Salary or Dividends?

Now that you've incorporated your business, you are going to need to decide how to pay yourself. As a shareholder of a Canadian Controlled Private Corporation, you have options as to how you can pay yourself. This means that you can decide what is best for you personally and for the long term plan of your business.

The common problem new business owners face is how to decide between a salary or dividends. To say one is better than the other would be inaccurate. In fact, both have pro's and both have con's. In order to truly determine what is most beneficial to you and your company, there are a number of different factors to consider.

Firstly, one of the most basic and fundamental parts of earning income is to save for your future, there are 2 different paths to take if you pay yourself a salary or dividends.

If you pay yourself a salary, you will be obligated to contribute to the Canada Pension Plan. As the company is your employer, you will be required to contribute the employer and employee portions of the Canada Pension Plan's annual contributions. This means that you will be potentially eligible to draw from the Canada Pension Plan at the age of 65 and receive a portion of what you contributed as income for your senior years.

If you pay yourself dividend payments you will not be contributing to the Canada Pension Plan. This means that you will not be able to draw the Canada Pension Plan annual income, however, you would be saving roughly $5,000 annually (based on max CPP insurable earnings). In lieu of contributing to the Canada Pension Plan, a corporation can use the annual savings from no CPP contributions and retain the income for future years. This means that once the corporation pays tax on the net income for the year, the additional monies left can be retained for future use. This is a good way to be in control of your pension contributions and have the ability to issue dividends as needed.

Secondly, the difference in tax implications if you pay yourself a salary or dividends can catch you off-guard if you're don't understand what is happening behind the scenes.

If you receive a salary, your personal income (including all deductions from your pay i.e. tax, CPP, etc) is used to reduce the net income of the company. This means that before the company pays tax on the income it generated throughout the year, it would reduce your salary from the income. This creates a significant benefit to the company as it would reduce the amount of taxes owing. As an employee, your tax and other obligatory remittances have already been paid to CRA before you get your paycheque.

If you pay yourself dividends, your income is not used to reduce the revenue of the company and is considered after-tax dollars. This means that the company receives no tax reduction from your dividends. In fact, dividends are the result of your company earning a profit. You can issue dividends out of the after-tax amount of earnings in a tax year. When you receive dividends, it is generally taxed more favorably than a salary which helps to reduce the amount owing on personal taxes based on the increase in the amount paid on the corporate taxes. The personal tax amounts owing will have to be paid in a lump-sum to CRA and may be subject to future installment payments for subsequent tax years.

Thirdly, there is a fundamental difference in the type of income you receive when you pay yourself a salary or dividends. The difference is that a salary is considered to be earned income to you personally whereas a dividend is a distribution from a corporation out of the profit from earned income of that corporation.

There are certain deductions that are only available to individuals who have earned income, some examples are RRSP and Childcare deductions. This means that only individuals with earned income are eligible to claim these deductions in order to reduce their income and ultimately the tax owing. Deductions are of the most beneficial claims to make on your personal tax as they reduce your income based on the value of your eligible deduction.

As a way to offset the loss in eligibility to claim certain deductions, there is a benefit called the Dividend Tax Credit. The Dividend Tax Credit helps to reduce your personal taxes based on the gross-up of your dividends received and tax paid on your income by the corporation. This reduction in tax can make a significant impact on your taxes, which can reduce your tax owing to $0 modest dividend incomes.

With all of this information in mind, the real answer to the question of whether to pay yourself a salary or dividends has little or nothing to do with saving on taxes - as we can see above, CRA has a system of integration which will balance the costs and benefits to individuals and corporations - rather it is a matter of the goals and long-term plan for you and your company. 

Take some time to set up a check list, a pro's and con's list and a budget to determine what works best for you. There is no right or wrong answer, only more or less beneficial ways to operate based on what your goals are.

Happy taxing!

MacLean Accounting