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.
