We work with business owners from across Canada and we are often asked about the difference between salary and dividends. If you own a business through that corporation, you can pay yourself a salary or dividends or a combination of both.
This article will look at the difference between salary and dividends and the main advantages and disadvantages of each.
Salary / Wages
If you are paying yourself a salary, wage, or a bonus (all three are the same thing-wages), the payments become an expense of the corporation and then the wages are your employment income- you’ll get a T4.
The expense reduces the corporation’s taxable income which reduces corporate taxes owing.
HOW IT’S DONE
To pay yourself a wage, the corporation will need to register a payroll account with CRA. Each time you are paid, the corporation will need to withhold source deductions (CPP and Income Tax) from your pay. These source deductions are then remitted to the Receiver General (CRA) on a regular basis. In addition, each year the corporation must prepare and file T4s for any employees that earned wages.
WHY CHOOSE SALARY? Paying yourself a wage means:
- Since a wage is spread over the full year, then taxes are paid through the year.
- This means you would receive a steady and predictable income through the year.
- Increases your RRSP Contribution Room – Dividends do not increase your RRSP Room.
- CPP Contributions – adds to your annual future benefit. But it also means that the CPP contributions are a cost for your corporation. Less cash now, more cash later.
- No EI! If you own more than 40% of the company Employment Insurance is exempt but can be requested by the shareholder.
- Fewer Surprise Tax Bills – through payroll remittances Income tax is withheld and paid to CRA. While through dividends income tax is not withheld and remitted. This creates personal taxes owing every April.
- When Applying for a Mortgage – When you are attempting to qualify for a mortgage, banks like to see steady, predictable income. Earning employment income like this will help show that steady income, whereas dividend income may not be looked at as favorably by the bank.
- Having Children / Parental Leave – Maternity or Parental Benefits, are only valid when EI Employment Insurance payments for the shareholder.
- Paying Bonuses – Sometimes tax can be reduced or deferred by paying wages in the form of a bonus to business owners. This is a bit complicated and is not applicable in every scenario, but it is important to know that the technique exists.
TYPE OF TRANSACTION
Dividends are payments to shareholders of a corporation that are paid from the after-tax earnings of the company. This means that dividends are not a corporate expense and do not reduce the corporate taxes paid. The flip side is that dividends carry less personal tax liability than wages because they come with a dividend tax credit (more on tax differences below).
HOW IT’S DONE
- Dividends are only paid to those shareholders who own shares of the corporation.
- Dividends are declared and cash is transferred from the corporate account to a shareholder’s personal account in one or many transactions.
- Each year, the corporation must prepare and file T5s for any shareholders who received dividends.
- Each year in the corporation tax return the dividends are reported.
- Dividends are issued and paid based on share ownership.
WHY CHOOSE DIVIDENDS
Paying dividends can be a simple way for business owners to withdraw money from their corporation. Some key advantages include:
- Lower Cost – Paying dividends removes the need to contribute to CPP, which reduces corporate and personal costs. The downside is that it does not allow you to contribute to the Canada Pension Plan. More cash now, less cash later.
- Simplicity – If you own 100% of your corporation, you can just declare a dividend and transfer cash from the company to your personal account. No need to register for payroll and remit source deductions.
- Less Chance for Payroll Penalties – Payroll remittances are relentless and late payments come with stiff penalties. Paying dividends eliminates the chance of late or missed payroll remittances.
- Filing of T5s must be completed on-time once per year when paying dividends by February 28th, of every year.
- Bad at Administrative Tasks – If making payments on time is a weakness that you have, then it may be easier and less costly to pay yourself using dividends. Wages require the regular, on-time payment of source deductions. If source deduction payments are missed or late, the penalties can add up quickly.
Which Method Creates Less Tax?
(Spoiler – the answer is “it depends”)
Ok, so the most common question we get about salary vs. dividends is “which method allows me to pay less tax?”. This is an important question, but changes to legislation that took effect at the beginning of 2018 have made it more difficult to reduce taxes by choosing one method or the other.
Often, the results of calculations show minimal tax savings one way or another, and there is a reason for that.
There is a tax concept called integration that legislation aims to implement. The idea is that there should be little to no difference in the overall income tax paid (personal tax + corporate tax) when comparing dividend payments and wage payments of the same amount. How this works:
- Wages reduce corporate taxes but create higher personal taxes than dividends.
- Dividends do not reduce corporate taxes but create less personal taxes than wages.
In the past, corporate shareholders could skirt the issue of integration and tip the scales of tax savings in their direction by using a technique called dividend sprinkling. This was accomplished by spreading out dividend payments to a lower income earning spouse or adult family member. Because the spouse or adult family member are in a lower tax bracket than the person operating the business, there would be less personal tax to pay on their dividend income.
Now that it is more difficult, due to TOSI, implementing dividend sprinkling. We should consider the non-financial factors discussed earlier when deciding which method of payment to use.
CALCULATING AND COMPARING TAXES
Although there may not be as much in tax savings to be had 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 taxes (corporate + personal) that would be paid if dividends were used and compare that with the total taxes that would be paid if wages were used.
We can Help!!!!
There are a lot of moving pieces and things to consider when deciding to pay yourself through wages or dividends. Luckily, we like talking about this stuff for a long time, so give us a shout if you have any questions!!!
Teixeira Accounting Firm / www.helpingbusinesses.com