Salary or Dividend - What's better for me and my business?

Salary or Dividends

This topic regularly comes up when meet with business owners. Most folks want to know how they can take money out of their company. There are a few ways – the two most common are in the form of salary or a dividend.

The following are the most common questions that we get asked about this subject:

· What is the difference between salary and a dividend?

· Does this affect my ability to apply for a loan?

· Which option will I pay less tax?

Before we get into these questions, lets understand how the different mechanisms work.

Payroll

Most of us have had a paycheque while working for a company. You get your paystub, you roll your eyes at the taxes being taken off (CPP, EI, and Income Tax), and the net amount gets deposited to your bank.

At the end of the year the company gives you a t4 and then you do your personal taxes.

Now, on the company payroll side, it gets a little bit more complicated. The company records your payroll as a salary expense on the books. This includes the amount paid to you plus the taxes the company withheld. Those taxes are then paid to the CRA on a regular basis and never held by the company. The CRA doesn’t like it if a company is late on paying the taxes they withheld from employees – it results in penalties and interest which we all want to avoid.

At year end, the company will tally up all the salary paid out which reduces net income thereby reducing the amount of corporate taxes the company owes.

Great!

The important point here to remember is that your company has paid taxes on the employees salaries. However, your company also saved some corporate taxes on the salary expenses it incurred.

Dividends

As a shareholder of the company, you are eligible to take a dividend(payment) of cash anytime and for any dollar amount throughout the year. Now, if you have multiple partners/shareholders, you will all have to agree to the $ amount of dividend as they are paid out based on the % amount each shareholder owns of the company.

Let’s say Fred, Bob and Rick each own 1/3 of a company - Fred, Bob and Rick must all agree to the $ amount of the total dividend as this amount of dividend will be split 1/3 amongst each shareholder.

A quick aside: Your corporation can have different classes of shares that can be allocated to the different shareholders. Each class of share can represent a different paying dividend structure (or non-paying). Something to keep in mind and discuss at the time of drafting the shareholder agreement when you are incorporating your company.

When a dividend is paid from the company, the cash comes from the earnings that have accumulated in the company after corporate taxes have been paid. This is also referred to as Retained Earnings as dividends reduce the retained earnings in your company. We go into more detail about retained earnings here as this concept can be confusing but very important to understand as a business owner.

Now doesn’t that result in double taxation you might ask after you add the dividends to your personal taxes in the year?

The answer here is no.

Dividends are taxed at a lower rate than salaries because the CRA is aware the funds taken out of the company have already been taxed. This way double taxation has been prevented.

Non-financial benefits - Salary

• RRSP – If you take a salary and pay income taxes, this will increase your RRSP contribution room. Dividends do not increase your ability to buy more RRSPs.

• CPP – As a salaried employee, you are required to pay CPP. The company must also match this CPP which is an increased expense to the company. However, this will contribute to your retirement CPP balance which might be worth it if retirement planning is a priority for you.

• Cash flow – Taking a salary is a more consistent cash outflow from your company as your company pays the salaries and then pays the taxes withheld to the CRA by the 15th of the following month. Dividends, on the other hand, can be paid out anytime during the year so there is flexibility on deciding when to take the money out.

• Tax Bills: Dividends will likely result in personal taxes owing after filing your personal tax return so it’s very important to have some money set aside for a tax bill around April if you’ve taken a dividend the year before.

• Loan applications (house/car/line of credit) – Banks prefer to see a consistent and predictable income stream when determining if they should loan you money. Dividends, on the other hand, get paid out once or a couple times a year. This infrequency is not looked at favorably by the banks and could make it harder to quality for a loan with only dividend income rather than salary.

• Having Children - If you plan on having children and plan to take time from work to raise your child, you can be eligible for parental benefits. It will be easier to apply for these benefits if you have received a salary prior to the child being born.

• Working Income Tax Benefit – The working income tax benefits is a fairly new credit that was created for families in the lower income tax bracket. If you pay yourself a small salary, this credit could be available on your personal taxes.

Non-financial benefits - Dividend

Paying dividends can be a simple way for you to take money from your company. Some key advantages include:

• CPP – As mentioned above, with dividends, you and your company don’t have to pay into the Canada Pension Plan (CPP). However, if CPP is part of your retirement planning, you may want to consider taking a mixture of Salary and Dividends each year.

• Planning – Paying a dividend has more planning opportunities – particularly if your company year-end does not fall on December 31. You can split a dividend up between two years to reduce a tax bill or pay it all out in one year if say you earned a lot in the other year. These are conversations you should have with your accountant as they can run some scenarios through your personal taxes and provide you with different options based on how much dividends to declare over the two years.

You made it this far – congrats! So do dividends result in me paying less tax?

We’ve listed this question down here again as I think it is more important to first understand and consider the issues before comparing various wage and dividend models for tax savings.

Often, the results of calculations show fairly minimal tax savings one way or another however we feel that there are other non-financial aspects mentioned above that can have a greater “value” to the business owner.

We find this topic as one of the more complicated aspects for a business owner to wrap their heads around. There are many complexities that can be quite overwhelming when you start going down the google wormhole.

The best thing to do would be to give us a call, and we would be happy to meet with you and discuss any questions you have about this topic, or anything else that is related to the financial well-being of your company.