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 of Paying Yourself a Salary?
- Receive legally recognizable personal income
- Easier to save for retirement through involuntary CPP and RRSP contributions
- Fewer surprise tax bills
- Easier to apply for bank loans and mortgages because you have record of consistent income
What are the Advantages of Paying Yourself Dividends?
- Avoid mandatory retirement contributions, mean more flexible cash flow for the business
- Less chance for payroll penalties
- Less tax payments
- Payment process is simple, no need to register for payroll and remittance
Taxes on Dividends
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.
Tax Treatment for 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.
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.
What Should You Pay Yourself?
As a small business owner, it’s essential to focus more on reinvesting money into your own business than taking a larger salary, especially in the early years of your business. Pay yourself enough to cover your basic living expenses. Consider creating a personal balance sheet that lists the items you need to pay each month, and then add up these expenses. Once you determine exactly how much money you need to live comfortably, make that amount your salary.
Another option is to take a percentage of revenue or net profit, and increase that percentage as revenues grow. For example, perhaps you decide to take 10% of revenue as salary up to $500,000, then 15% after. If your business earned $700,000 this year, you would pay yourself:
*($500,000 x 10%) + (($700,000 – $500,000) x 15%) = $50,000 + $30,000 = $80,000
Salary vs. an Hourly Wage
When you run your own company, the notion of hourly wages evaporates. As a small business owner, you might work longer hours, so paying yourself by the hour can get pretty costly. On the other hand, if you need help running your business and decide to hire staff members, it might be more economical to pay them by the hour. Try to minimize your overhead as much as possible until your net profits increase. As your business begins to grow, you can slowly add people to your team and pay them fair wages.
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, 5.6 million customers use QuickBooks. Join them today to help your business thrive for free.