How to pay yourself as a business owner in Canada with an incorporated business: Dividends or Salary?
As a business owner in Canada, one of the perks of being your own boss is the ability to determine your own salary. However, it can also be a daunting task, as there are certain rules and regulations that need to be followed. In this article, we will explore the different methods business owners can use to pay themselves, ensuring compliance with Canadian tax laws.
One common method is through salary payments, where business owners pay themselves a regular wage just like any other employee. This method allows for consistency in income and makes it easier to manage personal finances. Another option is through dividends, which are payments made to shareholders based on the company’s profits. This can be a tax-efficient way to take money out of the business, although they may not be suitable for all situations.
Additionally, there are other considerations such as taking loans from the business, as well as paying yourself through a mix of salary and dividends. The key is to find the right balance that aligns with your business goals and ensures compliance with tax regulations. By understanding the various options available, business owners can make informed decisions and effectively pay themselves in Canada.
Option 1: Pay yourself a salary
Let’s begin by discussing the concept of giving yourself a salary, where the terms “salary,” or “wages,” and “employment income” are used interchangeably in this context. This will result in you receiving a T4 slip, which you’ll use to report your employment earnings on your personal income tax filing.
Effects of paying yourself a salary
Here are the outcomes of paying yourself a salary from your business corporation:
- Offering a salary serves as a tax-deductible business expense for the corporation, reducing its taxable income.
- The salary received is considered employment income on your personal tax returns and is taxed accordingly.
- Your corporation is required to withhold federal income tax and CPP (Canada Pension Plan) contributions from salary payments, including the employer’s CPP share. These deductions and contributions are then sent to the Canada Revenue Agency (CRA) at regular intervals. Failure to make these deductions or delays in remittance can result in penalties.
- Your corporation is obligated to provide you with a T4 Slip and file an information return with the CRA at the end of the year.
- The salary you receive contributes towards both your RRSP (Registered Retirement Savings Plan) limit and the Canada Pension Plan, both of which play a role in effective retirement planning.
Pros and Cons of receiving a business owner salary?
Paying yourself from your corporation a salary has many advantages. We will discuss some of the advantages below:
Salaries result in fewer unexpected tax obligations
One of the benefits of receiving a salary from your business is that it provides a structured and consistent income stream for the owner. By paying yourself a salary as the business owner, you ensure you receive a regular and predictable income to cover your personal expenses. This is particularly important for small business owners in Canada, as it helps you manage your personal finances and maintain a certain standard of living.
Salaries can help qualify for government subsidies and tax credits
Paying oneself a salary allows the business owner to take advantage of certain tax benefits such as government subsidies and tax credits where employment income is an eligibility criteria. Some personal tax credits like the Canada Workers Benefit require that you have earned employment income to receive the tax credit. By paying a business owner salary, the income is subject to personal income tax, which can be advantageous depending on the individual’s tax bracket and may help optimize the tax situation by saving taxes.
Salaries create RRSP contribution room
Salaries play a crucial role in determining the amount of RRSP contribution room individuals have. RRSP, or Registered Retirement Savings Plan, is a popular investment vehicle in Canada designed to help individuals save for their retirement years. The amount of contribution room available to individuals is determined based on their earned income. Generally, individuals can contribute up to 18% of their previous year’s earned income, up to a certain maximum limit, into their RRSP. The more income individuals earn, the higher their RRSP contribution room will be. This means that individuals with higher salaries have the opportunity to contribute more towards their RRSPs, benefiting from potential tax advantages and the growth of their investments over time. On the other hand, individuals with lower salaries will have a lower RRSP contribution room, potentially limiting their ability to save for retirement. Therefore, salaries directly impact the amount individuals can contribute to their RRSPs and ultimately influence their retirement savings strategy.
