Paying yourself a salary or dividends is one of the most important business decisions to be made by business owners in Canada. Both of these alternatives have tax implications, advantages, and disadvantages that can greatly affect your personal and business finances.
Although salaries are controlled to a fixed income and will be useful towards RRSP and CPP benefits, dividends have the potential to introduce a more tax-efficient profit draw method.
Knowing the difference between salary vs. dividend in Canada and the dividend tax credit can assist you with decreasing your tax and increasing your income.
Let’s look at both and the strategic advantages.
Understanding Salary vs. Dividends
Salary: A Structured Approach
Paying yourself a salary means you receive regular payments, subject to standard payroll deductions. This includes:
- Canada Pension Plan (CPP) Contributions: Both employer and employee portions are deducted.
- Employment Insurance (EI) Premiums: Applicable unless you are a business owner with significant control.
- Income Tax Withholdings: Federal and provincial taxes are deducted at source.
Salaries are considered a business expense, reducing your corporation’s taxable income. Additionally, paying yourself a salary creates RRSP contribution room, enhancing your retirement savings potential.
Dividends: A Flexible Option
Dividends are payments made to shareholders from a corporation’s after-tax profits. They are not subject to CPP or EI deductions, providing immediate tax relief.
However, dividends do not generate RRSP contribution room and are paid from after-tax income, meaning the corporation has already paid tax on the earnings distributed as dividends.
Tax Implications in Canada
When deciding between salary and dividends, it’s important to understand the tax implications in Canada. Each method of payment has distinct tax treatments that can impact your personal tax obligations and overall financial strategy:
Salary Taxation
Salaries are taxed as regular employment income. The corporation deducts and remits federal and provincial income taxes, CPP, and EI premiums on your behalf. This method provides predictable tax withholdings and ensures compliance with tax obligations.
Dividend Taxation
Dividends are subject to a “gross-up” and a dividend tax credit:
- Gross-Up: For eligible dividends, the gross-up rate is 38%, and for non-eligible dividends, it’s 15%. This means if you receive $100 in eligible dividends, you must report $138 as income.
- Dividend Tax Credit: To offset the gross-up, you can claim a federal dividend tax credit. For eligible dividends, the credit is 15.0198% of the grossed-up amount.
This system aims to reduce the double taxation of corporate earnings. However, the actual tax rate on dividends varies by province and income level.
Strategic Considerations
When deciding whether to pay yourself a salary or dividends, it’s important to consider your business goals, financial needs, and tax situation. Each method offers unique advantages depending on your circumstances.
When to Choose Salary
- RRSP Contributions: If maximizing your RRSP contributions is a priority, a salary is beneficial as it creates contribution room.
- Loan Applications: Lenders often prefer salaried income when assessing loan applications, as it provides a stable income history.
- Consistent Income Needs: If you require a predictable income stream, a salary ensures regular payments.
When to Choose Dividends
- Tax Efficiency: If your corporation’s income is above the small business limit, dividends may be more tax-efficient due to the lower tax rates on eligible dividends.
- Flexibility: Dividends offer flexibility in timing and amount, allowing you to adjust distributions based on the corporation’s performance.
- No CPP/EI Contributions: If minimizing tax deductions is a goal, dividends do not require CPP or EI contributions.
Combining Salary and Dividends
Many business owners opt for a combination of salary and dividends to balance immediate income needs with long-term tax planning. For example, taking a base salary to cover personal expenses and supplementing with dividends to optimize tax efficiency. This approach allows for:
- Steady Income: A salary provides a consistent, predictable income stream, ensuring you have a reliable source of cash flow for day-to-day expenses such as mortgage payments, groceries, and personal bills.
- Tax Optimization: Dividends are often taxed at a lower rate than salary, which helps reduce your overall personal tax liability. By receiving part of your income through dividends, you can minimize the tax burden compared to relying solely on salary income.
- Retirement Savings: A salary allows you to contribute to CPP and RRSPs, helping build your retirement savings. By paying yourself a salary, you ensure you’re building up your pension plan and taking full advantage of RRSP contribution room.
