Salary vs Dividend: How to Take Money Out of Your Small Business in Canada

In short:

• Salary: Builds RRSP room, contributes to CPP, and is preferred by lenders for loans but comes with higher taxes and payroll obligations.
• Dividends: Taxed at a lower rate at the personal tax level, doesn’t require CPP contributions, but doesn’t build RRSP room or provide predictable income for loans.
• Combining Both: Can optimize taxes, balance income flexibility, and offer the benefits of both salary and dividends with proper planning.

If you're reading this you've likely grown your business to a point where you can pay yourself from it (nice!). The two primary options to do so in Canada are salary and dividends, each with its own tax implications and benefits. In this blog post, we'll explore both methods, their pros and cons, and provide guidance on how to choose the best option for your situation.

What is a Salary and How is it Taxed?

A salary is a fixed regular payment made by a company to an employee in exchange for work performed typically on a bi-weekly or monthly basis. When you pay yourself a salary from your corporation, it's treated as employment income which impacts your income taxes.

Taxation of salary:

• You pay personal income tax on your salary at graduated rates based on your total income.
• Both you and your corporation must contribute to the Canada Pension Plan (CPP).
• Employment Insurance (EI) premiums are optional if you own more than 40% of the voting shares.
• Your corporation can deduct the salary and related payroll taxes as a business expense, reducing its taxable income.

Pros and Cons of Salary

Advantages:

1. Builds RRSP contribution room
   • Salary generates RRSP contribution room, allowing for tax-deferred savings
   • These savings can later be used for large purchases, like a home, through programs such as the Home Buyers' Plan
2. Allows for CPP contributions, providing future retirement benefits
3. Easier to obtain loans or mortgages
   • Lenders prefer to see a consistent, predictable income when assessing loan applications
   • Banks calculate your debt service ratio based on your income, and salary is viewed more favourably than dividends in these calculations
   • Some mortgage products, particularly insured mortgages, specifically require salary income
4. Provides predictable personal income for budgeting
5. Helps build a strong credit history, which is crucial for future borrowing
6. May be required for certain employment benefits or insurance products
7. Demonstrates steady employment and compensation history, which can be beneficial for various financial and legal purposes (e.g. loans, mortgages, etc.)
8. Considered a business deduction

Disadvantages:

1. Higher personal tax rates compared to dividends - which isn't too big of a deal because with dividends you're still taxed, and you pay corporate taxes 
2. Subject to payroll taxes (CPP, potentially EI)
   • While CPP contributions provide future benefits, they represent an immediate cost
3. Requires more administrative work, including running payroll and making remittances to CRA - if you have an accountant though this isn't a concern
4. Less flexible than dividends - if you customize how much you take out with salaries, your payroll software may withhold more in fees

Implementing a Salary Strategy

To implement a salary strategy:

1. Determine a reasonable salary based on your cost of living and leave the rest in the company. Even if you want to invest your savings, doing so within the company gives you more buying power as the corporate tax rate is lower than the personal one and you'll have more money after taxes within the company.
2. Set up a payroll system or use a payroll service provider.
3. Withhold and remit income tax, CPP, and EI (if applicable) to the Canada Revenue Agency (CRA) - your payroll software should take care of this
4. Issue yourself regular paycheques and a T4 slip at year-end - again with the right payroll software this is automated
5. File payroll remittances (PD7A) and T4 Summary annually.

What is a Dividend and How is it Taxed?

Dividends are distributions of a corporation's after-tax profits to its shareholders. As a small business owner, you can pay yourself dividend income if as a shareholder of your corporation.

Taxation of dividends:

• Dividends are taxed at a lower rate than salary due to the dividend tax credit, which accounts for taxes already paid at the corporate level.
• There are two types of dividends: eligible (from large public corporations) and non-eligible (typically from small businesses). Non-eligible dividends are taxed at a higher rate.
• Dividends are not subject to CPP or EI contributions.
• Dividends are not a deductible expense for the corporation.