Salaries allow for CPP contributions
Salaries provide the necessary income for individuals to contribute to the Canada Pension Plan (CPP). The CPP is a government program that provides retirement, disability, and survivor benefits to eligible contributors. As a mandatory contribution, employees and employers are both required to make CPP payments based on the employee’s earnings. The amount of contributions is determined by a fixed percentage of the employee’s salary, up to a certain maximum amount per year. Without salaries, individuals would not have a source of income to contribute to the CPP. Therefore, salaries play a crucial role in ensuring a sustainable pension plan for Canadians. The contributions made from salaries are invested by the CPP Investment Board, which aims to maximize returns and grow the fund. In retirement, individuals can then receive a monthly pension based on their contributions throughout their working years. So, salaries not only provide for current financial needs but also set individuals up for a more secure future through pension contributions.
Drawbacks of paying yourself a salary
Receiving a business owner salary has its drawbacks. One of the major cons is the burden of tax obligations. As a business owner, you have the choice to pay yourself a salary from your corporation, which is subject to income tax. However, this salary may not be the same as what you would receive as an employee, as you need to consider the financial health of your business. Additionally, the Canada Revenue Agency requires business owners to open an account and regularly report their income and expenses. This can be time-consuming and may require additional resources to accurately maintain the financial records. Furthermore, depending on the structure of your corporation, you may have to pay additional taxes such as corporate income tax or payroll taxes. These extra tax obligations can increase the complexity and cost of running your business, impacting your overall financial situation.
Option 2: Pay yourself in dividends
Paying yourself in dividends can be a strategic way to manage your finances effectively. A dividend is a distribution of a company’s profits to its shareholders. By paying yourself in dividends, you can potentially reduce your personal tax liability. In most countries, including Canada, dividends are taxed at a lower rate than regular employment income. This means that by receiving dividends, you may be able to pay less tax compared to a salary. However, it is important to note that dividends paid to shareholders are subject to personal tax, so you will still need to report them on your personal tax return. Additionally, dividends are not tax-deductible for the company paying them. It is also essential to understand that paying yourself in dividends may affect your eligibility for certain government programs like the Canada Pension Plan (CPP). Therefore, it is important to consider the tax implications and seek professional advice to determine the most suitable way to pay yourself and maximize your financial benefits.
Effects of paying yourself dividends:
Dividends, which come from the corporation’s earnings, typically lead to the following outcomes:
- Dividends are distributed from the corporation’s income after taxes have been paid and don’t qualify for any deductions at the corporate level.
- The corporation must follow the relevant laws of the jurisdiction where it operates when issuing dividends.
- At the end of the year, the corporation submits a T5 form to the Canada Revenue Agency, detailing specifics like the type of , the taxable amount, and the tax credit related to the dividends.
- Dividends don’t count toward the RRSP limit, and no CPP contributions or deductions are associated with them.
- Relying solely on dividends as your income might make it challenging to qualify for personal credits like those related to a mortgage, since there’s no employment income in this scenario.
Pros and Cons of paying yourself dividends as a business owner in Canada
There are numerous benefits for small business owners to pay themselves dividends instead of a salary. We will discuss some of these advantages below:
Dividends Could Offer Cost Savings Over Salaries
When a company pays its employees through salaries, it incurs additional costs such as payroll taxes, benefits, and liabilities. These expenses can substantially increase the overall labor costs for a business. On the other hand, paying dividends to shareholders does not involve these additional costs as they are typically paid out of the company’s profits and are distributed among its shareholders. By opting to pay dividends instead of salaries, businesses can save a considerable amount of money and allocate these savings towards other areas such as research and development or expansion plans. Additionally, they are subject to a different tax treatment than salaries. This difference can lead to further cost savings for both the company and its shareholders. Overall, dividends can provide a cost-efficient alternative to traditional salary payments, allowing businesses to streamline their expenses and maximize their profitability.
Dividends Offer Simplified Administration Compared to Wages
Dividends offer simplified administration compared to wages. When a company pays out dividends to its shareholders, it only needs to calculate and distribute the dividends based on the number of shares each shareholder holds. This process is relatively straightforward and does not require the company to withhold and report payroll taxes, issue pay stubs, or maintain detailed employee records. On the other hand, wages involve more complex administration tasks. Employers must calculate and withhold payroll taxes, prepare and distribute pay checks or direct deposits, issue pay stubs that outline deductions and earnings, and maintain thorough employee records. The administrative burden of managing wages can be time-consuming and costly for businesses, especially those with a large workforce. In contrast, dividends simplify the process by providing a straightforward method of distributing profits to shareholders without the additional administrative tasks associated with wages.
