Should You Pay Yourself a Salary or Dividend? 7 Considerations For Small Business Owners
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 is significantly simpler. They only have to file one tax return and are simply taxed on the profits of their business.
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. When deciding whether to take salary or dividends there are several factors that every business owner should be aware of.
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Related: How to Pay Shareholder Dividends & What is a Capital Dividend
Active vs. Passive Income
Salaries are considered active income since they are paid to employees, while dividends are passive income paid to shareholders. Since RRSP contribution room is calculated based on active (earned) income, if your only source of income is dividends, you will not be able to build RRSP contribution room or benefit from the associated tax advantages. Similarly, child care expense deductions are based on earned income.
Tax Treatment of Salaries vs. Dividends
Salaries are paid from pre-tax income, which means they are tax-deductible. Dividends, however, are paid from after-tax earnings and are not tax-deductible. To compensate for the additional corporate-level tax on dividends, the CRA and MRQ apply a gross-up and dividend tax credit mechanism, which reduces the personal tax payable on dividends.
The tax system aims for “integration,” meaning the total tax paid (corporate plus personal) should be roughly the same whether income is paid as salary or dividends. However, perfect integration is difficult to achieve and not always the case in practice. Note that dividends paid from income taxed at the small business rate are referred to as ineligible dividends.
Administrative Requirements
Salaries require additional administration, including calculating, filing, and remitting source deductions on a monthly or quarterly basis. Late payments result in penalties and interest. At year-end, employers must file T4s (and RL-1s in Quebec) along with related summaries.
Dividends, on the other hand, only require the annual preparation of T5s and the corresponding summary. No payment is due at the time of filing the T5, although quarterly instalments may be required based on prior year income.
Impact on Business Income
Salaries, within reasonable limits, can be used to reduce taxable business income to the small business limit, which is taxed at a lower rate. Care must be taken to ensure that salaries are reasonable, as excessive amounts may be subject to scrutiny.
Since dividends are paid from after-tax income, they do not reduce corporate profit. In Quebec, to qualify for the small business tax rate, a corporation must have employees who work more than 5,500 hours per year. Otherwise, the small business deduction is not available.
CPP and QPP Contributions
CPP (Canada Pension Plan) and QPP (Quebec Pension Plan) contributions are not required on dividend income. This can result in annual savings of nearly $10,000 compared to salaries. However, not contributing means you will not be entitled to CPP/QPP benefits at retirement.
As of 2024, the maximum monthly CPP retirement benefit starting at age 65 is $1,364.60, while the average monthly amount is $758.32. Your actual benefit will depend on how much you’ve contributed to the plan over the years.
You can get an estimate of your CPP retirement pension by logging into your My Service Canada Account.
You can estimate your QPP retirement pension by logging into your Retraite Québec account using your login for “My Account for Individuals,” which provides access to both Revenu Québec and Service Québec services.
Salaries and the SRED Tax Credit
When calculating the SR&ED (Scientific Research and Experimental Development) tax credit, eligible salaries are an important part of the claim. Dividends do not qualify. If the business owner is involved in the SR&ED work, it may make more sense to take a salary to maximize the reimbursement.
Eligibility: Salaries vs. Dividends
Salaries must be paid to employees of the corporation, while dividends must be paid to shareholders. If you are only one or the other, the choice is clear.
Employment Insurance (EI) Considerations
Shareholders who own at least 40% of their corporation are not entitled to Employment Insurance, whether they receive salary or dividends. They are also not required to contribute to EI if they take a salary, unless they specifically register for the self-employed EI program.
You can also estimate your tax liability using the Simple tax calculator. When including dividends, the ineligible dividends field would be used.
final Thoughts
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 and CPP contributions which can reduce your tax liability. As always with these situations it is good to solicit the advice of your accountant.
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