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Salary or Dividends? How to Pay Yourself

As a business owner in Canada, determining how to pay yourself from your corporation is a critical decision that can significantly affect your financial health and tax obligations. The two primary methods for doing this are through a salary and dividends. Both options have distinct advantages and disadvantages, and the choice between them—or a combination of both—depends on various factors, including your income needs, tax planning strategy, and long-term financial goals. In this comprehensive guide, we'll explore the ins and outs of these payment methods, and how using Ribbon can help streamline the process.

Understanding Salary vs. Dividends: The Basics​

Before diving into the details of how to pay yourself, it's essential to understand the fundamental differences between salary and dividends.

Salaries are regular payments that are considered an operating expense for the corporation, which reduces the company's taxable income. They require contributions to the Canada Pension Plan (CPP) and, optionally, Employment Insurance (EI). Salaries also provide Registered Retirement Savings Plan (RRSP) contribution room, which is beneficial for long-term retirement planning.

Dividends, on the other hand, are distributions of the company's after-tax profits. They do not require CPP or EI contributions, making them a more flexible and often more tax-efficient way to extract profits from your business. However, dividends do not provide RRSP contribution room, which can be a disadvantage for those focused on retirement savings.

Deep Dive into Salary: Structured Income with Comprehensive Benefits​

Paying yourself a salary offers a structured way to receive a steady income while maintaining a clear separation between your personal and business finances. This method is particularly beneficial for those who need a regular income to meet personal expenses, as it provides a predictable cash flow.

Key Benefits of Salary:

  • Regular Income: Salaries provide a steady and predictable income, making it easier to manage personal finances.
  • Fewer unexpected tax bills: By paying your income tax throughout the year, you minimize the risk of facing unforeseen tax charges or discrepancies when filing your personal taxes.
  • Tax Deductibility: Salaries are fully deductible as a business expense, which can reduce the corporation's taxable income.
  • CPP and RRSP Contributions: Salaries allow you to contribute to the CPP and create room for RRSP contributions, both of which are essential for retirement planning.
  • Easier mortgage approval: Lenders prefer to see a consistent source of employment income, and receiving a regular salary increases your chances of qualifying for a mortgage.
  • Health and Insurance Benefits: Salaries often come with the option of receiving health and insurance benefits through the corporation, which can be tax-advantaged.

Steps to Implementing a Salary:

  1. Register Your Payroll with the CRA: Start by obtaining a Business Number (BN) from the Canada Revenue Agency (CRA) if you don't already have one. Then, set up a payroll deductions account to handle tax withholdings, CPP contributions, and any optional EI payments.

  2. Determine a Reasonable Salary: It's crucial to ensure your salary is in line with market rates for your industry. Overpaying yourself could result in the CRA reclassifying part of your salary as a dividend, which could have tax consequences. Documenting your salary decision with justifications and comparisons to similar roles in the industry can help avoid this.

  3. Calculate Payroll Deductions: Once the salary is set, calculate the necessary withholdings for income tax, CPP, and EI. These withholdings need to be remitted to the CRA on a regular schedule, either monthly or quarterly, depending on your corporation's size.

  4. Filing Requirements: By the end of February you must file a T4 slip for each employee (including yourself), detailing the total earnings and deductions for the previous year. This slip is necessary for both personal tax returns and corporate tax reporting. In some provinces for certain jobs you may also require to register for and remit various insurance programs, examples are WSIB in Ontario and WorkSafeBC in BC.

Common Mistakes to Avoid:

  • Overpaying or Underpaying Salary: Ensure the salary is within a reasonable range to avoid CRA scrutiny.
  • Missing Payroll Remittances: Late remittances can result in penalties, so it's crucial to stay on top of payment schedules.
  • Forgetting Provincial Insurance Programs: It's easy to overlook provincial insurance programs, such as WSIB or WorkSafeBC, due to their separation from the federal system.
  • Incorrect Tax Filings: Make sure all T4 slips are accurate and filed on time to avoid penalties and interest.

Exploring Dividends: Flexible Income with Tax Advantages​

Dividends offer a more flexible way to pay yourself, as they are not tied to a regular payment schedule and are based on the company's profits. This flexibility can be advantageous, especially if you prefer to take distributions based on the corporation's financial performance.

Key Benefits of Dividends:

  • Flexibility: Dividends can be issued at any time, making them an ideal choice for business owners who want to manage cash flow and tax obligations strategically.
  • Personal Cashflow: Unlike salaries, dividends do not require contributions to CPP or EI, increasing the total amount of personal cashflow.

Steps to Issuing Dividends:

  1. Assess Retained Earnings: Dividends can only be paid from the corporation's retained earnings. Before declaring a dividend, ensure that your corporation has sufficient retained earnings and cash flow to cover the payment without jeopardizing the company's financial stability.

  2. Declare Dividends: Even if you are the sole shareholder, you must document the dividend declaration. This includes specifying the amount of the dividend, the payment date, and the method of payment (e.g., cheque, electronic transfer).

  3. Distribute Dividends: Once declared, dividends can be paid to yourself through your preferred method. It's important to ensure that the payment is properly recorded in the corporation's books.

