One of the most common questions I get asked by corporate business owners is whether to take salary or dividends and how much tax can be saved by taking only dividends. The answer unfortunately, like most issues relating to tax, is that it depends on your circ*mstances. The concept of integration in the Canadian tax system theoretically strives to make taxes payable the same whether you take salary or dividends or a combination of both. In reality, there is always a difference as everyone’s tax situation is distinct.
Compensation options for small business owners
A business owner can choose to pay themselves exclusively salary or dividends or a mix of both. Some different types of compensation options are as follows:
Pay yourself a salary at the market rate that you would pay to an employee with similar qualifications and experience. The advantage of using this method is that by recording your salary as a cost of doing business, you have a more accurate view of your financial picture. Additional compensation can be paid by dividends.
Pay yourself enough salary to maximize CPP(Canada Pension Plan) /QPP (Quebec Pension Plan) contributions. This allows you to receive a pension from Canada or Quebec upon retirement. Additional compensation can be paid by dividends.
Pay yourself enough salary to maximize RRSP contributions which means that you can continue to contribute to your RRSP while receiving a tax deduction for the amount of the contribution. The side benefit is that you will also be contributing to the CPP/QPP. Additional compensation can be paid by dividends.
Pay yourself a salary exclusively so that all your payroll deductions are paid up front and you don’t have to worry about paying taxes at the end of the year.
Don’t pay yourself a salary and only take dividends. The advantage of this option is that you don’t have to make payroll contributions such CPP/QPP. The downside is that you don’t receive a pension upon retirement.
Pay yourself enough salary to cover your monthly living expenses. Dividends can then be taken when you have non recurring or one time needs.
How much do you need for you personal living expenses
Just because you have excess funds in the corporation, it doesn’t mean that you have to withdraw the full amount as salary or dividends. An assessment of your personal living needs can help you determine how much to withdraw as compensation. The balance of excess funds can then be invested within the corporation.
How much have you borrowed from the corporation during the year
If you have already withdrawn amounts from the corporation as a shareholder loan, you only have until the fiscal year following the one in which the amounts borrowed to either repay it or declare it as dividends. For example if you borrow $100,000 from the corporation in February 2021 and your year end is December 31st, you have until December 31st, 2022 to either repay the loan or declare the amount as dividends. You do have flexibility here in that you can either declare the full amount of dividends in 2021 or 2022 or you can split them up depending on your tax situation.
What is your taxable income for the calendar year and How much do you expect your taxable income to be in the future
The amount that you take in dividends might change depending on your other sources of taxable income during the year and in future years. If for example, you have a large capital gain due to sale of a property or investments, then you might want to reduce or defer dividends to a future year when your marginal tax rate is lower (ensuring that you don’t run afoul of the rules regarding repayments of shareholder loans).
Considerations for leaving excess funds in the corporation
Many business owners invest excess cash directly within the corporation . It should be noted that in the event of lawsuit, all assets of a corporation are at risk so if you have a large investment portfolio it might be worth considering creating a separate corporation.
Also, if you want to take advantage of the small business capital gains exemption which allows you to sell you shares and not pay tax on the capital gains up to a certain amount, there are rules governing how much you can have in passive investments.
Passive income in a corporation which are amounts earned in investment portfolios or rental properties are taxed at a significantly higher rate. It can also reduce your small business tax deduction once the passive income earned exceeds a certain amount.
How much RRSP room do you have
The best tax savings strategy available to Canadians is to invest in RRSPs. Every year, you build RRSP room depending on the amount of active income that you earn. As mentioned previously dividend income is not active income so in order to build RRSP room you would have to pay yourself a salary from your corporation. RRSP deductions are most beneficial i.e. provide the highest reduction to taxes payable at your highest marginal tax rate
Other Considerations
The calculation for the Scientific Research and Development (SRED) credit is often based on salaries. If this is something that your small business is planning to apply for and you specifically work on the project for which the SRED is being claimed, then you should consider taking a salary.
Child care expenses can be deducted by the lower income earner in a family. However, the deduction is only based on earned income which includes salary but excludes passive income such as dividends. As this deduction can be significant for some, it should be evaluated when determining your salary vs dividend mix.
Salary-dividend mix can change from year to year and should be reassessed on an annual basis while taking your other tax circ*mstances into consideration. Sometimes, even if you don’t require the funds, it makes sense to pay yourself a certain amount of salary and/or dividends just to split income between years thereby reducing your overall taxes as taxes payable on $100,000 in one year will be higher than taxes payable on $50,000 split over two years.
Looking for guidance on small business dividends and how to prepare your year end T5 dividend declarations? Download our free small business dividend checklist and check out our dividend guide for small business.
Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.
