If you run an incorporated business in Canada, then one of the trickier decisions that you will have to face at year-end is what to actually do with your company’s profit. Should you pay some of it out as a bonus, or should you leave it inside the corporation? This is what bonuses vs retained earnings all comes down to, and it’s a question that comes up quite often for owner-managers, especially as their business starts to grow.
The good news is that there isn’t a single right answer here. The best choice for you and your business really depends on your numbers, your goals, and how your business is doing this particular year. The team here at Strata-G has put together this guide to explain how it all works, so that you can make a confident and well-informed decision about bonuses vs retained earnings.
Understanding the Basics
Before we start talking about strategy, it helps to slow down for a second and get a good understanding about what we’re actually comparing here.
A bonus is extra compensation that your corporation pays out, usually to a shareholder-employee or an important team member, on top of their regular pay. Because it’s treated just like employment income, the corporation can deduct it as a business expense, and this is what helps reduce the company’s taxable income for the year. The flip side of this is that the person who receives it pays tax on it personally, just like they would on a salary or a dividend.
Retained earnings, on the other hand, are the profits that you choose to keep inside the corporation after corporate tax has been paid. Instead of paying that money out, you’re leaving it inside the business so that it can be reinvested, saved for a slower period, or used to help fund future growth. The money stays put and it keeps working for the company.
So when you look at bonuses vs retained earnings, the real question is whether it’s better to move profit out of the company now or to keep it inside for later
How Bonuses vs Retained Earnings Are Taxed
Taxes are usually the first thing on an owner’s mind here, and that’s completely understandable.
When you pay a bonus, the corporation gets to deduct that amount, so it lowers the company’s taxable income for the year. The trade-off is that the bonus is then taxed in the hands of the person who receives it, and that is at their personal rate. You’re shifting income from the corporation over to the individual.
When you retain earnings instead, the profit stays in the corporation and it’s taxed at the corporate rate. For a Canadian-controlled private corporation (CCPC), the first $500,000 of active business income is usually taxed at the lower small business rate, which is 9% federally plus a provincial rate on top, according to the CRA’s corporation tax rates. Anything above that business limit is taxed at the higher general rate, which is 15% federally. Because those corporate rates are often lower than personal rates, retaining earnings can let you defer some tax, at least for the time being.
The thing to remember is that this is mostly about timing. Money that stays in the company gets taxed once at the corporate level today, but it will usually face more tax later when it eventually comes out as a dividend or a bonus. So the bonuses vs retained earnings decision is really about when you want to pay tax, and at what rate.
The 180-Day Rule You Can't Ignore
If you do decide to pay a bonus, then there’s one rule that you really need to keep on your radar, and that’s the 180-day rule.
Here’s how it works. Your corporation can accrue a bonus at its fiscal year-end and claim the deduction in that year, even if the cash hasn’t actually gone out the door yet. But to keep that deduction, you have to pay the bonus within 180 days of your year-end. This comes from subsection 78(4) of the Income Tax Act. If you miss that window, then the CRA can deny the deduction for that year, and that means a bigger corporate tax bill and possibly some interest charges as well.
So if part of your year-end plan involves accruing a bonus, then it’s really important to mark that deadline and make sure that you pay it on time. This is one of those small details that can quickly undo an otherwise smart corporate tax planning strategy.
When Paying Bonuses Might Make More Sense
There are plenty of situations where paying a bonus is the smarter move in the bonuses vs retained earnings decision.
One of the most common is when your profit is about to push past the $500,000 small business limit. Income above that limit gets taxed at the higher general corporate rate, so paying a bonus can bring your taxable income back down and help you hang on to that lower small business rate. This is something that a lot of small business owners take advantage of.
Bonuses also make sense when you, or a team member, actually need the cash personally. If the money has to come out of the company anyway, then paying it as a deductible bonus is sometimes easier than leaving it to be taxed twice. On top of that, bonuses give you flexibility, because you can size them up or down each year based on how the business actually performed.
For these reasons, paying bonuses to shareholders or staff is a great strategy that many businesses depend on, and this is especially true during a strong, profitable year.
