Small Business Owners: When To Take Salary Versus Dividends

Incorporated business owners can choose how to pay themselves. Some receive limited input from their accountant regarding their compensation strategy, or they simply continue using the same approach without occasionally reconsidering it.

Corporate compensation planning should be intentional and does not have to be complicated. So, here is a primer in layperson’s terms for business owners.

Difference Between Salary And Dividends

There are important differences between salary and dividends. For one, salary is paid to employees and dividends are paid to shareholders. Many owner-managers have the flexibility to choose because they are both.

Salary is considered a business expense and is deductible from corporate profit. If a corporation pays all its income out as salary, the company has no taxable income, and therefore, no tax to pay.

From the perspective of the employee, the tax implications of the salary would be comparable to not having a corporation in the first place, as if they were a self-employed unincorporated sole proprietor. Therefore, the tax benefits of incorporation may not apply; namely, the ability to benefit from the low small business tax rate for profit retained corporately.

Dividends, on the other hand, are paid from after-tax corporate profit. So, the corporation does not deduct a dividend from its income. It must pay tax on its income first, at a low corporate tax rate, and then the dividend is paid from what is left over.

As a result, a shareholder receiving a dividend from a Canadian company, whether it is a small business or a large, publicly-traded one, pays a lower rate of tax on dividends than on other income. This is because recipients of Canadian dividends can claim the dividend tax credit on their personal tax return. This credit is meant to roughly approximate the tax already paid corporately.

When To Pay Yourself A Salary

When you pay yourself a salary, there are payroll deductions to remit monthly to the Canada Revenue Agency (CRA) or Revenu Québec. You receive the after-tax amounts deposited into your bank account. If you have no other sources of income, nor tax deductions or tax credits, you should have little to no balance owing or refund. Since most taxpayers have deductions and credits to claim on their personal tax return, employees tend to receive tax refunds.

Salary is a predictable way to pay yourself if your business has a steady cash flow. Beyond the predictability, there are other benefits.

When you pay yourself a salary, you contribute to the Canada Pension Plan (CPP). This will boost your entitlement to a CPP retirement pension. The implied rate of return for a business owner's CPP contributions is not great, but it is not terrible either. It is like contributing to a Registered Retirement Savings Plan (RRSP) and earning a comparable rate of return to a moderate risk investment portfolio in terms of the future income it can provide through life expectancy.

Salary is considered earned income, so it increases a taxpayer’s RRSP room. Incorporated business owners with good cash flow and the ability to save money in their corporation, or in their RRSP, often come out ahead, contributing to an RRSP in the long run.

If an owner-manager has children, salary, not dividends, allows them to claim childcare expenses as a tax deduction.

When To Take Dividends

When a shareholder opts to pay themselves dividends instead of a salary, they simply take withdrawals as needed or on a regular schedule. Unlike salary, which has tax withheld and monthly payroll remittances, dividends are taxed at year-end. This may seem appealing at first.

However, after a taxpayer owes more than $3,000 of tax in two consecutive years ($1,800 in Quebec), they are asked to start prepaying their tax each year. This prepayment is called income tax instalments. Instalment requests are sent to taxpayers to suggest quarterly payments based on their tax owing for the two previous years. Although these instalment payments are not required, if you do not pay them, and you owe tax, you could be charged interest and penalties.

Dividends do not result in CPP contributions, RRSP room, or allow a business owner to deduct childcare expenses.

They may be simpler because you do not have to remit payroll deductions monthly, but in most provinces and territories, paying dividends results in more combined tax— corporate tax plus personal tax—than paying a salary.

One exception may be if a business owner has investment income earned in a corporation. Investment income is subject to a 38% refundable tax that must be paid corporately and can only be refunded when dividends are paid. So, an incorporated business owner with investment income should often take some dividend income as compensation to recover this tax.

If personal income is low or moderate, the personal tax payable may be significantly less than the corporate tax refund.

Paying Salary And Dividends To Family Members

You can pay a salary to your family members. However, the salary must be reasonable relative to what you would pay to an arm's-length individual to do the same work. If someone is an active owner-manager, the reasonableness test may be less stringent than a less active family member who is not a shareholder.

Dividends used to be more flexible. Prior to 2018, you could pay dividends to family members over the age of 18 to take advantage of their low tax rates. However, the Tax on Split Income (TOSI) rules introduced at the time made it more difficult to pay dividends to family members to save tax. Now, these dividends may be subject to tax at the highest tax rate.

There can be exceptions for family members actively involved on a regular and continuous basis, working more than 20 hours per week in the business. A common exception that helps couples applies once a business owner is 65 or older, allowing dividends to be paid to a non-active shareholder spouse. This age 65 rule appears to mimic the pension income splitting rules that allow up to 50% of Registered Retirement Income Fund (RRIF) withdrawals from age 65 onwards to be moved to your spouse’s tax return to minimize tax.

What Changes In Retirement

If a spouse is not a shareholder of a company that has significant assets retained within it, adding them as a shareholder by age 65 can be advantageous. Some professional corporations that must register with professional bodies have restrictions for non-professional shareholders. But once someone retires, their professional corporation may effectively function as an investment holding company if it simply holds passive investment assets.

Although there may be cases that support salary being paid from a corporation in retirement, salary is generally not deductible against corporate investment income. So, most retirees pay themselves dividends as compensation once they are no longer working. This also helps recover refundable corporate tax on investment income.

Retirement decumulation can become complicated for a business owner who may have corporate assets as well as RRSPs, Tax-Free Savings Accounts (TFSAs), and government pensions, let alone other sources. A thoughtful compensation plan for business owners during their working years, and after they retire, is important to minimize tax payable and boost cash flow.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.