Salary vs. Dividends: Which Is Better for Your Business?
As a business owner or shareholder in a corporation, one of the key decisions you’ll face is how to compensate yourself. While salary and dividends are the two primary methods of extracting money from your corporation, each has distinct advantages and disadvantages. Understanding the tax implications, cash flow requirements, and long-term strategy for your business is crucial in making the right decision.
In this blog, we’ll break down the differences between salary and dividends, helping you determine which approach is best suited for your specific situation.
What Are Salaries and Dividends?
Before diving into the comparison, it’s essential to define what salary and dividends are:
Salary: A salary is a fixed, regular payment made by the corporation to an employee (which, in your case, could be you as the owner). Salaries are subject to payroll taxes such as Canada Pension Plan (CPP) contributions, Employment Insurance (EI) premiums, and income tax withholdings.
Dividends: Dividends are distributions of the corporation’s profits to its shareholders. Unlike salaries, dividends are not considered a business expense for the corporation and are paid out of the company’s after-tax profits. They are typically taxed at a lower rate than salary but come with their own set of rules.
Salary: The Pros and Cons
Pros of Paying Yourself a Salary:
Tax Deductible for the Corporation: One of the biggest advantages of paying yourself a salary is that the salary is considered a business expense, which reduces the corporation’s taxable income. This means the company pays less corporate tax in the year it pays out the salary.
Contributions to CPP and EI: Salary payments enable you to contribute to the Canada Pension Plan (CPP) and Employment Insurance (EI), which can provide you with future benefits, including pension and unemployment benefits. This is particularly useful if you’re looking ahead to your retirement or if you anticipate needing EI.
Predictable Income: Receiving a salary offers regular, predictable income, which can be important for your personal budgeting and cash flow needs.
RRSP Contribution Room: Salary payments increase your RRSP contribution room, which can be an important strategy for retirement savings.
Cons of Paying Yourself a Salary:
Higher Personal Taxes: Salary is subject to personal income tax, and you’ll pay higher taxes compared to dividends, especially if your income places you in a higher tax bracket. Additionally, both you and the corporation will have to pay CPP contributions.
Payroll Costs: Paying a salary means that the corporation must also cover payroll taxes and the associated administration costs, which may require additional resources or third-party services to ensure compliance.
Dividends: The Pros and Cons
Pros of Paying Yourself Dividends:
Lower Tax Rate: In Canada, dividends are taxed at a lower rate compared to salary. This is because dividends are subject to the gross-up and dividend tax credit system, which reduces the overall tax burden. This is particularly beneficial for higher-income earners.
No CPP or EI Contributions: Dividends are not subject to CPP or EI, which means the corporation doesn’t have to make payroll tax contributions on the dividends paid out. This can result in a lower overall tax cost for the business.
Flexibility: The corporation has more flexibility when distributing dividends. Unlike salaries, which are predictable and regular, dividends can be issued at the corporation’s discretion. This allows the business to pay dividends when there’s sufficient profit.
No Payroll Administration: Since dividends aren’t subject to payroll taxes, the administrative burden is lighter for your business. You won’t need to deal with payroll calculations or remitting deductions to the Canada Revenue Agency (CRA).
Cons of Paying Yourself Dividends:
No RRSP Contribution Room: Unlike salary, dividends don’t increase your RRSP contribution room, which may be a disadvantage if you’re aiming to maximize your retirement savings.
Limited Eligibility for Benefits: Since dividends aren’t considered earned income, they don’t contribute to CPP or EI benefits. This means you won’t build up credits for these programs, which can be a drawback in the long term.
Non-Deductible for the Corporation: Dividends are not tax-deductible for the corporation. So, while the corporation will pay taxes on its profits before distributing dividends, it will not get a tax deduction for the dividend payouts, unlike salary.
Factors to Consider: Which Is Better for You?
When deciding whether to pay yourself a salary or dividends, there are a few important factors to consider:
Corporate Profits: If your corporation has limited profits, paying dividends may not be possible. On the other hand, if you’re in a profitable business, paying dividends might make more sense to reduce your personal tax liability.
Personal Cash Flow Needs: If you need a consistent income stream to cover personal living expenses, a salary may be the better option for you. Dividends are typically paid periodically, and may not offer the predictability you need.
Long-Term Tax Strategy: If you’re focused on building wealth for the long-term and minimizing taxes, you may prefer dividends. However, if you’re thinking about retirement and want to make the most of RRSP contributions and CPP, salary payments may be the better choice.
Future Retirement Plans: If you plan to rely on CPP benefits in retirement, paying yourself a salary will ensure that you contribute toward that program. On the other hand, dividends won’t provide that benefit.
The Best of Both Worlds: A Balanced Approach
Many business owners choose to take a combination of salary and dividends to optimize their tax situation. For example, you might pay yourself a reasonable salary to cover your living expenses and ensure you’re contributing to CPP, while also taking dividends to take advantage of the lower tax rate on corporate profits.
This mixed approach allows you to balance both immediate tax savings and long-term financial planning.
Conclusion: Making the Right Choice for You
The decision between salary and dividends depends on various factors, including your business’s profitability, your personal financial needs, and your long-term financial goals. A well-thought-out strategy that incorporates both salary and dividends could be the most beneficial.
As a business owner, it’s always a good idea to consult with your accountant or tax advisor to help you decide the best course of action. They can provide personalized advice tailored to your financial situation and ensure that you’re taking full advantage of the tax benefits available to you.