  4. Filing Requirements: Issue a T5 slip for the dividend, which must be filed with the CRA. The T5 slip reports the total amount of dividends paid to the shareholder and must be included in your personal tax return.

Considerations for Dividend Payouts:

  • Cash Flow Management: Dividends should be issued with careful consideration of the corporation's cash flow needs. Over-distributing can lead to cash flow problems.
  • Impact on Personal Taxes: While dividends are tax-efficient, they still contribute to your personal income and can affect your tax bracket.
  • Insolvency Risk: Ensure that issuing dividends does not make your corporation insolvent, as this could have legal implications.

Bonuses: An Additional Method for Rewarding Yourself​

In addition to salary and dividends, bonuses can be used as a flexible way to reward yourself for the corporation's success. Bonuses are typically issued at the end of the fiscal year when the company's financial performance is clearer.

Advantages of Bonuses:

  • Tax Deductibility: Like salaries, bonuses are tax-deductible for the corporation, reducing its taxable income.
  • Performance-Based: Bonuses can be tied to specific performance metrics or company profitability, providing an incentive for achieving business goals.
  • Timing Flexibility: Bonuses can be issued at any time but are often used at the end of the fiscal year to manage taxes effectively.

Steps to Issuing Bonuses:

  1. Determine the Bonus Amount: Based on the corporation's financial performance, decide on an appropriate bonus amount. It's important to consider both the company's profitability and your personal tax situation.

  2. Include in Payroll: Bonuses should be processed through the corporation's payroll system, just like regular salaries. This ensures that the appropriate tax withholdings are made and that the bonus is reported on a T4 slip.

  3. Document the Bonus Decision: Keep records of the bonus decision, including the rationale and how the bonus was calculated. This is important for both tax reporting and compliance purposes.

Best Practices for Bonuses:

  • Align with Company Performance: Use bonuses as a way to reward yourself based on the company's success, aligning your compensation with business performance.
  • Consider Tax Impact: Be mindful of how the bonus will affect both your personal and corporate tax liabilities.
What are T4 and T5 slips

In Canada, a T4 slip is a form that employers give to employees to show how much money they earned and how much tax was taken out. A T5 slip is a form that shows any money earned from things like dividends or interest. Both of these forms need to be submitted by the end of February each year for the money earned in the previous year.

Optimizing Your Payment Strategy: Salary, Dividends, or Both?​

Choosing the best way to pay yourself from your corporation requires a careful analysis of your financial goals, tax situation, and business performance. For many business owners, a combination of salary and dividends offers the best balance between regular income and tax efficiency.

Combining Salary and Dividends:

  • Salary for Stability: Use a salary to provide regular income and contribute to CPP and RRSP. This method also ensures that you have a steady income for personal expenses.
  • Dividends for Flexibility: Supplement your salary with dividends to take advantage of tax credits and to manage cash flow strategically.
  • Bonuses for Additional Rewards: Consider issuing bonuses based on year-end financial performance to reduce corporate taxes and reward yourself for the company's success.

Using Tools to Optimize Your Strategy: Ribbon's Salary vs. Dividend Calculator is an invaluable tool for determining the optimal mix of salary and dividends for your situation. The calculator is particularly useful for small businesses with revenues up to $500,000, which are eligible for the Small Business Deduction (SBD). This deduction can significantly reduce the corporate income tax rate, making the decision between salary and dividends even more critical.

Considerations for Special Cases:

  • Top Tax Bracket: If you're already in the top tax bracket, it may be more advantageous to take a larger portion of your compensation as salary to maximize RRSP contributions and other benefits.
  • Loan Agreements: Review any loan agreements or shareholder agreements to ensure that they don't restrict your ability to issue dividends or bonuses. Some agreements may have covenants that limit payouts based on the company's financial health.
  • Long-Term Planning: Think about your long-term financial goals, including retirement planning. A salary provides the opportunity to contribute to CPP and RRSP, which are important for securing your financial future.

How can I pay the least tax?​

Salary vs Dividend matters less to total tax than you think

The government uses a concept called integration to try to tax income similarly, whether it comes from salary or dividends, resulting in a nearly equal overall tax burden. So the choice matters less than you would expect. Try it out for yourself using Ribbon's Salary vs Dividend calculator.

Final Thoughts: Making Informed Decisions for Your Financial Future​

Deciding how to pay yourself from your corporation in Canada is more than just a financial decision; it's a strategic one that impacts both your personal and business finances. The right approach depends on a variety of factors, including your corporation's financial situation, your personal income needs, and your long-term financial goals.

Key Takeaways:

  • Evaluate Your Needs: Consider your personal and business financial needs when deciding between salary, dividends, and bonuses.
  • Consult Professionals: While this guide provides a comprehensive overview, consulting with a tax professional, accountant or service like Ribbon is recommended to tailor your strategy to your specific circumstances.

By understanding the nuances of each payment method and using available tools, you can optimize your income while ensuring compliance with Canada's tax regulations. Whether you choose salary, dividends, bonuses, or a combination of all three, the key is to make informed decisions that support both your personal and business financial goals.