When Retaining Earnings Might Be the Better Option
Of course, keeping profit inside the company has its own set of advantages, and retaining earnings is often the right call when you’re focused on the long game.
The biggest one is tax deferral. Since corporate rates are usually lower than personal rates, leaving profit in the corporation means that you pay less tax today, and this frees up more cash that you can put to work growing your business. This is handy when you want to be reinvesting profits in your business, whether that’s buying some new equipment, hiring new employees, or building up a cushion to help get you through the slower months.
Retained earnings for small business owners can also act as a financial buffer. Having money inside the company makes it easier to handle surprises, fund your growth, or weather a downturn without feeling like you have to scramble to come up with extra money. And if you don’t personally need the cash right now, then there’s often no rush to pull it out and trigger personal tax on it.
In the bonuses vs retained earnings conversation, retaining earnings tends to win out when stability and steady growth are the priorities of the business.
Finding the Right Mix of Bonuses vs Retained Earnings
For a lot of business owners, the smartest answer isn’t all bonus or all retained earnings. Instead, it’s a strategic blend of the two.
A common approach is to retain enough profit to keep the business healthy and well-funded, and then to pay out a bonus to help manage your taxable income, especially if you’re sitting right around that $500,000 small business limit. This lets you take advantage of the lower corporate rate on the money you keep, while still moving some of your profits out in a more tax-efficient way.
The nice part about a blended approach is that it’s really flexible. You can adjust the mix every single year based on your profits, your cash needs, and the direction that the business is headed in. That’s exactly the kind of thing that thoughtful owner-manager compensation planning is built around.
Other Factors That Influence Your Decision
Choosing between bonuses vs retained earnings goes beyond just the tax considerations…there are a few other things that are worth keeping in mind.
Cash flow is a major one. If your income changes from year to year, then retaining earnings can give you a steadier base to work with, while bonuses let you respond better in a strong year. Your growth plans are important as well, because a business that is heavily reinvesting may want to keep more profit inside, whereas a more established one might be comfortable paying more out.
It’s also a smart idea to think about associated companies and passive investment income, since both of these can affect your access to the small business deduction. That is where a bit of planning ahead of time can really pay off, and it’s a good idea to revisit your approach as the business changes over time.
Common Mistakes to Avoid When Deciding Between Paying Bonuses vs Retained Earnings
When you’re thinking about this decision, there are a few common mistakes that are worth knowing about so you can steer around them.
The first is focusing only on this year’s tax bill and forgetting the bigger picture, because saving a little now can cost you a lot more later on if it doesn’t fit your long-term plan. The second is missing the 180-day deadline on an accrued bonus, which, as we already covered, can wipe out your deduction entirely. The third is forgetting about associated companies and passive income, both of which can shrink your small business deduction.
It also helps to remember that figuring out how to reduce corporate taxes in Canada isn’t a one-time event. What works this year might need to be tweaked next year, so it’s worth revisiting your plan on a regular basis.
So, What's the Best Option for Your Business?
There isn’t a one-size-fits-all answer here, and that’s actually good news! The right choice depends on your profit, your growth plans, where you sit relative to the small business limit, and how much cash you need outside the company. If you’re not sure where your business sits, then it helps to first understand how much a small business can earn before the tax picture really changes.
Plenty of owners land on a mix of both, and they continue to fine-tune it each year. What matters most is that you’re thinking and planning ahead with purpose, and have a good understanding of the tax timing and all of the deadlines involved. This is really what good year-end tax planning is all about, and it’s a decision that’s a whole lot easier to get right with a second set of eyes.
How Strata-G Can Help
Figuring out what to do with your company’s profit is one of those decisions that is a lot easier with an experienced partner in your corner, and that’s where Strata-G can help.
Strata-G is a Canadian virtual accounting firm that works with businesses, so corporate tax is what we focus on every day. We help owner-managers with corporate tax planning, payroll, bonus accruals, and the year-end strategy that ties it all together, so that you can keep more of your profit working for you and stay in compliance with the CRA.
If you’d like a clear, customized plan for how to handle your profit this year, then Strata-G is ready to help. Contact us today to get started, or learn more about our corporate accounting services.
