While incorporation has many benefits for small business owners, it does introduce additional complexities that are not faced by registered businesses. Unincorporated business owners are essentially taxed on their net business income, which allows for more time to devote to tax planning and how to spend all of your richly deserved profits. Incorporated business owners, on the other hand, cannot just withdraw cash from their businesses as the need or whim arises. There needs to be a formalized structure in place which usually takes the form of either salary or dividends. Either type of remuneration has tax and other financial implications that need to be considered before making a decision.
Related: How to Pay Yourself Dividends
Salaries are considered to be active income, while dividends are passive income. Since RRSP contribution room is calculated on active (earned) income, if your only source of income is dividends you will not be able to build RRSP contribution room, nor benefit from the tax benefits. Similarly child care expense deductions are based on earned income.
Salaries are paid from pre tax income i.e. they are tax deductible. Dividends, however, are paid from after tax earnings and are not tax deductible. To compensate for the additional taxes paid on a corporate level, the Canada Revenue Agency (CRA) and Revenue Quebec allows for a dividend tax credit, which results in lower income taxes on dividends.
Salaries require additional administration in that you have to calculate, file and pay your deductions at source on a monthly or quarterly basis. Late payments result in penalties and interest. And at the end of the year you have to file T4s (and RL-1s if you live in Quebec) along with related summaries. Dividend payments only require annual preparation of T5s and summaries. No payment is due at the time of filing the T5.
Salaries, within reasonable limits, can be used to reduce taxable business income to the small business limit which enjoys a significantly lower tax rate. Care must be taken that the salaries paid are reasonable or they will be disallowed. Since dividends are paid from after tax income, they have no impact.
CPP and QPP contributions are not payable on dividends. This can result in a maximum savings of almost $10,000, which should be taken into consideration when calculating tax liability versus salaries.
When calculating the R&D tax credit, eligible salaries are a significant part of the calculation, whereas dividends do not qualify for the credit. If the business owner contributes to the R&D project being claimed, it may make more sense to draw a salary.
Salaries must be paid to employees of the company, while dividends must be paid to shareholders. If you are one but not the other, then the choice is clear.
This Salary vs Dividend Scenario provides some insight into the tax implications of taking a specified salary versus a dividend.
The choice of salary vs dividend depends on the specific circumstances of the business owner. It may be more beneficial to take out only the funds necessary to maintain your lifestyle while retaining any excess cash in your corporation, thereby deferring taxes. Alternatively, by taking out a salary you may be able to maximize your RRSP contribution which can have a significant impact on your tax liability. As always with these situations it is good to solicit the advice of your accountant.
Ronika Khanna is a Montreal Accountant who helps small businesses achieve their financial goals. Please sign up to receive articles pertaining to small business, accounting, tax and other occasional non business topics of interest. You can also follow her on Facebook ,Twitter, Google Plus or Linkedin