Should You Pay Yourself Salary or Dividends ?

One of the most important decisions that you have to make as the owner of a Canadian small business corporation is how to pay yourself. And in this video, I am going to help you make that decision by looking at the two primary ways of paying yourself, which is via a salary or a dividend. My name is Ronica Kenna. I am a cpa, a CFA, and the founder of Montreal Financial, where you can find lots of resources relating to your small business. And if you would like to dive deeper into the topic of salaries and dividends, I also have a book called Small Business and your Dividends, and I will leave a link to it in the description. Okay, so first of all, let us define the terms and it's really quite straightforward. Essentially, a salary is paid to an employee of a business, whereas a dividend is paid to a shareholder of a business. And this has important tax implications. And a lot of what we are going to be talking about relates to this distinction. So a salary for tax purposes falls under the the definition of earned income. And what earned income means that you have contributed labor to earn income. So a salary, if you were working at a job, for example, and you received a paycheck would be earned income. If you had a small business, you were a sole proprietor, that would also be earned income and salaries paid to an employee of your own corporation, which are pretty much identical to the salary that you would receive from from a third party employer, is also earned income. The other type of income that is relevant in this case is passive income. And passive income is paid to those who have investments, basically so they have invested capital into something. So for example, income that you receive, such as interest income or dividend income, which is related to investments that you have, would fall under the banner of passive income. And this is taxed a little differently. So what exactly are the differences in practice? Many of you will have worked for a third party employer, received a salary, would have had a gross pay deductions would have been taken off of your paycheck, and then you would have received a net amount and at the end of the year you would receive a T4, which you would then reflect on your your personal tax return along with all of the deductions that were taken. So this is literally exactly how it works. If you are an employee of your own corporation. The only significant distinction is that as the employer for a third party, you do have to pay into ei. However, as the owner of a corporation, if you own more than 40% of your corporation, you actually do not contribute to EI, nor are you entitled to claim it because essentially you cannot fire yourself. So with dividends on the other hand, because they are taxed as passive income, you would withdraw funds from the corporation, accumulate them, add them up and determine how much you took in dividends during the year. Whatever that total amount is would be reflected on a T5 slip, which then gets submitted to Revenue Canada. And you also show on your personal tax return, but as investment income, as non eligible dividend income. And so as you can see, the administration for dividends is significantly less with salaries. Once the deductions are taken from the employee's paycheck, which is you in this case as the owner of the small business corporation, these have to be remitted to Revenue Canada and Revenue Quebec. If you're in Quebec on a periodic basis, this can be monthly or quarterly. And then in addition to that obligation, you also have to prepare the T4 slip and make sure that everything kind of matches with a dividend. The only real administrative requirement is to prepare a T5 slip. And this might inform your decision as to whether you want to take a salary or a dividend. The next point that I think that it's important to understand is that there's a concept known as integration. And so CRA essentially wants you to pay the same amount of tax whether you take out a salary or whether you take out a dividend. And in practice this doesn't really work because of the way that they're taxed, which it would be impossible to achieve the identical tax amount, but they will be quite similar. And so that is something to keep in mind when you're making your decision. You are not going to save a significant amount by taking salaries or dividends, but it may be worth doing the calculation in advance. And again, this can be done every year. You can make a different choice every year. And we'll talk about that a little more. Now the next thing to keep in mind, and I think this is really important, is that again coming back to the definition of earned income. So if you have earned income, such as self employment income or income from a salary or wage or payroll, you are required to pay into the Canada pension plan, that is the cpp. And so this means that it is a forced retirement savings. The amount can be quite significant, but it is not a tax per se because you will get it back based on a very specific calculation when you retire. And of course, the more you put in, the more you will receive up to a maximum. And the contribution is capped as well at a maximum whenever you decide to retirement with dividends, there is no contribution to the cpp. This is irrelevant, not applicable for dividends. And so therefore, if you were only to ever have earned dividend income for your entire career, then when you retired you receive no CPP pension. And so this impacts how you save for retirement. And it also implies that you need a little more discipline if you're only taking dividends from your company because you do want to make sure that you save for retirement and related to retirement. One of the other distinctions between salary and dividend, which also relates to the earned versus passive income designation of each, is that salaries create RRSP contribution room. And an RRSP, for those of you who don't know, is a registered retired retirement savings plan. And the single best tax saving tax deferral mechanism available to Canadians. And the way RRSPs work is that if you contribute to an RRSP in any given year, it reduces your income and therefore the amount of income taxes that