Many Canadian business owners operate their business through a corporation rather than as a Sole Proprietor. The most common question we get is whether the owner should draw their income as a salary or as dividends. The answer, like most tax questions, is: It depends!
So let’s start by looking at these two options at the most fundamental level:
Dividends are a return on equity. They are paid to shareholders as a distribution of profit. Salary is a return on labour. It is paid to employees for their time and expertise contribution to the business. In larger corporations with external investors these two would usually be different. For smaller family-held corporations we get to choose which option best suits.
What are the differences between salary and dividend?
The following chart summarizes the major differences between the two.
|Deduction to the company||No; Dividends are paid AFTER corporate tax is paid.||Yes; Salary creates a deduction against the corporation’s income that can reduce it to or below zero|
|Subject to CPP?||No; Can affect your CPP entitlement when you retire||Yes – both the employee and employer must contribute CPP – combined rate for 2019 is 10.1% for earnings up to $57,400.|
|Subject to EI?||No||If the shareholder (and spouse) hold more than 40% of the shares of the corporation then no EI is payable. If under 40% then both employee and employer must contribute.|
|Taxable to the Employee?||Yes – subject to the dividend gross up||Yes|
|Limitations on distributions?||Yes, a company can’t declare a dividend if the dividend will make it insolvent; generally, dividends are only declared when there is positive Retained Earnings||No limitations on distribution, but CRA holds a reasonable salary test on payments to related persons. The working owner can generally pay themselves as much or as little as they want, but payments to spouses, kids, other non-arms-length parties must be reasonable in light of the work performed (paying your kids $10K to empty the trash once a week is probably too high).|
|Create RRSP contribution room||No. Dividends are treated as unearned income; only earned income generates RRSP contribution room; paying yourself dividends will limit your RRSP contributions in future years||Yes|
|Useful for borrowing||Less so; major banks don’t like Dividends and may exclude them from their lending calculations. You may need to look at a secondary lender if you have large dividend income.||Yes – bank prefer salary income when calculating your ability to repay a loan.|
|Impact on income-tested benefits (GST Rebate, OSAP funding, etc)||Dividend income is grossed up by 15% and shows on your return as higher than the amount of dividend actually granted (offset by a tax credit later)||Normal|
|Tax deducted at source||No – you will have to pay any additional income tax owing and may end up having to pay instalments||Yes – if done correctly you should have no tax to pay beyond your source deductions|
|Offer different payment to different people||Not usually – dividends are paid per share. If there is only one shareholder then there is no issue, but if you have two 50% shareholders then they each must receive the same amount (unless you have issued shares in separate classes)||Yes.|
|Can be backdated||No – dividends are a decision of the directors and should be documented at the time the decision is made.||Yes – you can accrue a salary or bonus payment as long as it is paid (and the payroll taxes reported) within 6 months.|
|CRA reporting forms||T5||T4|
|Cash Flow impact||Corporate taxes (much lower rate) may need to be paid in installments, and the owner may also need to pay a top-up on April 30, and then may be required to pay installments the following year.||All taxes need to be deducted from the payment and remitted to CRA the following month (just like any payroll payment)|
|Other tax return implications||Some tax credits (such as child care) can only be deducted against earned income and dividends don’t qualify.||It is possible to over-draw your profit when using a salary. This results in paying more income tax at the higher personal rate than may have been necessary. Proper tax planning is essential.|
How do I choose?
In Canada it is not supposed to matter whether you pay yourself by salary or dividend. We have a tax system that “equalizes” between the two – so if you pay yourself a dividend you get a credit for the taxes paid by the company so that it comes to about the same as if you had received a salary (this does vary slightly by Province and income level). However, when you factor in CPP the net tax burden on salary is higher).
So there are three questions I usually ask to help a client decide which path they should go down:
- Is CPP a significant factor in your retirement savings plan?
- Is contributing to an RRSP in the future a significant factor in your retirement savings plan?
- Do you foresee the desire to purchase or refinance a home in the next three years?
- Do you have sufficient free cash flow in the business to make a lump sum tax payment now?
None of these questions is definitive, but the more “Yes” answers there are the more favourable the salary option is to you.
While you can’t go back and change a decision once it has been implemented, you can change as often as you like going forward. In addition, it is not an either-or approach – you can do both. Keep in mind that any salary payment over $3500 will attract CPP, but you can pay yourself some salary, and the rest as dividends if you choose. Once you reach the CPP ceiling there is no significant difference between paying yourself salary or dividend.
Here are some of the things that we look at with clients in the lower income ranges. All numbers are using 2019 Ontario rates and assume no other income or deductions for an unmarried owner:
- If the company has losses but is expected to make these up in the future, consider a salary of $3500 – no income taxes or CPP will be payable and will avoid future taxes at the corporate rate. Or, consider a salary/bonus payment of $13800 – no income taxes will be payable, but $1050.60 will be payable in CPP (50% available as a tax deduction for the corporation). This is still less than the minimum corporate tax that would have been payable on this income had it been left in the corporation.
- If the company has tax paid retained earnings from prior years you can declare a dividend of $17391. Corporate tax has already been paid on this amount and no further tax will be payable by the owner. Increasing this amount slowly still gives very efficient tax for the owner. For example, a dividend of $30,000 results in tax payable by the owner of $546.95 (total corporate and personal tax paid = $4414). Had the same amount been paid in salary there would have been personal tax paid of $3255 + $1549 Employee CPP + $1549 Employer CPP = $6353)
As with all such commentary, this is not tax advice. In this article we are analyzing a single question and not factoring in all the possible factors that may affect your personal tax situation. Please consult your tax professional for advice specific to your situation. Tax numbers used may be estimates and use 2019 tax rates.