Pros and Cons of Dividends

Advantages:

1. Lower personal tax burden 
2. No payroll taxes (CPP, EI)
3. More flexible timing of payments, allowing for better cash flow management
4. Can be used for income splitting with family members (subject to tax on split income rules)

Disadvantages:

1. Doesn't create RRSP contribution room
2. No CPP contributions, potentially reducing future retirement benefits
3. May be harder to obtain bank loans or mortgages
4. Less predictable for personal budgeting

Implementing a Dividend Strategy

To implement a dividend strategy:

1. Ensure your corporation has sufficient retained earnings to declare dividends.
2. Hold a directors' meeting to declare the dividend for each class of shares and document it in corporate minutes.
3. Issue a dividend cheque or direct deposit to yourself as a business shareholder.
4. Prepare and file a T5 slip reporting the dividends paid.
5. Report the dividends on your personal tax return.

What is Income Splitting?

Income splitting involves distributing dividends to family members who are shareholders of your corporation, often in lower tax brackets. This can potentially reduce the overall family tax burden by “sprinkling” income to these family members, thereby lowering the effective tax rate on that income.

However, in Canada, the government has implemented strict rules to limit income splitting through the Tax on Split Income (TOSI) rules, which apply to dividends paid to family members.

Requirements for Dividend Sprinkling

To avoid the punitive TOSI rules, the family members receiving dividends must meet specific criteria:

• Family members aged 18 and over: Income splitting with minors is heavily restricted, as TOSI generally applies to minors.
• Family involvement in the business: Dividends can be paid to family members who actively participate in the business on a regular and continuous basis. This typically means working at least 20 hours per week in the business.
• Reasonable compensation: The amount paid as dividends should be reasonable given the recipient's involvement and contributions to the business.
• Ownership for more than five years: If a family member owns shares of the corporation for more than five years, they may avoid TOSI rules, even if they don't actively work in the business.
• Exclusions for spouses: In some cases, spouses of the business owner may receive dividends without triggering TOSI if the business owner is over the age of 65.

Pros of Dividend Sprinkling

• Tax Savings: The primary advantage of income splitting is reducing the overall tax liability for the family by using lower tax rates of family members who are in lower income brackets.
• Flexibility: Allows you to distribute income more flexibly among family members based on their tax situation.
• Retirement Planning: When used effectively, dividend sprinkling can be part of a long-term strategy to pass wealth to family members in a tax-efficient way.

Cons of Dividend Sprinkling

• TOSI Rules: The biggest downside is that the TOSI rules severely limit your ability to income split with family members who don’t meet the active involvement requirements or other exemptions. If TOSI applies, dividends paid to family members could be taxed at the highest marginal tax rate.
• Complexity: Income splitting requires careful planning and documentation to ensure compliance with TOSI rules and to avoid unintended tax consequences.
• Limited to Certain Family Members: Only family members who meet the criteria (age, involvement, or share ownership length) can participate in dividend sprinkling without triggering TOSI.

Example:

Let’s say you own a small business, and your spouse helps with bookkeeping for 20 hours a week. You pay dividends to your spouse, who is in a lower tax bracket. As your spouse is actively involved in the business, this income may not be subject to TOSI, allowing you to benefit from their lower tax rate.

Can I Combine Both Salary and Dividends?

Yes, you can absolutely combine both salary and dividends when compensating yourself from your corporation. In fact, many small business owners in Canada use a hybrid approach, taking a combination of dividends and salary to make up their income. This strategy allows you to balance the advantages of both methods and tailor your compensation to your needs, lifestyle, and tax situation.