you have to pay and it goes into a retirement account which then compounds, hopefully over time you invest it into an underlying vehicle such as stocks or GICs and, and then ideally when you retire, you will have a retirement nest egg in your RRSP. You start having to withdraw it by 71 years old and you do get taxed on it ultimately, but there's a good chance that your tax bracket will be lower and therefore you will have to pay a lower amount of tax. So because of the compounding effect of your investments, this can be a significant benefit. This is not the case with dividends. Dividends do not create any RSP contribution room. So once you have to be much better and much more intentional about saving for your retirement. And the final thing that I want to talk about briefly is the way dividends versus salary is taxed. And this can become a little complex, so I don't want to bore everybody with it. But suffice it to say that salaries are a tax deductible expense to your corporation. So that means if for example, say you earn $100,000 in profits in your corporation and you take the full amount out as a salary, you will have zero corporate taxes to pay. And then at the personal level, you will pay taxes based on a hundred thousand dollar salary, and as discussed, this will be taken off every paycheck and remitted to the government. So if that is all you earn come tax time, because you've already taken deductions and remitted them to Revenue Canada, you won't really have any taxes to pay. Dividends, on the other hand, are not tax deductible in the corporation. So that means if you have $100,000 of profit and you pay yourself dividends, none of it will be deductible. So you would still have to pay tax on corporate taxes based on the province in which you're located on on the corporate profits. So for example, in Ontario this is about 12%. You could then take out the balance $88,000 in dividends. And then what would happen is to avoid double taxation, CRA recognizes that you have paid corporate taxes on those dividends. So it gives you a tax credit that is roughly equivalent to the corporate taxes that you paid. So roughly speaking, you should end up paying around the same amount of tax when you add up both the corporate taxes paid and the personal taxes paid. So even, and I recommend, and I've also done a video about this, I it is the tool that I recommend most often which is the wealthsimple tax calculator where you can enter an amount of estimated earnings and see what your tax estimated tax liability will be. One thing to keep in mind when you are doing that when you're entering the amount for ineligible dividends because chances are you are a small business corporation which benefits from the small business deduction. So you have non eligible or on the simple tax calculator it calls it ineligible, it's really non eligible dividends. Then you will notice that your taxes are probably lower. But don't forget that you will also be paying corporate taxes, whereas with in the case of salaries, you will be paying a lower amount of corporate tax because they are a tax deductible expense. Okay, so now the question becomes what is the best thing to do for your situation? And of course the answer to this question is always it depends on right? It depends on what your goals are. It depends on how much you're earning. It depends on what your tax rate is. But let me give you some general guidelines and things to think about. First of all, because a salary is earned income, you do have that forced contribution to the CPP and you create RSP contribution room. This is a great way to contribute to your retirement, create a portfolio. And it just takes a lot of the work work out of managing it yourself and making sure that you're disciplined enough. Secondly, with a salary, because deductions are being taken from your paycheck, you generally won't owe any taxes at the end of the year unless you have other sources of income. So once again, this can greatly simplify your tax preparation. For those of you that take dividends, you will have to pay taxes on your tax returns. You need to make sure that you put a specific percentage percentage aside and you're prepared for that. And once you were paying over $3,000 of taxes per year, then you will have to make quarterly installments. And so that's another way in which you have to be more active in managing your tax liability with dividends as well as your preparation for retirement. Another factor to consider is that if you are, for example, planning to buy a house or take out a loan, a personal loan in the banks, prefer to see salaries rather than dividends. My suggestion after all this, generally speaking, is to take a combination of both. But more importantly, if you're only going to choose one, I always prefer a salary. First of all, the income taxes that you're going to save are often negligible with the dividends, and you might actually not save anything at all. It's worth putting the amounts into the wealth simple tax calculator. There will be a discrepancy, but that will be related more to your CPP contributions and other payroll taxes. If you're in Quebec. And again, remember with the cpp, this is a forced retirement savings. You will be happy that you did it. You'll be happy when you retire, if you choose to retire at 65, that you have an additional source of income that is coming in without. You haven't even really noticed at a certain point that it was taken out. However, if you feel more comfortable managing your own retirement and you have a plan, then perhaps that isn't necessarily as persuasive to you. But coming back to what my recommendation is, which is to take a salary to cover your monthly living expenses and when you need money for for more specific purposes such as maybe you want to buy something, take a vacation, buy a house, etc. You can withdraw funds from the corporation as a dividend. There are various other ways to structure this, which I discuss in my book Small Business and your dividends. So if you are interested, I recommend taking a look at that. So I hope this was helpful. If you have any questions, don't hesitate to leave a comment and I will try my best to answer it. And please like and subscribe. Have a great day.