How can you lower your personal income tax? And what should you consider when deciding how to pay yourself?
A salary is a regular fixed payment to an individual, usually paid on a biweekly basis and expressed as an annual sum. As personal income, salaries incur payroll source deductions including monthly CPP contributions and income tax deductions. They also create more RRSP contribution room, which is calculated as a percentage of annual personal income.
If you are self-employed, you will report your gross revenues and net income on Form T2125 (Statement of Business or Professional Activities) at tax time. The net amount is viewed as your salary and you are responsible to pay income tax and CPP deductions on this amount.
If you are incorporated, you can be paid a salary by your corporation.
Reducing Tax on Salary Income
RRSP contributions are one of the most advantageous strategies for tax minimization and long-term retirement planning. Each contribution can be used to reduce your annual taxable income.
For example, if you made $50,000 in salary in 2014 and made no RRSP contributions, you would be taxed on the full $50,000. But if you contributed $10,000 to an RRSP, your taxable income would only be $40,000 — you would not pay tax on the $10,000 until withdrawal from your RRSP.
Some employees are eligible to deduct specific employment expenses from their taxable income. This is often done when an employee needs to travel a lot between work locations, including house calls. This strategy requires the employer to sign Form T2200 (Declaration of Conditions of Employment), certifying that the expenses paid by the employee are required within the terms of employment.
A signed Form T2200 gives the employee the ability to use Form T777 (Statement of Employment Expenses) to deduct their expenses from their taxable income on a dollar-by-dollar basis. Some potentially eligible expenses include a home office, cell phone or travel expenses.
Since Form T777 is so useful for reducing tax, it is usually scrutinized by the CRA. If you plan to use this route, OCA members are advised to contact OCA Advantages partner SRJ Chartered Accountants or another accountant first for more information. Please also note that a signed Form T2200 does not guarantee that the employee’s expenses will be deductible. Eligibility to deduct expenses is governed by the CRA.
Tuition credits are non-refundable tax credits that can be used to reduce personal income tax. These credits are available for tuition, education amounts and textbooks. To receive these tax credits, you must have a Form T2202A from your school. If you have used your tuition credits to reduce your income tax to zero and you still have credits left over, you can carry any unused amounts forward indefinitely or transfer up to $5,000 in credits to a parent, grandparent, spouse or common-law partner.
If you are incorporated, you can pay yourself and your shareholders through dividends.
Dividends are considered investment income, rather than personal income.
They incur no payroll source deductions — no monthly CPP or income tax deductions. However, because dividends do not count as personal income, they do not generate RRSP contribution room and they are not eligible for personal tax credits such as childcare expense deductions, medical expense deductions and other GST credits.
Dividend Tax Credits
By paying yourself in dividends, you can take advantage of dividend tax credits which can reduce or even eliminate your personal income tax burden.
Dividends are paid out from the aftertax profit of the corporation. Because the corporation has already paid tax on this money, the government does not tax the shareholder for the full amount again.
The CRA has come up with a confusing but powerful strategy to mitigate the tax burden on dividends.
When you report dividend income on your tax return, you go through three extra steps, as shown in the following example.
|RRSP contributions reduce tax on salaries, and salaries create more RRSP contribution room. Salaries incur payroll source deductions (CPP, income tax deductions).||RRSP contributions do not reduce tax on dividends, and|
dividends create no RRSP contribution room. Dividends incur
no payroll source deductions.
|By requiring contributions to CPP, salaries help you to plan for retirement. If you have a corporation, it must pay the|
employer portion of CPP on salaries.
|Dividends may not contribute to CPP, limiting your retirement CPP income. If you have a corporation, it does not pay an employer portion of CPP on dividends.|
|Salaries are eligible for personal income tax credits such as child care expense deductions and medical expenses.||Dividends are not eligible for personal income tax credits.|
|Corporations issue a T4 for each salary. This can involve a lot of paperwork.||Corporations issue a T5 for dividends. This is much less|
cumbersome to prepare than a T4.
|Corporations can reduce their taxes by paying out salaries.|
This lowers the corporation’s net income and taxes owed.
|Corporations do not reduce their net income nor their tax|
burden by paying out dividends.
|Salaries always incur personal income tax.||Below a limit, dividends do not incur personal income tax.|
Dr. Lee’s only income in 2014 was $30,000 in dividends. On her 2014 tax return:
- She “grossed up” the dividend by multiplying it by 1.18. This gave her a total taxable income of $35,400 — approximately the amount her corporation had in the bank before paying tax on the original sum.
- She incurred approximately $7,456 in provincial and federal taxes on this grossed up amount.
- She received approximately $7,591 in tax credits from federal and provincial dividend tax credits (acknowledging the taxes already paid by her corporation) and basic personal amounts.
Because she incurred more credits than taxes, she owed zero tax on her personal tax return. Tax credits are not tax refunds, so the government did not issue Dr. Lee a refund.
Dr. Silva’s only income in 2014 was $60,000 in dividends and he did owe tax. His higher income pushed him into a higher marginal tax bracket, so he incurred more taxes than credits.
Tax can also be incurred if you receive a combination of incomes such as salary, rental properties and other income generators that are not eligible for the dividend tax credit.
The rates for the gross up and dividend tax credits can change each year. OCA members are advised to contact an accountant about this strategy.
The OCA would like to thank Rishabh Khamesra of SRJ Chartered Professional Accountants (SRJ) for his assistance with this article. Learn more about the OCA’s partnership with SRJ.
Please note that this article is not a legal document. It is provided as a general overview and is not to be treated as legal or tax advice or relied on as the basis for any decision-making with regards to your practice. OCA members are strongly encouraged to seek independent advice from their legal or tax advisers regarding income tax.
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Tax Planning – Dividends & Salaries
Article from ON Chiropractic – Issue: Fall 2015