If you own a business through a corporation, you can afford to pay your own salary or dividends or both. This article will describe the differences between these two methods and the main advantages and disadvantages of each method. We’ll also see some common scenarios where business owners may choose one method over another.
Dividend with. salary
We work with business owners from all over Canada and we are often asked about the difference between wages and dividends. If you own a business through a corporation, you can afford to pay your own salary or dividends or both.
This article will explore the difference between wages and dividends and the main advantages and disadvantages of each. We’ll also see some common scenarios where business owners may choose one method over another.
Salary/Wage
Transaction Type
If you pay your own salary or wages (same thing), those payments become an expense to the company, then your personal employment income – you’ll get a T4. This fee reduces the company’s taxable income, which in turn reduces the company’s tax payable.
how it’s done
In order to pay themselves wages, companies need to register a payroll account with the CRA. Every time you get paid, the company is required to deduct source deductions (CPP and income tax) from your paycheck. These source deductions are then periodically remitted to the Commissioner of Revenue (CRA). Additionally, companies must prepare and file a T4 each year for any wage-earning employee.
Why choose salary
Paying for yourself can be one way you can earn a steady and predictable personal income. Some of the main advantages of using this method include:
- RRSP contribution space – Paying yourself a salary will allow you to build RRSP contribution space that paying yourself through dividends does not.
- CPP Contribution – This is a double-edged sword. Salary will enable you to contribute to the Canada Pension Plan (dividends will not). This means that you will benefit when you receive CPP in the future, but it also means that CPP contributions are a cost to you and the company. Less cash now, more cash later.
- Fewer surprise tax bills – Income tax is withheld from every payment and remitted to the receiver. When you file your personal tax return, you have already paid income tax and you can avoid unexpected personal tax bills. Income tax is not withheld and paid when dividends are paid, which typically results in personal tax in April.
- When applying for a mortgage – When you try to qualify for a mortgage, banks want to see stable, predictable income. Earning such employment income will help to show steady income, while dividend income may not look good.
dividend
Transaction Type
Dividends are payments made to a company’s shareholders out of a company’s after-tax earnings. This means that dividends are not a corporate expense and do not reduce corporate taxes paid. Dividends, on the other hand, have a lower personal tax liability than wages because they carry a dividend tax credit (more on the tax difference below).
how it’s done
In practice, paying dividends to company shareholders is fairly easy. In one or more transactions, declare dividends and transfer cash from the company account to the shareholder’s personal account. Each year, the company must prepare and file a T5 for any shareholder who receives a dividend.
The tricky thing about dividends is that they are issued and paid based on share ownership. For example, if Pied Piper Ltd. wanted to issue a dividend of $100,000 to owners of its Class A common stock, it would have to do so based on percentage ownership. So if Dinesh owns 30% of the Class A stock in Pied Piper and Richard owns the other 70%, then Dinesh will receive $30,000 and Richard will receive $70,000. If they all own the same class of shares, this could make it difficult for them to distribute different amounts of income to multiple shareholders.
Why choose dividends
Paying dividends can be an easy way for business owners to withdraw money from the company. Some key advantages include:
- Reduced Costs – Paying dividends eliminates the need to contribute to the CPP, reducing business and personal costs. The downside is that it doesn’t allow you to contribute to the Canada Pension Plan. More cash now, less cash later.
- Simple – if you own 100% of the company, all you need to do is declare dividends and transfer cash from the company to your personal account. No need to register for payroll and remit source deductions.
- Reduce the chance of wage penalties – wage remittances are ruthless. Usually they have to make monthly payments, with severe penalties for late payments . Paying dividends eliminates the opportunity for delayed or missed payroll remittances. That being said, when paying dividends, a T5 filing must be completed on time each year.
dividend resolution
If you pay dividends, you will need to issue a T5 and prepare a corporate document called a dividend resolution.
Which method can reduce taxes?
(Spoiler – the answer is “it depends”)
OK, so the most common question about wages vs dividends is “Which way will I pay less tax?”. It’s an important question, but legislative changes that took effect in early 2018 have made it harder to cut taxes by choosing one approach or the other.
I list this question here rather than at the top because I think it is more important to first understand and consider the issues listed above before comparing various wage and dividend models to save tax. Often, the calculations somehow show fairly little tax savings, and there’s a reason for that.
integration
The legislation aims to implement a tax concept called integration. The idea is that when comparing dividend payments and salary payments of the same amount, there should be little difference in the total income tax paid (personal + corporate tax). Here’s how it works:
- Wages lower corporate taxes but generate more personal taxes than dividends.
- Dividends don’t reduce corporate taxes, but they generate less personal taxes than wages.
dividend
In the past, corporate shareholders have been able to get around integration issues and tip the scale of tax savings in their direction by using a technique called “dividends.” This is accomplished by paying dividends to a lower-income spouse or adult family member. Because a spouse or adult family member is in a lower tax bracket than the person running the business, their dividend income will be subject to less personal tax.
Implementing a dividend is now more difficult, and it is especially important to consider the qualitative factors discussed earlier when deciding which payment method to use.
Learn more about dividend limits in our article on Tax on Split Income (TOSI) .
Calculate and compare taxes
While the tax savings may not be as much as in the past, we can still do some simple calculations to help determine whether dividends or wages are more tax efficient.
The idea is to calculate the total tax (company + individual) that would be paid if dividends were used, and compare that to the total tax that would be paid if wages were used. You can use a tool like SimpleTax Calculator to calculate personal income tax estimates, and you’ll also need your corporate tax rate to estimate corporate tax. Or, if that sounds like a pain, you can call your accountant and they’ll be happy to do some calculations (we love these things).
Common scenarios
Finally, let’s take a look at some of the common scenarios we see and discuss what you as a business owner might consider in each case.
- Not good at administrative tasks – If paying on time is one of your weaknesses, it may be easier and less expensive to pay yourself using dividends. Wages require regular, on-time payments of source deductions. If source deduction payments are missed or delayed, fines can add up quickly.
- Eligible for financing – If you are planning to buy a home in the near future and know you need to qualify for a mortgage, it may be better to pay yourself (salary/salary) as an employee. Banks prefer to see steady income over sporadic dividend payments.
- Childbirth/Parental Leave – If you are planning to have a baby soon and want to get maternity or parental benefits , it may be better to earn income through wages. This is because withholding and paying employment insurance premiums allows employees to receive maternity or parental benefits.
- Paying Bonuses – Sometimes taxes can be reduced or delayed by paying wages in the form of bonus payments to business owners. It’s a bit complicated and doesn’t work in all scenarios, but it’s important to know that the technology exists.
- Working Income Tax Benefit – The Working Income Tax Benefit is a refundable tax credit designed to provide tax relief to eligible low-income working individuals and families. It can be beneficial to pay a small salary from your business to trigger a tax credit for your personal taxes. Consider this if your personal or household net income for the year is low.
Source: CPBCanada.org
