As the owner of an incorporated small business in Ontario, you may wonder which is the best method for paying yourself for optimal taxation benefits and profitability: salary or dividends?
Salaries and dividends are the two ways a business owner can be compensated in Canada. You can choose one type of compensation or the other, or even combine them both. In each case, there are pros and cons to consider.
The T2inc business tax accountants explain the differences between salaries and dividends, and provide tips on choosing the right payment type for you. Keep reading to learn how to make the most of the time and money you have invested in your Ontario small business.
What is the difference between a salary and a dividend?
For taxation purposes, a salary is an expense for your corporation, and income to you as an individual.
A dividend is a payment made out of company income. A minimum amount of company income must be declared before any dividends can be distributed.
What is a salary?
A salary is a fixed amount of money paid to an employee by an employer in exchange for the work they perform. It is typically expressed as an annual or monthly amount but is often paid out in regular intervals, such as weekly, bi-weekly, or monthly.
A salary is usually stated before any deductions, such as taxes and other withholdings, are taken out. A salary typically remains consistent regardless of the number of hours worked in a pay period.
Payroll calculations can be a time-consuming and complex task. You should always keep your corporate documentation up to date and produce a monthly schedule that shows your gross salary and CRA remittances. Remember that you can always rely on the help of business tax accountants for year-round bookkeeping services.
What is a dividend?
A dividend is a payment made by a corporation to its shareholders as a distribution of after-tax profits or earnings. When a company generates a profit, it can allocate a portion of these earnings to shareholders as dividends.
Dividends are usually paid out on a regular basis, such as quarterly, semi-annually, or annually, depending on the company's policy. The amount of the dividend payment is determined by the company's board of directors and is often expressed on a per-share basis.
An incorporated company can pay dividends of any amount they choose, as long as the payments do not bankrupt the company. Under corporate law, a company owing a large bank loan has to ensure that it retains enough assets (real estate, investments, money, etc.) to repay the loan before paying a dividend.
Dividends are a way for shareholders to participate in the company's financial success and share in its profits. The decision to pay dividends is ultimately determined by a company's management and its financial strategy.
Pros and cons of paying a salary
As an Ontario small business owner, you may decide to pay yourself a salary, which is your legal right as an individual providing services on behalf of your company. Let’s take a look at the advantages and disadvantages of paying yourself a salary:
Pros of salaries
There are three good reasons to pay yourself a salary.
- A salary allows you to contribute to a retirement account: By earning a salary you will be paying into the Canada Pension Plan (CPP), allowing you to receive retirement benefits based on how long and how much you contributed throughout our working life. Pension plan payments must be paid monthly to the Canada Revenue Agency.
- A salary or bonus is a tax deduction for your corporation: When your incorporated business pays you a salary, that amount will be a tax deduction for the corporation. Tax deductions lower the total amount of taxable income your business must declare for a single fiscal year.
- A salary gives you a personal income: When you pay yourself a personal income, you can make the most of your earnings by splitting your income amongst related employees such as a spouse or children. This can be a beneficial solution for owners of family businesses in Ontario.
Cons of salaries
There are also a few disadvantages to paying yourself a salary.
- Your personal income is 100% taxable: A salary is 100% taxable, which could increase your personal tax load.
- Your Canada Pension Plan payments will increase: If you pay yourself a salary, you will be obliged to pay into the CPP both as an employer and an employee.
- You will be responsible for completing more paperwork: When you pay yourself a salary, you will have to set up a payroll account with the Canada Revenue Agency and prepare all relevant paperwork. Remember that you can lighten the burden of day-to-day accounting responsibilities with the help of a business accountant.
Pros and cons of paying dividends
If their business is incorporated, Ontario small business owners can also choose to pay themselves dividends. Keep in mind there are three types of dividends and tax regulations differ for each type: eligible dividends, non-eligible dividends and capital dividends.
Let’s take a look at the advantages and disadvantages of paying yourself dividends:
Pros of dividends
There are four good reasons to pay yourself dividends:
- Capital dividends are taxed at lower rates: You do not need to pay as much personal tax on dividends as on a salary. If your company pays you capital dividends, this money will be completely tax-free, since capital dividends are procured from the non-taxable 50% of a company’s capital gains.
- Dividends can be paid at any time: Since dividends can be paid at any time, unlike a salary, you can optimize your tax situation by choosing an opportune moment to give yourself a dividend payment.
- Paying dividends is simple: To pay yourself a dividend, just write yourself a check from your corporation. At the end of the year, update your company’s minute book and prepare a director’s resolution indicating the dividends paid. Companies are obliged to pay their taxes before distributing any remaining amounts in the form of dividends.
- You do not have to pay into the CPP: While a portion of your salary will have to be paid to the Canada Pension Plan, earnings in the form of dividends do not have this requirement. Depending on your retirement financial plan, this could be a better choice for allocating your business earnings.
Cons of dividends
Paying yourself dividends can also involve several disadvantages, depending on your personal financial situation and goals:
- Some types of dividends are taxable: You need to pay personal tax on eligible and non-eligible dividends. The tax rate on eligible dividends is lower than on non-eligible dividends.
- You will not be contributing to the CPP: Keep in mind that you may want to make CPP payments even if you pay yourself dividends, depending on your long-term retirement plans.
- Dividends are not income: Since dividends are not income, they do not allow you to contribute to an RRSP or other type of investment.
- You cannot claim personal income tax deductions: Dividends are not paid as income, therefore you cannot apply personal income tax deductions to money received in this way. Note that Personal Services Businesses pay a higher tax rate and are not likely to benefit from a dividend pay strategy.
Paying both salary and dividends
If it earns under $500,000, a CCPC (Canadian-controlled private corporation) pays income tax at a much lower rate, calculated according to varying provincial tax regulations. To arrange their financial reporting so that their corporation does not earn above the small business limit in Canada ($500,000), some Ontario small business owners may choose to pay themselves a combination of salary and dividends.
When choosing to pay yourself a combination of salary and dividends, you need to consider several important factors:
- Your income level
- Your cash flow needs
- Your personal need to invest in as RRSP or take advantage of personal tax deductions
- Your age
- Your projected annual earnings
By consulting a professional business taxation accountant, you can be certain of having the information you need to choose the right payment method for your unique situation.
T2inc accountants are ready to help you choose between salary and dividends
When deciding how to pay yourself as an Ontario small business owner, there are many factors to consider. There are advantages and disadvantages to each method of paying yourself and your family members.
Whether you choose salary or dividends, your allocated earnings can affect both your business and personal finances. Taxation differences among provinces can also further complicate the issue.
Contact the tax accountants at T2inc to get answers to your questions about paying yourself as a small business owner. Whether you need assistance on a regular basis or are looking for professional corporate tax software come tax season, we’re ready to help!