You’re a business owner and it’s that time of the month where your wallet should have a swell. So what’s it going to be? Are you taking home a salary (whoa you’re the boss! Salary?) Or a wad of dividends (that’s could be more like it!).
So as ‘bossy’ as it sounds, you need to make a deal with yourself. Paying yourself first is an important rule of business. And you need to make sure that no matter what it’s entitled to be called, your net compensation should be meeting your needs. So how do you determine what to choose?
Let’s dive in to check the pros and cons of each of the compensation methods.
In this type of compensation, you basically treat yourself as an employee and pay yourself a salary. All you would have to do is set up a payroll account with the CRA (Canada Revenue Agency) and process payroll. Salaries aren’t given from the profit of the business, but rather they are paid prior to the deduction of taxes. All salaries are subject to CPP, EI, withholding taxes that need to be remitted to CRA monthly.
- Registered Retirement Savings Plan (RRSP) contribution is based on previous years ‘earned income’. So, if you pay yourself a salary, you can contribute towards RRSP which ends up as an income tax deduction.
- Salary is a legally recognizable personal income. If your business needs financing as a line of credit or you would need a mortgage to buy a home; your paychecks, pay stubs and T4 tax slip can provide substantial proof of income.
- Canada Pension Plan (CPP) allows you to receive a pension once you attain sixty-five years of age. If you pay yourself a salary, only then can you remit to the CPP contributions.
- Setting up and paying salary brings in more administrative workload. You have to calculate the taxes, the CPP contribution, pay deductions at source on a monthly or quarterly basis. Late payments would end up causing penalties and interest.
- Pro Tip: Even if you don’t take a salary in a given month, you still need to file a nil return with CRA!
Dividends are paid from the profits your company earns. Each share in a given class is given the same dividend amount. The tax on the dividend is deducted at source by the company. Therefore, personal tax impact tends to be lower.
- Since dividends are paid after tax deductions, you don’t have as many administration taxes. A T5 return and withholding taxes are still required.
- If you do not have any other source of income, then dividends for just over $40,000 can be easily paid without having a personal federal tax liability.
- If you have a family, you could even split your income with them. They could hold shares directly in your company or via a family trust. Salaries are paid on the basis of the work of a person in the company. But your family member who is just above 18 years of age could be receiving dividends without having to do the work, thereby increasing your family income. Note: recent changes to shareholder participation makes this a little harder for small family-owned businesses where the shareholders are not active participants.
- Dividends are a strong source of income for a business owner. When you pay yourself in dividends, deductions like CPP contributions, income tax, RRSP, etc will not be deducted from the net amount paid to yourself. This also ensures a greater cash flow in the company because it is devoid of the compulsory deductions that are associated with salary payments.
- As dividends do not count as ‘earned income’, paying dividends instead of salary cannot make room for contributions towards RRSP in the following year. You would have to make other external arrangements towards your retirement savings.
- Being paid in dividends is not a proven income on papers to be able to apply for financing your personal credit needs.
- Since dividends are tax at source, the amount you may receive in the end may be almost similar to that of a salary.
So, What Shall It Be?
The system is designed so that ideally.. in a perfect world.. the net taxes paid under both options are the same at the end of your life. This is why a corporation is called a tax-deferral vehicle. The key is using the timing differences of the tax payments to make the most of your money and the return on your investments.
So how to decide? We need to have a conversation about your goals and needs to make the determination; the more the shareholders the more complex this decision-making process can be. You may have a family, or you may have a minimalistic lifestyle, or you may be intending to buy a home on a mortgage, or you may want to have secure retirement savings in place.
So to decide if you need to be taking home a salary or a dividend, you need to take a lot of factors into considerations. These factors play a crucial role in helping your decision in a way that may be a combination of both could be more appropriate in your case.
The best way to determine what works more profitable for you would be to discuss it with us, so we can look at all the aspects of your business and help you pay yourself in the best way. This is why for us, tax planning and financial planning, go hand in hand!