If you own a Canadian small business corporation, one of your first actions is to determine whether you want to pay yourself a salary income or dividends – or both. Though the correct decision for you comes down to personal circumstances, you should have an objective understanding of the advantages and disadvantages of each payment method. Pay special attention to your business and personal needs, especially as they relate to the Canada Pension Plan or your registered retirement savings plan.
What Are the Advantages and Disadvantages of Paying Yourself a Salary?
Although salary is taxed at a higher rate than dividends, there are several reasons to consider paying yourself a salary. For one, you receive a legally recognizable personal income. You can also use your salary to save for retirement through involuntary CPP and voluntary RRSP contributions. If you rely on forced retirement savings, it’s better to take a salary so you don’t fall behind on contributions.
However, you have to go through payroll processes if you pay yourself a salary, including setting up a payroll account with the Canada Revenue Agency (CRA). Paying yourself a salary also limits what you can do with your company’s cash flow.
Dividends: Advantages and Disadvantages
Compared to salary, dividends are clearly the more flexible payment option. Your external pension and retirement capabilities are really important when you choose the dividend route. Canadian business owners need to pay themselves $54,900 in salary to maximize their CPP benefit. The RRSP has a much higher threshold, at $144,500.
Dividends offer room for greater cash flow for the business, since dividends avoid mandatory retirement contribution rules. They’re a better option if you can manage retirement through non-traditional methods, since dividends don’t trigger CPP contributions or count towards RRSP contribution limits. However, if you only pay yourself in dividends, you have a harder time applying for non-business credit, such as a mortgage, because dividends don’t count toward your salary calculations on loan applications.
Mixing and Minimizing Taxes
If you want to minimize your tax exposure, you may want to balance several considerations and create your own blend of salary and dividend income. For example, you probably want to pay yourself enough salary to avoid the $500,000 small business limit. You can then pay out dividends as needed. Speak with a tax expert for additional guidance.
Using Your Spouse and Children to Reduce the Tax Burden
Suppose that you are a small business corporation owner and also the head of a family. You have three children, ages 20, 19, and 13. You can set up a family trust for all family members ages 18 and older (meaning the eldest two children qualify). Your family trust can legally become a shareholder of the corporation and receive dividends, and the family trust can then pay those dividends to the kids.
Come tax time, the recipients of the trust pay little or no taxes on dividend income thanks to exemptions and tax credits. These exemptions and credits start to fall off when the recipients earn other income during the year, so this technique is probably most useful for children who are in university.
Determining if you should pay yourself a salary or dividends is only one of thousands of important financial considerations when you run a small business. To help handle these issues, 4.3 million customers use QuickBooks. Join them today to help your business thrive for free.