Have you ever wondered what the difference between salaries and dividends are? Payroll is something that every business owner needs to consider, not only for your employees but also for yourself.
When it comes to taking money from a corporation, there are three main ways that you can do it. These include:
- Via a shareholder loan, which you are required to repay
- Through dividends
- By paying yourself a salary
If you’re a business owner, you have the option of paying yourself a salary, dividends or a hybrid of the two. However, you choose to pay yourself depends on multiple business and personal factors. There are upsides and downsides to both. Let’s explore each option in detail.
Paying Yourself a Business Salary:
If you are paying yourself a salary from your company, you must report it as personal income.
With a salary or a wage (which are the same things), the payments become an expense of the corporation and equate to employment income, meaning you will receive a T4. The expense reduces your company’s taxable income, which in turn reduces the corporate taxes owing.
When you draw a business salary and report it to the Canada Revenue Agency (CRA) as personal income, you are subject to the personal income tax rate on your salary. This rate tends to be higher than the corporate tax rate. A salary can be classified as a business expense for your organization and lowers the overall taxable income. In this scenario, your business salary can be counted as personal income, and you will also qualify for income tax credits, including medical expenses and child care benefits.
If you choose to draw a personal salary from your corporation, you must register a payroll account with the CRA. For every payment received from your salary, you will need to withhold and remit income taxes to the CRA. By choosing a salary instead of dividends, you must remember to also contribute to your Canada Pension Plan (CPP). Because you are a shareholder, however, you are exempt from EI contributions — although this also means that you are not eligible to receive benefits in the event that you have to fire yourself from your own company.
It’s important to note that if you own a small business, and your net income exceeds $3,500 a year, you are required to pay double your CPP contribution than if you were a regular employee. Also, remember that your business salary also impacts your RRSP deduction room.
This choice is ideal for small business owners that rely on mandatory retirement savings.
Paying Yourself Dividends:
Unlike a salary, which counts as personal income, dividends are considered investment income. Dividends may yield a marginally lower tax rate than what is usually paid on a salary since they are subject to the corporate tax rate.
Dividends are not considered a company expense, and will not lower your company’s overall taxable income. Most often, dividends are paid out to your company’s shareholders. When you are looking to provide these shareholders with dividends, money is transferred from the corporate account to the shareholder’s bank account. According to the CRA, when preparing dividends for you and your shareholders, you must also prepare and file individual T5s for every individual who receives one. If you choose to pay yourself a dividend, the process would be the same for you, as it is with your shareholders.
Dividends can be tricky, as they are issued and paid based on share ownership. For example, if Cutco Inc. is looking to issue $100K in dividends to the owners of their Class A common shares, it will be paid out based on a percentage of ownership.
So, if Clint owns 20% of the company’s class A shares, and Kara has the rest (80%), Clint can expect to receive $20K, and Kara would earn the remaining $80K.
At this point, the process can become confusing: if multiple shareholders own the same class of shares, it can become challenging to allocate different amounts of income.
Bear in mind that you do not need to register a payroll with the CRA and remit source deductions if you are the sole owner of your company. Choosing the dividend route is ideal for someone who does not want to be forced to contribute to the CPP, but be aware that dividends do not help build your RRSP contribution room. When you do not contribute to your CPP, you must have a plan for retirement in place since you will not be relying on the Canadian Government.
So, Which Do I Choose? Salary vs. Dividends?
Given the different opportunities and benefits each affords, the choice of paying yourself a salary vs. dividends truly depends on your individual business and personal situations.
Dividends can be a more flexible option, and you are free to choose how you save for retirement. You also are not paying the higher personal income tax rate, helping you increase savings. Be mindful that you will have to be smart about saving for your retirement if you choose this option. Salaries can come with many upfront costs but reduce the amount of surprise tax bills you may receive since income tax is withheld from every payment for remittance to the CRA.
With a salary, when you file your tax return, you will have already paid the income tax and avoided any surprise tax bills. This differs with dividends since income tax is not withheld and remitted, although you should expect to pay taxes to the Government.
Another big difference between the two concerns potential mortgage applications. In the case of salary vs. dividends, salary wins out here. Most banks prefer seeing consistent, predictable income if you are looking to qualify for a mortgage. A personal salary will show a steady, earned employment income and is more likely to help you be eligible. Mortgage brokers may not consider dividends as favourably.
On the other hand, dividends tend to be lower in cost, which allows you to have more cash now, but less later, as you forego your CPP contributions.
Choosing dividends can also be straightforward, especially if you are the sole owner of your corporation. As a sole owner, you can declare a dividend and then transfer the cash amount from your company’s account to yours. This reduces the need to register for payroll and will help you avoid any remittance or source deductions.
No Clear Cut Answer
As with most things in life, the answer to the question “salary vs. dividends” is dependent on many factors. Review your own needs and choose according to what suits your current personal and business situation.
Are you looking for more insight into managing your payroll or company finances? We can help. Contact Knit today, or learn more via our handy blog.