Here’s how a combination of salary and dividends might work:

1. Salary: You can pay yourself enough salary to take advantage of certain benefits:
   • Build RRSP contribution room for future savings.
   • Ensure you contribute to the Canada Pension Plan (CPP), which can help with your retirement income later on.
   • Meet the income requirements for mortgage applications or other financial products.
2. Dividends: The remaining compensation can be taken as dividends:
   • Helps reduce your overall tax burden by benefiting from the lower dividend tax rates.
   • Avoids the need to pay CPP contributions on this portion of income, offering immediate tax savings.

Things to Consider:

• Admin Complexity: Using both methods means you’ll need to manage payroll calculations for the salary portion and prepare dividend documents like T5 slips for the dividend portion.
• Planning Required: A combined strategy can be complex, so it's advisable to work with an accountant to optimize the amounts for maximum tax savings and benefit contributions.

Example Situation

Let's consider a hypothetical small business owner, Sarah, who runs a consulting firm earning $150,000 in profit before her compensation.

Scenario 1: Full Salary

• Sarah takes a $150,000 salary
• Corporate tax: $0 (fully deductible)
• Personal tax (assuming Ontario rates): Approximately $47,000
• Total tax burden: $47,000

Scenario 2: Full Dividends

• Corporate tax (assuming small business rate): $18,000
• Dividend payment: $132,000
• Personal tax on dividends: Approximately $23,000
• Total tax burden: $41,000

In this simplified example, the dividend strategy results in a lower overall tax burden. However, Sarah would need to consider other factors like RRSP contributions, CPP benefits, and her long-term financial goals before making a decision.

Combined Strategy:

Now suppose Sarah takes a $50,000 salary and $50,000 in dividends:

• Her salary generates RRSP contribution room and builds up CPP benefits.
• The dividends benefit from a lower tax rate.
• The total taxes paid on this combination could be less than if she had taken either a full salary or full dividends, depending on the specific tax rates in her province and her other personal income.

Questions to Help You Decide 

1. What's your personal tax situation?
   • If you're in a lower tax bracket, salary might be more beneficial.
   • If you're in a higher tax bracket, dividends could result in lower overall taxes.
2. What's your business's financial health?
   • Strong cash flow and consistent profits? Dividends might be suitable.
   • Tighter cash flow or reinvestment needs? Salary offers more predictable expense planning.
3. Do you need to build RRSP room for retirement savings?
   • Yes: Lean towards salary to create RRSP contribution room.
   • No: Dividends might be more tax-efficient if RRSP room isn't a priority or if you've hit your contribution limit.
4. Are you planning to apply for a mortgage soon?
   • Yes: Salary is generally preferred by lenders.
   • No: You have more flexibility to consider tax-efficient dividend strategies.
5. Do you want to maximize CPP benefits?
   • Yes: Salary contributions build CPP benefits.
   • No: Dividends avoid CPP contributions if you have other retirement plans.
6. Is income splitting with family members an option?
   • Yes: Dividends offer more flexibility for income splitting (subject to tax rules).
   • No: Salary might be simpler and still allows spousal RRSPs for some splitting.

Special Considerations for Salary vs. Dividends in Unique Situations

In addition to the tax and financial planning factors already discussed, certain real-life situations make one compensation method more beneficial than the other. Here’s a closer look at how specific scenarios like applying for a mortgage, maximizing government benefits, or handling corporate cash flow can impact your decision.

1. Mortgage or Loan Applications

Lenders prefer consistency when evaluating income for mortgage or loan applications. Salaried income, which is predictable and steady, is often favored by banks and financial institutions over dividends, which can be less consistent and seen as less reliable.

• Salary Advantage: If you're planning to apply for a mortgage or personal loan, paying yourself a regular salary improves your chances of approval. Lenders typically use your salary to calculate your debt service ratio, and some mortgage products, particularly insured ones, may require evidence of regular employment income.
• Dividend Disadvantage: While dividends can supplement income, they may not be treated as favorably in the application process, especially if they are irregular or vary from year to year. This could limit your borrowing capacity.

