As a small business owner, one of the most pressing questions you may encounter is how to pay yourself from your corporation. You can choose between paying yourself a salary or taking dividends, each of which has its own set of advantages and disadvantages. Whether you’re looking to maximize your income, minimize your tax burden, or find a balance between the two, this guide will help you understand the nuances of salary vs. dividends.
Paying Yourself a Salary
Paying yourself a salary is similar to receiving a paycheck from an employer. It involves receiving regular payments, typically biweekly or monthly, which are subject to payroll deductions such as income tax, Canada Pension Plan (CPP), and Employment Insurance (EI) contributions. The amount you earn is reported via a T4 slip at the end of the fiscal year, which you will use for your personal tax return.
How Salary Works
When you pay yourself a salary, these payments count as an expense for the corporation, which reduces the taxable income of the business. Consequently, this also lowers the corporate taxes owed. Your earnings are taxed as employment income, which means you will receive various tax benefits and deductions associated with being an employee.
Advantages of Paying Yourself a Salary
There are several benefits to consider when opting for salary:
- Builds RRSP Contribution Room: Paying yourself a salary allows you to contribute to your Registered Retirement Savings Plan (RRSP), which is not possible with dividends.
- Predictable Tax Payments: Income tax is withheld from each paycheck, helping you avoid unexpected tax bills when filing your personal return.
- Contributes to CPP: Salary payments contribute to CPP, providing you with future retirement benefits.
- Qualifying for Mortgages: A steady salary can help you qualify for loans and mortgages, as banks prefer consistent income.
- Access to Government Subsidies: Certain subsidies and tax credits require proof of employment income, making salary payments beneficial.
Disadvantages of a Salary
- Higher CPP Contributions: Involves additional costs for CPP contributions.
- Fully Taxable Income: Salary is taxed at regular personal income tax rates.
- More Paperwork: Requires managing payroll, withholding deductions, and filing T4 slips.
How to Pay Yourself a Salary
To establish a salary, your corporation must register for a payroll account with the Canada Revenue Agency (CRA). This process involves withholding the necessary deductions from your pay and remitting them to the CRA. You must also file T4 slips at the end of the year for all employees, including yourself.
Paying Yourself Dividends
Dividends offer a straightforward way for small business owners to extract profits from their corporation. Unlike a salary, dividends are paid out of the company’s after-tax earnings and are not considered a business expense. This means they do not reduce the corporation’s taxable income.
How Dividends Work
When a company generates profits, it has the option to either reinvest those earnings back into the business or distribute them to its shareholders in the form of dividends. Dividends are typically calculated based on the shareholder’s ownership percentage in the company. These dividend payments come with specific tax implications that can be advantageous for the shareholders.
Advantages of Paying Yourself Dividends
Choosing dividends over salary has its own set of advantages:
- No CPP Contributions: You can avoid making mandatory contributions to the Canada Pension Plan, leading to short-term savings.
- Simplicity: The process of paying dividends is relatively straightforward, often involving a simple declaration and transfer of funds.
- Reduced Risk of Penalties: Since there are no payroll remittances, the risk of penalties for late payments is eliminated.
- Lower Tax Rates: Dividends are often taxed at a lower rate due to the dividend tax credit, offsetting the corporate taxes already paid.
Disadvantages of Dividends
- Not a Deductible Expense: Unlike a salary, dividends do not reduce the corporation’s taxable income.
- Not Personal Income: Dividends do not contribute to RRSP room or other personal benefits.
- Dependent on Company’s Financial Status: Dividend payments are made from the company’s after-tax profits and are therefore dependent on its profitability.
- Possible CRA Claims: The Canada Revenue Agency (CRA) may claim unpaid corporate taxes before dividends can be distributed to shareholders.
How to Pay Yourself Dividends
When paying dividends, you simply declare the amount and transfer it from the corporate account to your personal account. Each year, the corporation must file T5 slips for shareholders receiving dividends.
Impact of Corporate Structure on Salary vs. Dividends
1. Canadian-Controlled Private Corporation (CCPC)
- Tax Advantages: CCPCs benefit from preferential tax rates on the first $500,000 of active business income due to the Small Business Deduction (SBD). Paying yourself a salary can help maximize this deduction by reducing the corporation’s taxable income.
- Dividend Tax Credits: Dividends from a Canadian-controlled private corporation (CCPC) benefit from the dividend tax credit, reducing the personal tax burden. However, the overall tax rate on dividends might still be higher compared to the tax rates on small business income. A balanced approach using both salary and dividends may optimize tax efficiency.
- Income Splitting: CCPCs can issue dividends to shareholders, including family members, which might help with income splitting. This strategy can reduce the overall family tax burden but must adhere to Income Splitting rules.
2. Personal Services Business (PSB)
- Restrictions on Deductions: If your business is classified as a Personal Services Business (PSB), you face significant restrictions on allowable deductions, such as salaries and limited office expenses, which increases your taxable income. However, this structured approach can simplify tax compliance and reporting.
- Higher Corporate Tax Rates: PSBs do not qualify for the Small Business Deduction (SBD), meaning they are subject to higher tax rates. The federal tax rate for PSBs is around 33%, much higher than for other small businesses.
- Salary-Only Compensation: PSBs are required to pay a minimum salary to the shareholder-employee and cannot use dividends for compensation. This reduces flexibility in managing taxes, as dividends are not tax-efficient for PSBs due to additional penalties and restrictions.
- Avoiding PSB Classification: If possible, independent contractors should structure their business to avoid PSB classification. To do so, ensure your business meets CRA’s criteria for being a true independent contractor rather than an employee working through a corporation.
3. Non-Profit or Charitable Organizations
- Restrictions: Non-profit or charitable organizations cannot distribute dividends as they are not profit-driven. Compensation is typically managed through salaries or stipends, with specific regulations governing allowable compensation structures.
Comparing Salary and Dividends: Tax Implications
When deciding between paying yourself a salary or dividends from your corporation, it’s essential to consider how each option affects your taxes:
- Salary: Paying yourself a salary reduces your corporation’s taxable income because it is considered a business expense. However, this results in higher personal income taxes and additional costs such as Canada Pension Plan (CPP) contributions. This method provides predictable tax withholdings and contributions towards your retirement and other benefits.
- Dividends: Paying yourself dividends does not impact your corporation’s taxable income, as they are distributed from after-tax profits. While dividends can benefit from a lower personal tax rate due to the dividend tax credit, they do not contribute to CPP or help build RRSP room. Dividends are typically simpler to administer but may not provide the same tax benefits or retirement contributions as a salary.
Factors to Consider When Choosing Between Salary and Dividends
Choosing between salary and dividends depends on your individual circumstances, both personal and financial. Consider the following aspects:
- Do you want to build RRSP contribution room?
- Are you concerned about potential surprise tax bills?
- Do you want to contribute to CPP for retirement benefits?
- How will your choice affect your ability to secure loans or mortgages?
- Will your decision impact eligibility for government subsidies?
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