As a Canadian small business owner, should you pay yourself entirely through salary, entirely through dividends, or using a combination of the two? The answer, unfortunately, is, “it depends”.
In theory, the tax concept of integration says that there should be little to no overall difference in income tax paid when comparing dividend and salary payments of a roughly similar amount. In reality, however, dividends or salaries may be favourable depending on the specific tax legislation in the region where your small business is located.
This article will look at the benefits and complications of both options and help you understand when choosing a salary and when paying out dividends makes the most sense for your business.
What is a Salary?
A salary (or wage) is a fixed regular payment made by an employer to an employee. Salaries paid by a company must be recorded as payroll expenses by the company and as personal income by the individual who receives them.
The same principle applies when paying yourself a business salary through your own company. As such, the company would prepare a T4 (and RL-1 in Quebec) delivered to the employee and to the Canada Revenue Agency (CRA) for tax purposes (RL-1 is filed with Revenu Quebec).
What are the Benefits of Paying Yourself a Salary?
1. Reduces business taxes: The corporation’s taxes would decrease because the additional salary expense would drive down the taxable income of the corporation.
2. Automatic tax deductions: When drawing a salary from a company, the business owner also need not worry about surprise income tax bills because of the automatic tax deductions in biweekly or monthly payroll deposits. See our partner’s payroll calculator to learn about how payroll software can help ease this process.
3. Easily save for retirement: In addition to tax deductions, there are also CPP contributions (Canada Pension Plan or Quebec Pension Plan QPP in Quebec) that are automatically applied, which allow you to start saving early for retirement without having to think about it.
4. Additional RRSP room: Since the maximum Registered Retirement Savings Plan (RRSP) contribution is an annual percentage of earned income, business owners who pay themselves with salary are able to benefit from this.
5. Proof of consistent income: Banks love the salary remuneration method. If you’d like to apply for loans, mortgage, and other credit products for personal use, salaries help you do that because they are an indicator of balanced and sustained cash flows.
What to Consider
1. Despite the deductions in taxable income for the corporation, the salary you draw from the business must be reported to the CRA and is subject to the personal income tax rate (which will differ depending on how large the salary is). Often, gross personal taxes are higher than corporate taxes, especially for small businesses.
2. As a small business owner, you have to pay the CPP as both an employer and an employee.
3. In order to properly remunerate with salary, you must set up a payroll account with the CRA (and with Revenu Quebec for Quebec corporations). Missing any deadlines for filing and remittance can lead to penalties.
What are Dividends?
Dividends can be classified as investment income and refers to distribution of a portion of a company's profit to its shareholders. Remuneration using dividends does not reduce corporate taxes, but it does create less personal tax than salaries. Dividend income is thus taxed by the CRA at a corporate rate, not the personal tax rate. Because dividends are not a form of business expense like salaries, the company will have to complete a T5 form (and RL-3 for Quebec) for each shareholder receiving a dividend to declare the income.
What are the Benefits of Paying Yourself Dividends?
1. Less complicated: The process of paying yourself dividends is much easier than paying your salary. All that you must do is get approval for the dividend according to company bylaws, transfer funds from the corporate account to the business owner’s personal bank account and update the corporation’s books. The CRA has criteria for what constitutes an eligible dividend for corporations in Canada.
2. Annual reporting: If you are worried about keeping track of frequent filings, fear no more. The remuneration for dividends involves filing a T5 form which can be done at the same time as your tax return.
3. No set schedule: Dividends can be declared at any time! Unlike salary, they do not have to be doled out at biweekly or monthly intervals.
4. Extra savings: Money is saved by not paying into the CPP (twice if you are a business owner). You can choose to invest this in a retirement plan of your own choosing.
What to Consider
1. Dividends are not considered expenses (unlike salary expenses) and are therefore subject to corporate taxes. However, corporate tax rates are much lower than personal tax rates.
2. The more mature or developed the company structure is, the more difficult it becomes to remunerate with dividend payments because of the number of shareholders who would be eligible for dividends.
3. It becomes your responsibility as a business owner to save for your own retirement. Because dividends are considered 'investment income' and not 'earned income', you do not contribute to CPP, and will not benefit from the additional RRSP contribution room made available to those remunerated by salary.
4. Because banks value a source of “steady income,” it will be more difficult to establish a line of credit through dividend remuneration.
Conclusion
While there's no single "best" option applicable due to varying provincial and territorial tax regulations, doing an initial calculation and consulting with a professional can help you determine the right compensation strategy.
If you're still unsure about choosing salary vs. dividends in Canada, click here to book an appointment with our accountants at ReInvestWealth. We can provide guidance on how to set up an optimal remuneration strategy and streamline it with accounting software to help you save money and grow your business.
Written by: Shaan Hooey