Understanding the tax implications of draws vs. salaries

A common mistake is to assume owner drawings are tax deductible. They're not, because the owner is using the money for personal purposes. When a business isn't incorporated, the owner pays tax on their net income through their personal tax return, so the money they take in draws will be taxed at that time.

The primary considerations for choosing between an owner's draw and a salary are the business structure and how the draws and salary are taxed. Owners who take a draw must pay income tax on their taxable business income, regardless of the amount withdrawn.

In contrast, salaries from incorporated businesses to shareholders are subject to payroll deductions such as Canada Pension Plan (CPP) contributions and income tax. The company is taxed on the income remaining in the company, and the shareholder is taxed on their wages via a T4-slip. 

Legal considerations

It's crucial to comply with Canadian business laws, which dictate that certain business structures, like corporations, must pay owners a salary if they work as directors or employees. Draws are not permissible as a form of compensation in these scenarios.

Your business structure largely determines whether you should pay yourself a draw or a salary. Sole proprietors and partners in partnerships can opt for draws without much complication, whereas shareholders of corporations are typically required to take a salary.

Consider your business's financial stability and your long-term objectives. A salary might be more stable and predictable, which can be beneficial for obtaining personal or business credit. Draws may offer more flexibility but require careful financial tracking and management.

To set up a salary, you'll need to register with the Canada Revenue Agency (CRA) for a payroll account and adhere to the regular remittance of payroll deductions. For draws, it's essential to keep accurate records to ensure that your personal and business finances are distinct, aiding in smoother tax filing.

How to pay yourself from your business

Deciding how to compensate yourself as a business owner is an important decision. The choice between an owner's draw and a salary can have significant implications for your tax responsibilities, your financial planning, and the structure of your business.

Consider Maria, a fictional Toronto-based entrepreneur who runs a boutique graphic design firm. Maria's business is registered as a sole proprietorship. She started her business two years ago and has seen steady growth in client projects.

Maria is contemplating whether to continue taking an owner’s draw or to incorporate her business and switch to a salary because she plans to continue to expand her business.

Option 1: Owner's draw

• Flexibility: Maria can withdraw funds as needed, which provides flexibility depending on the cash flow of the business.
• Tax implications: As a sole proprietor, all business income passes through her personal tax return. Maria will pay personal income tax and CPP (up to the annual maximum) on her business's total net income, regardless of the amount she takes in draws.
• Record-keeping: She must maintain meticulous records of all draws to ensure her personal and business finances are clearly delineated for tax purposes.

Option 2: Incorporating to take a salary

• Stability: Paying herself a regular salary could help Maria manage her personal finances better, as she will have a predictable income.
• Payroll obligations: If Maria decides to incorporate her business to start paying herself a salary, she will need to register for a payroll account with the CRA and adhere to payroll remittance schedules.
• Tax planning: With the corporation being taxed as a separate entity and Maria paying personal tax and CPP on her salary, this may provide opportunities around tax planning that Maria wouldn't have as a sole proprietor.

Given Maria's plans to expand and potentially restructure her business as a corporation, opting for a salary might align better with her goals. This change would not only simplify her personal financial planning, but also position her business favourably for future financing opportunities.

There can be additional costs associated with incorporating, so Maria should consult with a professional adviser to discuss the implications of changing her business structure and transitioning to a salary-based compensation system.

Deciding between an owner's draw and a salary involves understanding your business's legal structure, its financial state, and your personal needs. Let QuickBooks tools streamline your payroll management and financial tracking to enhance your business's financial health.