Salary vs Dividends for Canadian Business Owners
Running your own business comes with many rewards and advantages, not only from an administrative perspective but from a financial one as well. However, it also comes with some essential considerations to ensure the health of your business.
One of the key decisions you’ll face as a business owner is how to pay yourself. Ideally, there are two typical models to keep in mind here, which are salary and dividends.
Each has its own set of advantages and disadvantages that can impact your taxes, retirement planning, and overall financial security.
To help you understand the difference between the two and choose the best approach for your situation, we’ll break down these key differences in today’s article.
What Is a Salary?
A salary is a predetermined, fixed payment that is typically paid to an employee as compensation for the work they perform in a company. Besides salary, it can be expressed in various other terms that typically mean the same thing, such as “employee income” or “wage”.
In Canada, a salary is typically stated annually but is paid at regular smaller intervals, which can be monthly, weekly, or bi-weekly. However, a salary remains largely consistent regardless of the number of hours of work you’ve clocked in.
The income you receive as a salary is deducted as an expense from your business. Additionally, even as a business owner or a shareholder, you’ll need to submit a T4 for your salary income to the Canadian Revenue Agency (CRA).
If you want to pay yourself a salary, your company must first register a payroll account with the CRA. You’ll also need to deduct income tax and Canada Pension Plan (CPP) from your pay, which is then sent to the CRA on a regular basis.
Advantages
Paying yourself a salary comes with several advantages. In the following section, we’ll take a brief overview of the most common ones.
Predictable Income Stream
One of the simplest reasons you might want to consider a salary over a dividend is that you get much better financial stability with a salary over dividends.
When you take a salary, you can guarantee that you’re earning a fixed payment that is paid out at regular intervals regardless of how well your company is doing.
On the other hand, while there’s no set amount to what you can earn from a company as a dividend, your company typically needs to declare a minimum amount of income before it can distribute dividends.
As a result, choosing a salary over dividends as a business owner can significantly improve your financial stability.
The predictability of income allows you to budget effectively so you can consistently meet your personal and household expenses without affecting your business’s financial stability.
Retirement Fund
If you plan to continue contributing to your Registered Retirement Savings Plan (RRSP), you need to consider how your income is structured.
When you receive a salary or wages, you’re considered to be earning employment income, which allows you to contribute a portion of that income toward your RRSP, up to a certain limit.
You can then accumulate these contributions over the years to establish a retirement fund if this is something you’re aiming for.
Relying solely on dividends won't give you any room for contributions, limiting your ability to establish a retirement plan, as it’s not considered an employment income.
Establish a Pension Plan
Besides retirement funds, employees in Canada are entitled to pension payments and benefits through the Canadian Pension Plan (CPP), which offers a source of continuous income after retirement.
Unlike the RRSP, which you contribute to voluntarily, CPP contributions are mandatory for all individuals aged 18 to 64 years old.
While contributing to the CPP means less take-home pay now due to obligatory deductions, it’s an investment for the future that you shouldn’t underestimate.
Essentially, you're trading a smaller paycheck today for significantly improved financial security later in life.
Of course, the amount you receive is based on how much and for how long you’ve contributed until the age of retirement.
Minimizes Surprise Tax Bills
With a salary, income tax is withheld at the source, meaning it's taken out of your paycheck before you even receive it.
This ensures you've already paid the appropriate taxes throughout the year, resulting in fewer surprises when it’s time to file your taxes, especially if you also need to keep corporate income tax in mind.
Dividends, on the other hand, are not subject to withholding tax. This might seem beneficial at first, but it can lead to unexpected tax bills.
Since dividends haven't been taxed at the corporate level, they are subject to personal income tax when paid out to you, which depends on your total taxable income and the tax bracket you fall under.
Spreads Out the Tax Burden
When an incorporated business or a company pays an employee a salary, it can deduct the salary from its taxable income. This helps you split the tax burdens between personal income and corporate income.
This strategy can be an excellent way to reduce your tax burdens if your company’s income is quite high.
