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What happens from a tax perspective at retirement time for the sole-owner/employee of a Corporation versus Sole-Proprietorship?

In the case of a Corporation, I assume that the owner pulls money from the Corporation to pay for his/her retirement and, as such, pays income tax.

In the case of a Sole-Proprietorship, I assume that the owner pulls money from his/her personal investment accounts and as such pays no tax (for TFSA), capital gains (for non-registered investments) and income tax (for RRSP).

  1. Does this mean that Sole-Proprietorships are more tax-efficient at retirement time than Corporations?
  2. Is there a more tax-efficient way to proceed (especially for Corporations) than the strategy I've outlined above?
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  1. Not really, no. The assumption you're making—withdrawals from a corporation are subject to "[ordinary] income tax"—is simplistic. "Income tax" encompasses many taxes, some more benign than others, owing to credits and exemptions based on the kind of income.

    Moreover, the choices you listed as benefits in the sole-proprietor case—the RRSP, the TFSA, and capital gains treatment for non-registered investments—all remain open to the owner of a small corporation ... the RRSP to the extent that the owner has received salary to create contribution room. A corporation can even, at some expense, establish a defined benefit (DB) pension plan and exceed individual RRSP contribution limits.

  2. Yes, there is a more tax-efficient way for small business owners to benefit when it comes time to retirement. Here is an outline of two things I'm aware of:

A. Dividends are Good, and Deferrable.

If your retirement withdrawals from your Canadian small business corporation would constitute withdrawal from the corporation's retained earnings (profits), i.e. income to the corporation that had already been subject to corporate income tax in prior years, then the corporation is able to declare such distributions as dividends and issue you a T5 slip (Statement of Investment Income) instead of a T4 slip (Statement of Remuneration Paid).

Dividends received by Canadian residents from Canadian corporations benefit from the Dividend Tax Credit (DTC), which substantially increases the amount of income you can receive without incurring income tax. See TaxTips.ca - Non-eligible (small business) dividend tax credit (DTC). Quote:

For a single individual with no income other than taxable Canadian dividends which are eligible for the small business dividend tax credit, in 2014 approximately $35,551 [...] could be earned before any federal* taxes were payable.

* Provincial DTCs vary, and so combined federal/provincial maximums vary. See here.

If you're wondering about "non-eligible" vs. "eligible": private small business corporation dividends are generally considered non-eligible for the best DTC benefit—but they get some benefit—while a large public corporation's dividends would generally be considered eligible.

Eligible/non-eligible has to do with the corporation's own income tax rates; since Canadian small businesses already get a big tax break that large companies don't enjoy, the DTC for small businesses isn't as good as the DTC for public company dividends.

Finally, even if there is hardly any same-year income tax advantage in taking dividends over salary from an active small business corporation (when you factor in both the income tax paid by the corporation and the individual), dividends still allow a business owner to smooth his income over time, which can result in a lower lifetime average tax rate.

B. Capital Gains ... Even Better.

So you can use your business as a retained earnings piggy bank to spin off dividends that attract less tax than ordinary income.

But! ... if you can convince somebody to buy your business from you, then you can benefit from the lifetime capital gains exemption of up to $800,000 on qualifying small business shares. i.e. you can receive up to $800K tax-free on the sale of your small business shares.

This lifetime capital gains exemption is a big carrot—designed, I believe, to incentivize Canadian entrepreneurs to develop going-concern businesses that have value beyond their own time in the business. This means building things that would make your business worth buying, e.g. a valued brand or product, a customer base, intellectual property, etc.

Of course, there are details and conditions with all of what I described, and I am not an accountant, so please consult a qualified, conflict-free professional if you need advice specific to your situation.

  • "Dividends are Good" this is no longer true. See cibc.com/ca/pdf/small-business/… page 3. As of 2014, it is not really beneficial to pay out dividends (unless you operate out of Nova Scotia, which I do not). Meaning, the extra mental and financial overhead of incorporation is not worth the sub-1% you get back in some provinces. – Gili Feb 19 '15 at 19:07
  • Regarding your second point (selling the business) it's a good idea in general but I'm a programming consultant and in practice I don't see why anyone would want to buy such a business (it has no assets). If you have any good ideas on how to structure such a business for sale, I'm all ears. – Gili Feb 19 '15 at 19:08
  • @Gili You are asking about the case for retirement, not how to pay yourself compensation from a corporation while you are still working [a different issue]. If you have been saving excess earnings within the corporation, then it certainly makes sense to pay those retained earnings out as dividends because they are already after-corporate-tax money. Does that make sense? As to your second point, you're right, but developing some intellectual property (software) that has value might make a business attractive for a buyer; that's just one possibility. – Chris W. Rea Feb 19 '15 at 20:35
  • @Gili p.s. On whether an owner should draw salary vs. dividends in any given active business year, and even though the same-year tax benefit of dividends has been mostly neutralized, taking dividends still has two advantages: (1) you can smooth your personal income and pay less tax at the higher marginal rates, and (2) you can avoid paying excess CPP contributions (9.9% for self employed, up to YMPE) by choosing dividends over salary. The CPP benefit calculation ends up dropping your 8 lowest earning years anyway.. – Chris W. Rea Feb 19 '15 at 20:56
  • @Gili p.p.s. Re: issue (1), consider an example: A small business corp. has revenue of $500K/year for 3 years, then nothing thereafter. An owner in that situation would be far better off drawing some salary in years 1-3, paying small business income tax rates on the profits, and then drawing dividends in years 4 onward, rather than paying out all corporate revenues as salary and being taxed personally at the highest marginal rate on most of it. In theory, retaining earnings to draw as dividends in retirement is similar; the overall average tax rate across years can be lower. – Chris W. Rea Feb 19 '15 at 21:02

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