pay cheque.Salaries paid to family members must be reasonable (i.e. comparable to what a stranger would be paid); otherwise CRA could disallow the salary deduction. This would result in taxes for your family member but no deduction for the PC (i.e. double taxation).Employer Health Tax (EHT) is required when total gross payroll (including payments to casual labour but not independent contractors) exceeds $450,000 in a year.
DIVIDENDSDividends are payments to shareholders from funds available in the PC after paying corporate taxes. Your PC does not receive a deduction for dividends paid, but the shareholder reports the dividends received as income. Since the PC paid corporate taxes on these dividends, the shareholder gets a special tax credit which reduces the effective tax rate on the dividends received. See Table 1 for an illustration of the differences between how salaries and dividends work.
Benefits of dividends:
Simple: No payroll deductions; write a cheque to the shareholder for the dividendIncome splitting: Dividends are fully discretionary. No test for reasonableness.No EHT: Dividends are not subject to EHT
Caveats of dividends:
No RRSP room is created with dividendsNot eligible to contribute to CPPNo $10,000 tax-free benefit to loved ones upon deathNo child care expenses may be claimed
TABLE 1.
TABLE 2.
CAPITAL GAINSCapital gains arise from the sale of capital property (i.e. your PC shares, stocks, bonds, real estate and other assets). Historically, the tax laws have given capital gains favourable tax treatment over other forms of income. Both the principal residence exemption on the sale of your house and the $800,000 lifetime capital gains exemption on the sale of qualifying small business shares (i.e. your PC shares) are examples of such preferred treatment. Only 50 per cent of capital gains outside of these two exemptions are included in taxable income, the remaining 50 per cent is tax-free.Here are some ways to take advantage of this favourable tax treatment.
1) Purchase your dental building: Instead of issuing dividends, purchase your dental building and use the accumulated profits in your PC to pay down the mortgage on your dental building. You save on rent, secure your lease premise and can sell the building in the future for a capital gain.2) Pay down debt: When you sell shares, you sell both the assets and liabilities of the corporation. Any liabilities remaining as of the date of sale reduces both your proceeds/selling price and capital gains. If you pay down debt instead of issuing dividends to yourself, you maximize the proceeds and capital gains upon sale while minimizing dividends.3) RRSP investment mix: All withdrawals from an RRSP plan are 100 per cent taxable even if the investment income earned is a capital gain. Consider speaking to your investment advisor about the appropriate mix of growth-oriented and fixed income investments held in both your registered and non-registered investment accounts.
CONCLUSION:Understanding the types of income will help you maximize the amount of dollars that reaches your pocket. Each form has its purpose and when used effectively, the 50 cents in your pocket may just turn into a dollar. This concludes our DENTIST Approach to Tax Planning series. In using our approach, we hope you understand that while tax planning may not be easy, it doesn’t have to be scary.