In that case, with the help of a reliable professional advisor, you might be able to defer an amount of the corporate income tax by paying out wages and bonuses to yourself as a business owner.
Improves Loan and Mortgage Applications
When it comes to securing a loan or mortgage, taking a salary as a business owner holds a distinct advantage over dividends.
When assessing loan eligibility, financial institutions will typically prioritize stability and consistency of income over how much you’re making, as this allows them to predict your ability to repay the loan.
On the other hand, company profits and income can fluctuate, especially if the company is already encumbered by debt.
As a result, your dividend income might vary from one year to another. This variability can affect your ability to secure a loan/mortgage by increasing interest rates.
Employment Benefits
When a company pays an employee, there are additional costs besides the salary itself. One of these costs is the previously mentioned CPP itself.
However, there are additional forms of benefits and tax-related advantages associated with being on a payroll rather than earning dividends.
For example, as an employee, you’re entitled to collect various benefits, such as maternity or paternity leave, employment insurance, and other premiums.
Keep in mind that your situation as a business owner might vary from regular employees, so it’s best to consult a business lawyer about the intricate details of this aspect.
Deductions
A salary will also qualify you for some relief programs like the Canada Workers Benefit, which is a refundable tax credit aimed at low-income earners.
In that case, you might want to consider paying yourself a small wage from your business to benefit from this tax credit, especially if you have low personal or family income for the year.
Similarly, when a business owner pays themselves a salary, it opens the door for some forms of tax deductions, such as childcare expenses.
Many of these tax benefits are linked to a salary income, so it won’t be available if you opt for dividends instead.
Disadvantages
While earning a salary has its advantages, it’s not always perfect. Here’s a quick look at some of the downsides associated with getting paid a salary as a business owner.
Fully Taxable Income
When you’re paid a salary, you’re subject to full taxation on the personal income you earn from your own company. This means that you must report your earnings to the CRA and submit a T4 for your earnings as a whole.
Higher CPP Contributions
Salaries trigger mandatory contributions to the CPP. Although you’ll end up earning a consistent income through pensions after retirement, it reduces the amount of money you’re able to draw from the company income at the present.
Despite the lucrative financial security of pensions, you may have alternative retirement plans that don’t rely on pensions. In that case, a dividend might be a better option for you, as it’ll pay out remarkably more money.
More Paperwork
To earn a salary, you need to go through the hassle of establishing a payroll account with the CRA. This also includes filing additional paperwork and keeping track of all the legal documents associated with it.
This typically requires a specialist which may incur additional expenses that take away from the tax deductions and savings associated with getting a salary.
What is a Dividend?
When a company earns a profit, it can reinvest it back into the business for future growth or distribute it to its shareholders.
A dividend is simply when a business goes with the latter and shares its earnings with those who own portions of the company.
An incorporated company can roll out dividends regularly (annually, semi-annually, or quarterly) or irregularly, and is often determined depending on the number of shares each shareholder has.
Advantages
Here are some of the reasons why you might want to consider dividends as your source of income if you’re a business owner.
Higher Payout
One of the direct advantages of getting dividends is that they’re typically taxed at a lower rate than salary income.
In some cases, the company can pay the dividends from the company’s accumulated profits, which are known as capital dividends.
Dividends can also be tax-free when they’re generated from non-taxable capital gains, resulting in significant tax savings for business owners, and therefore, a larger payout.
Control Over Payment Frequency
Unlike a salary, which is usually paid regularly, dividends can be distributed at the discretion of the business owner.
This allows you to choose when to receive the desired income to better manage your personal cash flow.
Controlling your earnings timing allows you to optimize your personal income tax for maximum return.
Convenience
Paying yourself dividends involves significantly less paperwork compared to a salary. You only need to write yourself a cheque and record it in the company’s books.
There are no payroll taxes to withhold or remit, and you don't need to maintain detailed payroll records for the CRA. However, you must make sure that the company has paid out its taxes before distributing dividends.
The relative simplicity can also save you even more money because you don’t have to pay extra accounting fees.
No CPP Contributions Required
Another way you get to keep more money by opting for dividends is that it doesn’t contribute to pension plans.
