How to Pay Yourself as a Canadian Small Business Owner: Salary or Dividends?

Small business owners often ask me how they should pay themselves –  Salary or dividends? In other words, they want to know what the most tax-efficient method of extracting profit from their own companies is. Today we are going to answer this question. This article will discuss the pros and cons of receiving a salary versus dividends and some important non-tax considerations.

In discussing this issue, we first need to understand the concept of tax integration. Regardless of how you pay yourself (in salary or dividends) the net income after all tax should be the same. In other words, no matter how you take the money out of your corporation, you must pay the same amount of tax. This is what the CRA wants to achieve in general.

(source: Advisor.ca)

To better explain this concept, let’s take a look at this example:

Mr. Johnson is a small business owner who owns a profitable corporation in Ontario. Whenever he pays himself, he has a headache because he does not know what the best way is to take money out of his corporation – salary or dividends? Suppose he is taxed at the highest marginal tax rate. In this example, we consider only corporate tax and personal tax and ignore all other taxes such as CPP, EI, and workers’ compensation insurance. He is planning to pay himself $1,000. Let’s see whether one method is more tax-efficient than another.

As can be seen from the picture above, no matter how you pay yourself, the net income after all tax is very similar. The theory is really good, but in practice, we have a lot of room for optimization. Let’s further compare the pros and cons of salary and dividends.

Salary:

Pros:

1. CPP contribution is required; therefore, you can receive a pension as early as age 60.
2. Salary counts towards “earned income.” RRSP contribution room is created.
3. When a small business owner applies for a loan or credit, salary is a better proof of income than dividends.
4. Currently, many Canadian-controlled private companies (CCPCs) use a Small Business Deduction (SBD) to reduce corporate tax rates on their active business income. The SBD limit is $500,000. The salary paid out will be a tax deduction for a corporation. If the corporate income is over the limit, you might want to pay yourself enough salary to bring your corporate income below $500,000.

Cons:

1. You have to set up a Payroll account with the CRA and file the paperwork. There is an additional administrative cost associated with this.
2. CPP contribution is required. Many small business owners consider the CPP a disadvantage because they have to pay extra taxes to the government.

Dividends:

Pros:

1. Dividends can be distributed according to the needs of shareholders. You can choose when to declare dividends and therefore possibly defer your taxes.
2. No need to pay the payroll tax to the government, less administrative cost.
3. No need to contribute to the CPP.

Cons:

1. Without CPP, shareholders need to invest by themselves to prepare for retirement.
2. Dividends do not count towards “earned income.” RRSP contribution room is not created.
3. Eliminate other personal income tax deduction opportunities. For example, child care expenses can be used to deduct salary, but not dividends.

In conclusion, whether to pay yourself in salary or dividends completely depends on your personal financial circumstances. Each has its own advantages and disadvantages.  Some important non-tax implications also need to be considered. For example: what is the profitability of your company? What are your cash flow needs? What are your company’s expected earnings next year? Do you need CPP and RRSP? How old are you? Do you have children? You will need to discuss these factors in detail with your accounting and financial advisors to develop a suitable plan. Finally, it should be emphasized that salary and dividends are not necessarily mutually exclusive. You can pay yourself a mix of salary and dividends to maximize tax efficiency.

Small business owner retirement strategy

From the above example, we can see that regardless of salary or dividends, taxes are inevitable. However, if you don’t need to use the money right now, we have better a strategy to help you save taxes, which is to use the company’s retained earnings to purchase permanent life insurance. Corporate-owned life insurance is a tax-effective savings vehicle. The investment returns of the policy can qualify you for preferential tax treatments. In some cases, you can transfer income, completely tax-free, from a corporation to an individual through a Capital Dividend Account (CDA).

If you want to know more about corporate-owned life insurance,  please check out How to Accumulate Wealth Through Corporate-owned Life Insurance?

Disclaimer

All content on this site is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the site constitutes professional, legal, tax, investment, financial, insurance or other advice, nor does any information on the site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. For more information, please visit ApexLife.ca.