- Flexible Compensation Structure: Combining both salary and dividends gives you flexibility in adjusting your overall compensation based on your company’s performance. If the business performs well, you can increase your dividend payout, and if cash flow is tighter, you can reduce it.
- Income Splitting Opportunities: Paying a salary allows for income splitting with family members, as you can pay a portion of the salary to your spouse or children, helping reduce the overall family tax burden, especially if they fall into a lower tax bracket.
- Avoiding Double Taxation on Salary: By using dividends, you avoid the double taxation effect that salary income may face at both the corporate level and personal level. The corporate taxes are already paid before the dividend distribution, reducing the burden.
- Increased Access to Tax Deductions: Drawing a salary increases your business’s deductible expenses as salary payments are considered a business expense for tax purposes. This helps reduce your corporation’s taxable income, further lowering your overall tax obligation.
- Build Business Credibility: Regular salary payments can improve your business credibility when applying for loans or attracting investors. Lenders often prefer consistent salary payments, which reflect a stable income history.
- Access to Employee Benefits: Paying yourself a salary can provide access to certain employee benefits such as group health insurance, disability insurance, and paid leave. These benefits are unavailable through dividends but can be vital for both business owners and employees.
- Avoiding Cash Flow Issues: By mixing both salary and dividends, you can better manage your business cash flow. When cash flow is lower, you can reduce dividend payouts and rely more on your salary to ensure financial stability.
- Better Loan and Credit Opportunities: If you rely solely on dividends, it can be harder to prove consistent income when applying for loans or credit. A salary ensures that you have steady income documentation, making it easier to qualify for personal loans, mortgages, and credit lines.
Conclusion
Deciding whether to pay yourself a salary or dividends depends on various factors, including your income level, tax situation, and financial goals. Consulting with a professional accountant can provide personalized advice tailored to your specific circumstances.
Remember, the optimal strategy may evolve as your business grows and your financial situation changes. Regularly reviewing your compensation strategy ensures it aligns with your current objectives and maximizes your financial benefits.
Maximize your business’s financial potential with Webtaxonline. Whether you’re looking for expert advice on salary vs. dividends, tax optimization, or business incorporation, our professional accountants are here to help.
FAQs
1. How much dividends can I pay myself in Canada?
You can pay yourself dividends based on the after-tax profits your corporation has. There is no specific cap, but the total amount must align with your ownership percentage in the company. It’s essential to ensure that your business has sufficient cash flow to maintain operations, and paying out too much in dividends can deplete business funds, affecting its growth potential.
2. Tax Implications in Canada for Salary vs. Dividends?
Salaries are taxed at personal income tax rates, with Canada Pension Plan (CPP) and Employment Insurance (EI) deductions. Dividends, however, benefit from a dividend tax credit, which reduces the tax burden. While salary payments are fully taxed at the individual rate, dividends are grossed up and taxed at a reduced rate, typically leading to overall tax savings.
3. Can I split income with family members using salary or dividends?
Yes, income splitting is possible with both salary and dividends. If family members work for the business, you can pay them a salary to reduce the family’s overall tax burden. Alternatively, you can distribute dividends to family members who own shares in the business, which allows you to use their lower tax brackets to reduce the family’s overall tax liability.
4. Is it possible to combine both salary and dividends for tax efficiency?
Yes, combining salary and dividends is a popular strategy. You can pay yourself a salary to meet your regular income needs, and dividends to reduce the overall tax burden. Salaries help with RRSP and CPP contributions, while dividends offer a more tax-efficient method of withdrawal, especially when your business is profitable.
5. How are dividends taxed in Canada for small business owners?
Dividends are taxed at a lower rate compared to salary income in Canada. For eligible dividends, the income is grossed up by 38%, and for non-eligible dividends, it’s grossed up by 15%. After the gross-up, a dividend tax credit is applied, which reduces the effective tax rate. Eligible dividends are taxed more favorably as they come from income that has already been taxed at the corporate level.