Keeping money in the corporation

You’re a sole, small business owner. Your corporation is making a profit. Should you keep the profits that exceed your living expenses inside the corporation, or pay it to yourself?

If you pay yourself, the money will be immediately taxed according to your personal income tax bracket.

If the money remains in the corporation beyond the end of the tax year, the principal will be taxed at a much lower rate (the Canadian Controlled Private Corporation tax rate). If the money is invested, any interest it may yield will be taxed at a much higher rate (the small business deduction is not applicable on passive income). But since the principal you invested is more substantial, would it be better to defer paying income tax and keep it invested inside the company?

While investment income inside a corporation is taxed at a high rate, some of the tax (26.67% of the investment income) is refundable once dividends are paid to the shareholders. The corporation keeps track on the available refund with an on-paper “Refundable Dividend Tax on Hand” (RDTOH) account. Amounts in the RDTOH account are refundable to the corporation when a dividend is paid at the rate of $1 of refund for every $3 of dividends paid.

While you can expect to get some tax refunded, you cannot earn compounded interest on the funds inside this account.

So lets crunch the numbers. In year 0 the company made a profit of $100. In model A the money was kept in the corporation for a specified number years, earning invesment income, and then paid to the shareholder as dividends, refund included. In model B the money was immediately paid as dividends to the shareholder, and invested with the same rate of return. All applicable taxes are deducted.

Below is the chart for BC, 2016. You can edit the variables according to the applicable rates in your province and year, and the expected rate of return on your investment.1

% BC Combined Federal+Provincial tax rate for a CCPC (Canadian Controlled Private Corporation) in 2016

% BC Combined Federal+Provincial coporate tax rate on investment income in 2016

Personal Income bracket

% BC Combined Federal+Provincial personal income marginal tax rate

% BC Combined Federal+Provincial marginal tax rate on non-eligible Canadian dividends

% Refundable Dividend Tax On Hand

% Interest rate

Year After corporate tax RDTOH account Model A Model B Difference
0 0
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5
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10

Note:2 In the long term, for a company with ongoing profits, given there’s no difference in the overall taxation whether the company owner is paid by salary or by dividends (see my previous post!), the owner may be better off paying themselves a salary (and enough dividends to recover the RDTOH), to create RRSP contribution room. Then, should they decide to liqiudate the company, they’ll be able to shelter some money in an RRSP, rather than having it all taxed at the highest possible rate.

Paying the shareholder a combination of salary and dividends would bring forth tax-free CPP contributions, as well as the possibility of RRSP and TFSA tax shelters. Even without factoring these tax advantages into model B, the two models seem comparable, at least for some combinations of tax brackets and interest rates.

1 The model assumes the rates are fixed for the duration of the simulation. However, in real life rates may change.
2 I’m not an accountant. Your feedback is welcomed.

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