This could be a downside if you do depend on CPP for retirement income, but if you have other retirement plans, the situation should be perfect for you.
Disadvantages
Although dividends show clear advantages in the payout aspect, it also has some downsides that you need to consider before making up your mind. Here’s what you need to watch out for:
Not Considered a Deductible Expense for the Company
Unlike salary, companies can’t deduct the dividends as business expenses while filing corporate income tax.
This can increase the company’s upfront tax burdens, which wouldn’t be a problem for an employee, but it’ll affect you eventually when you’re the business owner.
Not a Personal Income
Dividends not being a personal income for tax purposes is a double-edged weapon. On one hand, it does save you money because it doesn’t deduct personal income tax like salaries do.
On the other hand, you can’t claim various tax deductions associated with salary income when you earn money through dividends.
Similarly, lenders and financial institutions typically don’t prefer dividends because they’re not as consistent and predictable as salary.
Depends on the Company’s Financial Status
Dividends are allocated from the accumulated profits that your company has achieved over time.
However, if your company is generating any profit, you may not be able to receive dividends, which can be a problem if you depend on the dividends to support yourself.
Can Be Claimed by CRA When Corporate Taxes Aren’t Paid
The CRA can collect unpaid taxes from a shareholder who received dividends from a company that hasn't paid its payroll remittances or taxes, such as income tax or Goods and Services Tax.
This rule is in place to stop situations where a company or a shareholder tries to avoid paying taxes by giving dividends to shareholders instead of paying salaries.
Key Differences Between Salary and Dividends
To help you understand the two payment methods more clearly, here’s a summarized comparison between salaries and dividends that includes the key differences between the two.
Tax Considerations
A salary is a direct compensation for your contribution to the company as an owner, so it’s subject to payroll taxes as well as salary-related deductions.
Dividends are also taxed, but the taxes aren’t held upfront and are typically at a slightly lower rate, depending on your situation.
Frequency and Predictability
Salary is a fixed amount and must be paid regularly, which offers predictability and reliability if you rely on them as an income stream. Dividends are heavily dependent on profits and could be even claimed by the CRA after it’s issued.
Flexibility
Dividends are far more flexible for a business owner because they give you full freedom to control when to take them, which makes them more reliable for those who can easily handle their budget and expenses.
Impact on the Company
Companies can deduct salaries from their taxes, which reduces the overall burden, especially for high-earning businesses.
They can’t do the same for deductions, as they’re not considered a company expense and don’t affect the company's taxable income.
Eligibility for Loans Financial Institutions
Having a consistent salary is usually more favorable in the eyes of financial institutions because of their consistency and reliability.
Earning the same amount of money as a salary should typically grant you a higher credit score than earning the same amount of money as dividends. This reflects on your ability to apply for a loan or mortgage.
Package Benefits
As an employee, you’re entitled to various package benefits, including insurance benefits. You can also be eligible for some tax relief programs that save you extra money in the long run. However, dividends aren’t associated with any of those advantages.
How to Choose Between Salary vs Dividend
Choosing between salary and dividends depends on your individual circumstances, both personal and financial. You need to consider a variety of aspects before making up your mind, such as:
Your cash flow requirements
If you already have additional sources of income
The financial situation of your company
The tax implications of either choice
Whether you’re going to apply for a loan or mortgage soon
The potential of splitting taxes through childcare
Whether paying salaries and bonuses will help your company reduce its tax burdens
As you can see, the list goes on and can vary from one individual to another depending on specifics.
Consulting with our financial advisor at Parr Business can help you understand the specific tax implications and develop a personalized strategy for your situation.
TL;DR
Having a salary from your business offers stability and predictability with regular payouts. It can also contribute to your retirement plans and improve loan applications. However, it comes with relatively higher taxes and extra paperwork.
On the other hand, dividends are potentially taxed lower and offer more flexibility, but they depend on company profits and aren't considered income for various purposes, including benefits or loans.
Choosing the right method depends on your situation. Parr Business can provide you with expert advice and help you pick what’s best for you and your business in both short and long terms.