If you’d like to discuss salary vs dividends in more detail or need help crafting a tax strategy that works for you, feel free to reach out. Our team is here to help you navigate these important decisions with confidence.
Tax Benefits of Incorporating Your Business: Is It the Right Move?
As a small business owner, you may have wondered whether incorporating your business is the right move for you. While incorporating can seem like a significant decision with many considerations, it can offer numerous tax benefits that may help you grow your business and reduce your overall tax burden.
In this blog, we’ll dive into the key tax advantages of incorporating your business and explain how these benefits can help you achieve both short-term and long-term financial success.
1. Lower Corporate Tax Rates
One of the main reasons small business owners choose to incorporate is the lower tax rate on corporate income. In Canada, corporations are taxed separately from their owners. Corporate tax rates are generally lower than personal income tax rates, which means that incorporating your business can help you retain more of your earnings.
For Canadian-Controlled Private Corporations (CCPCs), the first $500,000 of active business income may be eligible for the Small Business Deduction (SBD), which reduces the corporate tax rate to as low as 9%.
After the $500,000 threshold, corporate income will be taxed at the general corporate tax rate, but it’s still typically lower than the highest personal tax rates.
By incorporating, you’re able to take advantage of these lower tax rates, allowing you to keep more of your business’s profits within the corporation for reinvestment or other purposes.
Tip: If you’re operating as a sole proprietorship or partnership, consider incorporating to take advantage of these lower corporate tax rates, especially if your business is generating significant profits.
2. Tax Deferral Opportunities
Incorporating your business also opens up the possibility of tax deferral. When you operate a corporation, you can choose to leave profits inside the business instead of taking them as personal income. This deferral allows you to reduce your current personal tax liability.
For example, if you pay yourself a salary or dividends from your corporation, you’ll be taxed personally on that income in the year you receive it. However, if you leave the profits within the corporation, you won’t pay personal taxes on those funds until you withdraw them.
This gives you the opportunity to defer personal taxes to a later year, which can be beneficial if you anticipate being in a lower tax bracket in the future.
This flexibility allows you to manage your tax situation more effectively and make smarter financial decisions for your business.
Tip: The ability to defer taxes is a powerful strategy for long-term tax planning. Work with your accountant to determine the best approach for managing your business’s income and tax liability.
3. Income Splitting with Family Members
Incorporating your business can provide opportunities for income splitting with family members, which can lower the overall family tax burden. If your family members are shareholders of your corporation, you may be able to distribute dividends to them, especially if they’re in a lower tax bracket than you.
Dividends paid to family members are subject to personal tax rates, but the lower the income of the recipient, the lower their tax liability. This can be an effective way to spread income among family members and reduce the overall tax burden on the family unit.
However, be aware that Tax on Split Income (TOSI) rules limit income splitting in certain situations, particularly if the family member is not actively involved in the business. These rules are complex, so it’s crucial to consult with a tax professional before implementing any income splitting strategy.
Tip: Speak with your tax advisor to ensure you’re maximizing the benefits of income splitting without triggering any penalties or compliance issues related to TOSI.
4. Access to Corporate Tax Credits and Incentives
Corporations are eligible for various tax credits and incentives that aren’t available to sole proprietors or partnerships. For example:
Scientific Research and Experimental Development (SR&ED) Tax Credit: If your business is involved in research and development, you may be eligible for the SR&ED tax credit, which can offset some of your R&D expenses.
Investment Tax Credits (ITC): Your corporation may be eligible for tax credits if it invests in certain assets, such as equipment, machinery, or environmentally friendly technologies.
Additionally, corporations may qualify for provincial or federal grants, funding programs, and other incentives that can reduce operating costs or fund specific business initiatives.
Tip: Keep track of any research, innovation, or investments your business makes, as they could potentially qualify for tax credits or other incentives. Consult your accountant for guidance on available programs.
5. Enhanced Credibility and Legal Protection
While not directly related to taxes, incorporating your business provides legal protection through limited liability. As a corporation, your personal assets are generally protected from business debts or liabilities. This can provide peace of mind as you grow your business.
Furthermore, incorporation can enhance your business’s credibility with clients, suppliers, and investors. Being a registered corporation shows that your business is established, formal, and potentially more stable than a sole proprietorship or partnership.
Tip: While incorporating provides legal and business advantages, it’s important to consider the associated costs and administrative requirements. Consult with a lawyer or business advisor to ensure that incorporation aligns with your business goals.
6. Ability to Build a Corporate Pension Plan
Corporations have the ability to set up Individual Pension Plans (IPP) or other retirement savings plans for their employees (including themselves as business owners). These plans allow for larger annual contribution limits compared to an RRSP, making it easier to build retirement savings.
IPP contributions are considered a business expense, reducing the corporation’s taxable income.
If you have employees, setting up a pension plan can also help attract and retain top talent.
Tip: If you’re looking to save for retirement in a more structured way, setting up an IPP through your corporation can offer significant benefits. Consult your financial advisor to explore this option.
Conclusion: Is Incorporating Right for Your Business?
Incorporating your business offers significant tax advantages, such as lower corporate tax rates, tax deferral opportunities, and access to various credits and incentives. It can also provide legal protection and enhance your business’s credibility. However, the decision to incorporate should be made after considering your business’s unique needs, goals, and financial situation.
If you’re unsure whether incorporating is the best option for your business or need assistance with the incorporation process, our team of tax professionals is here to guide you through every step. Reach out to us today to discuss how incorporating can benefit your business and optimize your tax strategy.