So you've incorporated - now how do you pay yourself? As a Chartered Professional Accountant, I get this question a lot. My answer might surprise you.
In this article, I am going to discuss the little-known factors you should consider when deciding how to pay yourself from your corporation
Are taxes the only thing you are considering when deciding between salary or dividends? If so, you may end up making the wrong choice.
Let's break each option down so you can be well-informed.
A Bit About Dividends
A dividend is a type of payment shareholders of a corporation receive. You must own shares of an incorporated business to be paid dividends.
Dividends do not reduce corporate taxes AND they also incur personal taxes.
You do pay taxes twice; but, the personal taxes are at a reduced tax rate in recognition of the corporate taxes paid.
This is called integration.
It is CRA’s intention that income taxes be approximately the same no matter if the income is received through dividends or a salary.
It is a common myth that dividends are received ‘tax free’.
This is not the case and can cause some very shocked business owners when they look at their personal tax bill come tax time.
What are the main things you should know about dividends?
Number 1: They Incur Personal Taxes
Setting aside 20-30% of your dividend draws to pay your tax bill can help you be prepared.
A client didn’t end up doing this and had a personal tax bill of around $50,000. When looking at their bank accounts it was clear the money had long since been spent.
Don’t end up in this situation and set money aside for taxes.
Number 2: They Don't Take Advantage of Childcare Write-Offs
This means they aren’t a great option for parents of young children in daycare.
A client was spending $15,000 a year on childcare. This is normally a deduction on your personal income tax return.
Because they had been taking dividends, they couldn’t take advantage of these write-offs which increased their tax bill by thousands of dollars.
Number 3: They Don't Grow Your RRSP Contribution Room
This can really stifle small business and retirement planning options down the road.
A client had spent years growing a profitable business. They had saved for retirement in their corporation and been using dividend draws to pay for their living expenses. When they wanted to shift this money into their personal name and close their corporation after retirement, they had no way to take the money out of their corporation tax-free because their RRSP contribution room limit didn’t exist.
A salary grows your RRSP contribution room and can allow business owners to move large sums of money into their personal RRSP accounts tax-free.
Dividends don’t grow an RRSP contribution room which means you can’t use this strategy.
Number 4: They Don't Contribute To Your Canada Pension Plan
This means you aren’t entitled to CPP when you retire and can leave you impoverished as a retiree unless you save appropriately for retirement.
It is the good intention of all of us to win the lottery, create the next big thing, and make it rich through real estate.
Sadly, this leaves your retirement savings account neglected. I’ve seen many retirees with no savings and no Canada Pension Plan because they had been taking dividends out of their corporation.
This can leave people destitute and is truly horrific later in life.
Many older clients have been dismayed, disgruntled, and distraught by being unaware of these considerations when taking dividends out of their corporation.
A Bit About Salaries
A salary is familiar to most Canadians because it results in a T4 wage statement at the end of the year.
Wages and salaries in a corporation reduce your corporate income taxes but you pay slightly higher personal income taxes.
This is the CRA again employing the theory of integration.
It is their intention your income taxes be about the same no matter how your income is received.
The tax differences often ends up being only 1 or 2% between salaries and dividends.
Because of this, I often encourage my clients to consider other factors when deciding how to pay themselves. These include:
Deductibility of childcare costs
RRSP contribution room growth
Canada Pension Plan contributions
Paying a salary involves regular payroll calculations and monthly remittances to the CRA.
This is a lot of work.
It adds administration tasks to your busy schedule and can cause significant penalties if you miss deadlines.
"The tax differences often ends up being only 1-2% between salaries and dividends." – Jillian Battaglio, CPA, CA
To help overcome the administration challenges one client found relief by using a payroll service provider who automatically made their CRA remittances and prepared their T4.
The last thing you may want to consider if you are a subcontractor is personal services business risks or PSBs which can add thousands and thousands and thousands of dollars to your corporate tax bill.
Wages are one of the best ways to reduce your PSB risk so be sure to check out our other video on personal services business if you are a subcontractor.
Which Is Right For You?
Well, this is going to be different for every individual. My recommendations often depend on your life stage, business stage, and retirement savings.
A Bit Younger?
I often recommend younger clients go with the salary method.
This gives you much more flexibility down the road in terms of childcare and RRSPS. It also sets money aside in your Canada Pension Plan as a backup encase making it rich doesn’t pan out.
Now, I eat my own cooking. RRSPs and CPP are important to me, so I personally take a salary from my corporation.
On the flip side – older clients or those who are very secure in their retirement plans might want to choose dividends.
Childcare deductions and RRSPs may not be advantageous for them at this stage and saving the $5,000 CPP can cost each year is a nice perk of dividends along with the reduced administration requirements.
Why Not Mix It Up?
As a third option, you can also consider a mix of these methods.
A salary can give you structure for your personal finances while taking advantage of childcare deductions, RRSP contribution growth, and CPP benefits.
Extra dividends can provide flexibility around extra cash draws when your business does well.
"Are taxes the only thing you are considering when deciding between salary or dividends? If so, you may end up making the wrong choice." – Jillian Battaglio, CPA, CA
I’ve given you lots to think about today. I hope this article has illuminated the little-known factors to consider when deciding between salaries and dividends.