When you own an incorporated business, you’re faced with the same choice as other shareholder/owners: should you pay yourself a salary or dividends? Both options have advantages and disadvantages, and the correct answer is usually a combination of both. It’s time to take a look at the benefits of paying yourself in dividends to help you decide.
What Is a Dividend and What Are the Benefits of Dividends?
A dividend is a right that is attached to shares that you own in a specific company. You don’t even have to work for the company to receive a dividend. All you need to do is own the shares. In contrast, a salary is related to actual work you put into the company. As such, you can declare your dividends where and when you decide to, pursuant to certain cash flow accounting tests. At your discretion, you can pay dividends on a regular schedule or an irregular one. This provides you with flexibility, and some planning is possible.
For example, you could choose to pay a dividend on January 1 rather than the previous December 31. In doing this, you would defer your personal taxes on the dividend by a full year.
Tax Treatment of Dividends
In theory, the income you earn through a company and the money you receive as dividends are taxed at about the same rate. This fiscal theory, known as the integration mechanism, works well on paper but not always in practice. Depending on the province in which you reside, your personal tax rate, the type of income earned by your company, and the company’s tax rate, there may be a real difference in practice. Before making a decision, sit down with your tax adviser and run some simulations to determine what works best for your specific case. Dividends, unlike salaries, are not subject to the payment of Canada Pension Plan contributions, employment insurance contributions, and other provincial payroll taxes. These amounts can have a significant impact on how much is left in your pocket at the end of the day and must be taken into consideration.
Tax Planning Using Dividends
Dividends can be a useful tool when planning for your personal and business taxes. Other than the deferral mentioned above, new businesses can take advantage of an interesting two-year deferral. New companies can lend funds interest-free to their shareholders for two years. For new companies, after two years, the amounts are deemed to be dividends. This means you can defer payment of your taxes for that period, helping with cash flow early on in the business. You want to make sure you set aside money to pay the taxes at the end of year two, because the bill might be quite high.
Other more complex planning can allow you to split your dividend income with members of your family through family trusts or shares with discretionary dividends. These useful structures are complex and should not be put in place without professional advice. As always, there is no single correct answer when determining if a salary or a dividend is the best way to pay yourself. You should consider every case on its own merits, but it is worth putting in the effort early on to avoid paying unnecessary taxes.
As a small business owner, you want to keep track of all your expenses, sales, payments, and other financial records. You can make it easier for yourself by storing everything in one location. Keep your books accurate and up to date automatically. Change the way you manage your finances now.