You might be both an investor and an employee of your business. Whether to take a salary or a dividend from your business tends to be a crucial decision for business owners.
Whether to take a salary or a dividend tends to be a complex and challenging decision involving your business and personal finances. Your decision must be the best for your personal and business tax situation.
The goal of tax laws in Canada is to create a system where there would not be a difference in the amount of taxes owed, whether the owner is taking a salary or a dividend. However, because of the complexity of this decision, there can be differences in practice. Plus, there might be non-monetary aspects to consider when making this decision.
We can go through the mechanics of taking a salary or dividend from your business. Then we will focus on some critical considerations before you decide whether you want to take a salary or a dividend from your company.
A salary is a recurring compensation payment to an employee in a business.
The salary payment is an expense or a write-off of the company’s income. Therefore, the salary is a source of earned compensation for the business owner.
When a company pays a salary, it must register for payroll and withhold income taxes from you, even if you are the business owner.
A dividend is a payment from the company to its shareholders from after-tax profit. Dividends are paid after tax to investors and owners of the company from the profit the company makes.
Dividend payments are a straightforward administrative process—a simple payment from the company to the owner.
Advantages of a Salary:
Lower corporate income tax
Salaries are an expense to the company. Dividends, on the other hand, are paid with after-tax profits. Therefore, a salary increases expenses, lowering the company’s net and taxable income. In addition, the owner is responsible for their taxes. Thus, the business’s taxable income will be lower when the owner receives a salary.
It can help you save for your retirement.
Salary is referred to as earned income, making it easier for the business owner to save for retirement through involuntary contributions to the CPP. Earned income, such as a salary, is employment income, which builds room in the RRSP. RRSP contributions can be a part of your retirement plans and offer additional taxable benefits.
Automatic deductions make for fewer surprise tax bills.
The company must deduct payroll taxes and remit them to the CRA before paying a salary to the owner. As a result, the business owner will likely have no surprise taxes due at the end of the year if they receive a salary instead of a dividend.
Easier to qualify for personal loans and mortgages
If the business owner is looking to buy a house and apply for bank loans and mortgages, banks may view a salary more favourably as a consistent record of income.
When a company pays a salary, it has to register a payroll account, issue a T4 and make remittances to the CRA for payroll taxes. The extra work can be an administrative burden for small businesses, adding more work to their plate.
Salaries are typically regular payments, and there are remittances to the government. If a business goes through periods of tight cash flow, this can be an added source of stress on the business’s finances.
Advantages of taking a Dividend
The payment process is simple; there is no need to register for payroll, nor are any withholding or remittances made to the CRA.
Dividend payments can be arbitrary. However, they don’t need to be scheduled and offer more flexibility to help the business manage cash flow.
A dividend is not an expense to the company. Instead, the business will pay dividends from after-tax income. Therefore, when a business pays its owners through a dividend, it will have a higher taxable income when compared to paying the owner through a salary.
While the company is paying dividends, the owner has to include the dividends as income in their tax return. Therefore, the dividend payment is subject to taxes for the owner. Consequently, they will have to set aside a portion of the dividend payments to pay their taxes when due.
RRSP and CPP contribution rooms do not increase with dividend payments. Therefore, if an owner wants to save for retirement, the business owner must make a retirement plan rather than rely on government programs such as RRSP and CPP.
If you own a business but are looking to take out a personal loan or mortgage, it can be harder to show proof of income. Since dividends are voluntary payments, lenders and banks may not consider them proof of income. Furthermore, many tax benefits and credits require proof of employment income, such as the Child Tax Credit. If the only source of income is dividends, you will not be eligible for such government programs.
For many, from a financial standpoint, this can be a close decision. For example, there may be virtually no difference between your combined personal and business taxes, no matter which option you choose between a salary and a dividend. In other cases, after running the numbers, there may be a clear winner between the two options.
However, some non-financial considerations, such as retirement planning or access to loans and mortgages, may affect your decision.
If you’re trying to decide between taking a salary or dividend from your business, it can help to sit down with a tax or business advisor. They can help you run the scenarios based on your business and personal finances so you can make an informed decision.
Contact KSSP Partners LLP in Markham for all your Tax Planning Needs
Talk to an experienced Canadian tax professional to optimize your tax situation. At KSSP Partners LLP, our business and tax advisors can provide personalized tax planning advice for your personal and business taxes. To learn more about how KSSP Partners LLP can provide you with the best tax planning expertise, contact us online or by telephone at 289-554-5997.