Should You Put Your Severance Pay Into a Corporation to Cut Taxes?

This is a common and sensible question. When you receive severance or salary continuance, it’s important to understand how those payments are taxed and when a corporation can genuinely reduce or defer tax on income and investments.

How is a lump-sum severance taxed?

A lump-sum severance payment is typically a number of weeks’ pay calculated based on factors such as your length of service, age and seniority. Employers may also factor in other considerations when setting severance amounts.

At the time of payment, withholding tax on a lump-sum severance is often a flat rate (frequently shown at about 30%). However, the amount withheld at source does not determine your final tax liability. When you file your tax return, that severance is combined with your other income and taxed according to your marginal tax rate. If the severance is large or you already have high income, you could face significantly more tax owing when you file—often many percentage points above the initial withholding.

Related reading: How to avoid tax on severance pay

How is salary continuance taxed?

Salary continuance means your employer keeps paying your regular salary for a set period after your employment ends. These payments are treated like regular payroll: tax is withheld in the same way as during employment, and the withholding is generally aligned with the tax you will ultimately owe, subject to other income, deductions and credits you report on your return.

How does a corporation save tax?

Corporations can be powerful tax-deferral tools, but their benefits depend on the type of income and how the funds are used. The clearest advantage for small businesses is on active business income: if a corporation earns business profits and you leave those profits in the corporation instead of withdrawing them personally, the corporate tax rate on that income can be substantially lower than personal top marginal rates.

Depending on the province or territory, the small business tax rate on qualifying active business income can be in the range of roughly 9% to 12%. That lower rate lets a business owner retain more after-tax dollars inside the corporation to reinvest or grow the business. However, when you eventually take money out of the corporation for personal use (for example as dividends), there is additional personal tax to pay.

The key point for severance is this: severance and other employment income are reported on a T4 as employment income. Simply transferring that severance payment into a corporation or having it paid to a corporation does not convert employment income into corporate active business income. Because the income’s character does not change, using a corporation will not eliminate or reduce the immediate tax liability on the severance itself.

Does putting money into a corporation to invest save tax?

Investment income earned inside a corporation is generally taxed at rates comparable to high personal marginal rates in many provinces and territories. That means holding personal savings inside a corporation purely to earn investment income often produces similar or even greater total tax than investing personally.

People do use holding companies as part of an overall tax-efficient structure, but typically those strategies rely on earning active business income at the lower small business corporate rate and then leaving that profit inside the company to invest. Business owners commonly operate an active company and use a separate investment holding company to move after-tax business profits into an investment vehicle. But if you simply deposit personal severance or savings into a corporation to invest, you normally won’t reduce the tax you pay on investment returns.

How can you save tax on a severance?

If your goal is to reduce the tax payable on severance, there are two practical, commonly available options.

First, contribute to your registered retirement savings plan (RRSP). You may be able to have some or all of your severance transferred directly into your RRSP without withholding tax. Contributing to an RRSP reduces your taxable income and therefore the tax you owe, though keep in mind this is effectively receiving the tax benefit now rather than later—your RRSP contribution reduces tax this year, and you will face tax when you withdraw the funds in retirement.

Second, discuss timing with your employer. If the severance payment is scheduled late in the calendar year, your employer might agree to defer part or all of the payment to the following year. Deferring creates a timing benefit by pushing the tax hit into the next tax year, which can be useful if you expect lower income or better tax circumstances the following year. In some cases, employers may spread severance payments over multiple years, though that is less common and depends on employer policy and agreement.

Summary

A corporation can be an effective vehicle for tax deferral and reduction, particularly for qualifying active business income that can be retained and invested inside the company at lower small business rates. However, severance and salary continuance are employment income and do not become corporate active business income merely by moving the money into a corporation. Likewise, investing personal savings inside a corporation will generally not lower tax on investment income. If you want to reduce tax on severance, consider RRSP contributions or negotiating timing of payments with your employer.