Dividends Mitigate the Risk of Late Filing Penalties
Dividends are a great way for businesses to mitigate the risk of late filing penalties. When a company pays out dividends to its shareholders, it provides them with a financial incentive to ensure that all necessary paperwork and filings are completed on time. This is because late filing penalties can not only be financially burdensome, but they can also damage a company’s reputation and credibility. By providing shareholders with a stake in the company’s success through dividends, they are motivated to stay on top of important deadlines and comply with all legal obligations. Overall, dividends are a valuable tool for businesses to mitigate the risk of late filing penalties and promote efficient compliance.
Dividends Lead to Reduced Employer Health Tax Expenses
Dividends can have a positive impact on reducing an employer’s health tax expenses. When companies distribute dividends to their shareholders, it allows them to allocate a portion of their profits, instead of keeping them within the company. By doing so, the retained earnings decrease, which directly affects the employer’s health tax liability. In many jurisdictions, the amount of health tax payable by an employer is linked to their net income. When dividends are distributed, the net income decreases, resulting in a reduced health tax liability for the employer. This reduction in health tax expenses can provide financial relief for employers, allowing them to allocate more resources to other areas of their business. However, it is important for companies to carefully consider the implications of dividend distributions and ensure they are in compliance with tax regulations to avoid any penalties or legal issues.
Drawbacks of paying yourself dividends
There are several cons of being paid in dividends, especially when it comes to personal tax. Dividends are typically subject to personal tax, meaning that individuals receiving dividends will have to pay taxes on that income. This can reduce the overall amount of money that individuals receive. Additionally, unlike other sources of income, dividends do not qualify for certain tax deductions or credits. As a result, individuals receiving dividends may not be able to take advantage of certain tax benefits that are available for other types of income. This can further increase the tax liability for individuals receiving dividends. Furthermore, small businesses in Canada may face additional challenges when being paid in dividends. For instance, small businesses may prefer to retain their earnings for reinvestment and growth, rather than distributing them as dividends. However, if the business chooses to distribute dividends, the owners may face higher tax rates on that income. This can discourage small businesses from choosing the dividend payment option.
Best way to pay less tax as a Canadian business: Salary or Dividends ?
When it comes to paying taxes, choosing between methods that create less tax can be important for individuals and businesses. One way to ensure less tax is by understanding the difference between personal tax and corporate tax. Personal tax is levied on an individual’s income, whereas corporate tax is imposed on a company’s profits. The tax rate for personal tax varies depending on the individual’s income bracket, while the corporate tax rate is typically a fixed percentage. To pay less tax personally, individuals have the option to pay themselves a salary from their business, which will be subjected to personal tax. On the other hand, paying dividends allows individuals to receive income from their business that is subject to a lower personal tax rate. This method of paying dividends can result in a lower tax paid compared to paying oneself a salary. However, it is essential to consider the overall tax implications of either method and consult with a tax professional to make an informed decision.
How much should you pay to optimize your salary vs. dividends mix?
When deciding how to allocate income from a business, it is important to optimize the salary versus dividend mix in order to minimize taxes paid. You may consult with a tax planning professional to determine what best suits your business needs and business structure for you to grow your business. Dividends are payments made to shareholders out of retained earnings, while salary is income received as compensation for work. The tax implications of these two forms of income differ. Dividends are taxed at a lower rate than personal tax rates, making them a more attractive option for taking income from a business. However, it is important to consider the impact of corporate tax on the business’s retained earnings. The business limit, which is the amount of income eligible for a lower corporate tax rate, should be taken into account when determining the optimal salary versus dividend mix. By carefully considering the tax rates and the amount of income left in the business, business owners can maximize their after-tax income and ensure efficient allocation of resources.