Salary or dividends? The small-business owner’s dilemma
If you have set up your small business as a corporation, you have a choice as to how to pay yourself. Usually, Owner-managers want to withdraw cash from their corporations throughout the year and might use shareholder loan account for such withdrawals. Many business owners are unsure of whether to opt for salary-based earnings or payments in dividends. This indecisiveness might lead to a debit balance in shareholder loan account, which will be taxed in the hands of the shareholder (Without the benefit of dividend tax credit) if the balance remains unpaid for two consecutive balance sheet dates. In an attempt to make it easier for the owner-manager to decide whether to withdraw money in the form of dividend or salary, my article throws light on the pros and cons of salary and dividends.
Dividends Advantages:
- Dividends are taxed at a lower rate than salary, which can result in you paying less personal tax.
- Paying yourself with dividends is comparatively simple, you write a cheque to yourself from your corporation and at the end of the year, you update your corporation’s minute book and prepare a director’s resolution for the dividends paid. A T5 slip which reports dividends paid by a Canadian corporation to its shareholder(s), must be prepared and issued to you (the taxpayer) and to the Canada Revenue Agency (CRA). You use it to report any investment income you have on your tax return.
Dividends Disadvantages:
- Receiving dividends instead of salary can eliminate other possible personal income tax deductions for you, such as child care expense deductions.
- You can only pay dividends out of profits made by the company (If there is no balance in retained earnings, dividends can’t be paid out).
- Directly reduces the equity of the company. (For example, when a dividend of $50,000 is declared and paid, the corporation’s cash is reduced by $50,000 and its retained earnings is reduced by $50,000).
- Dividends are issued and paid based on share ownership. This can make it difficult to allocate different amounts of income to multiple shareholders if they all own the same class of shares.
- Dividends are not an expense of the corporation and, therefore, dividends do not reduce the corporation’s net income or its taxable income.
- Receiving dividends doesn’t allow you to build RRSP room as dividend is not “earned income “.
- If you pay more in dividends, you can create tax problems later on and, if the company becomes insolvent, you may be liable to repay the dividends taken.
- Banks and financial institutions prefer to see a T4 slip with a stable salary as opposed to a T5 Slip with the dividend.
Salary Advantages:
- Salary will count as earned income for pension contributions (RRSP). You claim your RRSP contribution as a deduction on your tax return.
- Child care costs incurred are deductible against your salary income.
- Help with financing purposes. If you are planning on applying for a line of credit or a mortgage, then paying yourself a salary will help you qualify.
- Salaries paid by the company are an expense to the company and will be a tax deduction for the corporation.
- Certain expenses such as automobile expenses incurred for work are only deductible against employment income.
- Income Splitting can be achieved by paying salary to related employees such as spouse or children. There are, however, several traps to watch for. Any salary must be reasonable and commensurate with the nature of the work that the spouse or children perform. As a rule, one can pay a salary that is equivalent (or even slightly higher than market rates). Since the payment would be within the family, it is advisable to keep detailed records as the CRA will want cogent evidence for the deductions.
- Salaries are subject to CPP (Canada pension plan). Paying your CPP now will increase your CPP benefits when you retire.
Salary Disadvantages:
- You will be required to deduct income tax and CPP premiums from your salary.
- Have the burden to do payroll. (For example, manage payroll remittances to the Canada Revenue Agency, preparation of T4 slips, calculation of source deductions, etc.)
- Salary is one hundred percent taxable.
Some common compensation strategies are:
Only dividends to low income family members such as spouse and children; provided they are shareholders in the company and are engaged on a regular, continuous and substantial basis in the business. With effect from effective January 1, 2018 ,dividends received from the family business by adult family members, will be subject to the new TOSI rules (Tax on split income-this tax is charged at highest marginal tax rate) unless covered by certain exceptions such as the satisfaction of 20 hour work test per week or if the taxpayer has previously met the above test for at least five years .
Beware that dividends paid to children may be subject to tax at the highest rates because of “Kiddie Tax” rules, whereas salaries paid to children are taxable at normal rates.
For those of you, who prefer saving for retirement on their own and aren’t relying on the CPP or want to use their operating company (or better yet, a holding company) to accumulate their retirement savings on a tax-deferred basis, we often recommend:
i) A nominal salary of at least $5,000 per year to qualify for the non-refundable employment tax credit on their annual personal income tax return as well as to provide a base level of disability insurance coverage through the nominal CPP premiums that will be triggered as a result.
ii) Optimum salary to the owner (often professionals) to maximize RRSP deduction room with any excess compensation requirements coming out in the form of dividends, often to an inactive spouse as well as to the owner. Additionally, if personal income is so low that the dividend tax credit would be unused, a salary may be more tax efficient.
Bonus Down Strategy:
Since $500,000 is the small business limit, the bonus‐down strategy works in many instances which advocates to pay enough salary/bonus to reduce the company’s taxable income to $500,000 as Canadian Corporation (CCPC) pays income tax at a lower rate up to this amount of income. This strategy works as long as the eligible dividend regime has been taken into consideration (two tax rates that can apply to dividends) and the salary fits neatly into the CRA’s administrative position . For example, an owner manager may attempt to income split with a family member who is not a shareholder or is not active in the business, in which case, the CRA will disallow the excessive salary declared consequent to the provisions of section 67 of the income tax act.
The amount of tax savings achieved by the bonus‐down strategy is different for everyone and is based on the number of years the funds are left in the company, the rate of return, and whether the shareholder(s) are disciplined enough to use company’s funds. Once the after-corporate tax profits are paid out as a dividend, then integration “equalizes” the tax.
There are a lot of moving pieces and things to consider when deciding to pay yourself through salary or dividends or a mix of salary and dividends. The law is that taxpayers must characterize (although not necessarily document) a payment as salary, dividend, or loan at the time it occurs and not re-characterize it later (by means of general ledger adjustments by the accountant). It is highly recommended that you consult with a CPA who can help you determine which option is more suitable for your situation and discuss other tax planning strategies to put more money back in your pocket.
This article is being provided as general information only and is not meant as legal opinion or advice. Each situation is unique and should be reviewed on its own, with the appropriate attention and care it deserves. Please do not hesitate to contact any member of our Tax Group if we can be of further assistance in this regard.
Amandeep Singh (CPA, CGA, CA(India) ,MBA,MCOM)
President -Cloudiverse CPAs Inc
aman@cloudiverse.ca