2. Health Benefits

If your business offers a Private Health Services Plan (PHSP) or a Health Spending Account (HSA), paying yourself a salary may be necessary to take advantage of these corporate health benefits.

• Salary Requirement: Some plans require that employees (including yourself, as the owner) receive a salary to qualify for health-related reimbursements. A steady salary allows you to access these benefits, which can offset personal medical expenses.
• Dividends Limitation: Dividends are typically not considered employment income, so they may disqualify you from participating in certain health plans tied to employment.

3. Child Care Expense Deductions

If you have child care expenses, only salary or other "earned income" allows you to deduct these costs on your personal tax return.

• Salary Advantage: Paying yourself a salary qualifies as earned income, meaning you can deduct child care expenses, reducing your taxable income.
• Dividend Disadvantage: Dividends do not count as earned income, so you won’t be eligible to deduct child care costs if dividends are your primary source of income.

4. Government Programs and Subsidies

During times of crisis, such as the COVID-19 pandemic, the Canadian government extended financial support to businesses that paid salaries, including programs like the Canada Emergency Wage Subsidy (CEWS) and Canada Emergency Business Account (CEBA) loans.

• Salary Advantage: Companies that paid themselves or employees through salary were eligible for these programs. Having a salary structure in place meant you could access these benefits to cover payroll costs during tough times.
• Dividend Disadvantage: Businesses that primarily paid dividends were generally ineligible for wage subsidies, potentially missing out on government aid during periods of reduced income.

Invested Your Own Money When Starting the Business? - There May Be A Third Way to Take Money Out

If you've personally lent money to your corporation, repayment of shareholder contributions can be an effective way to extract money tax-free.

How it works:

• You invested money to your corporation (documented properly)
• The corporation uses the funds for business purposes
• When the corporation repays you, it's a tax-free return of capital

Pros:

• Tax-free withdrawal
• No impact on personal taxes or benefits

Cons:

• Limited to the amount you've actually lent to the company
• Requires proper documentation and tracking

This method is particularly useful when you've invested personal funds into your business and want to recover them without tax implications.

To Recap

Choosing between salary and dividends (or a combination of both) is a complex decision that depends on various factors including your personal financial situation, basic living costs, business goals, and long-term plans. While dividends often result in a lower overall tax burden, salary offers benefits like RRSP room and CPP contributions that shouldn't be overlooked.

Keep in mind that tax rules can change, and everyone's situation is different. It's a good idea to talk to a tax expert or accountant to figure out what's best for you. Also, make sure to look at your pay strategy regularly to check if it still fits with what you want for yourself and your business as things change over time.

By understanding how each option works and thinking carefully about what you need, you can make a smart choice that helps both you and your small business do well.

FAQ

Is there a limit to how much salary or dividends I can take from my business?

No, but the amount of salary you pay yourself should be "reasonable" based on your role in the company. Dividends are limited to the corporation’s retained earnings, so you can only pay dividends if the business has after-tax profits.

However keep in mind that the income tax rate is a lot higher than corporate tax rates. If you only take out what you need and save additional cash in the business, you have a tax advantage which gives you more buying power

Which is better for tax savings: salary vs. dividends?

It depends on your total income and tax bracket. Dividends often result in a lower tax burden overall because of the dividend tax credit, but salary has benefits like RRSP contributions and CPP. The best option depends on your specific financial situation.

Will taking dividends affect my eligibility for a mortgage?

Yes, it can. Lenders typically prefer consistent, predictable salary income over dividends, especially for insured mortgage products. If you plan on applying for a mortgage, a salary might improve your chances of approval.

How are dividends taxed differently than salary?

Dividends are taxed at a lower rate than salary due to the dividend tax credit, which accounts for taxes already paid by the corporation. Salary is taxed as regular personal income and is subject to CPP (and potentially EI) contributions.

Can I split income with my spouse using dividends?

Yes, dividends can be used for income splitting with family members, but there are strict tax rules (like the Tax on Split Income or "kiddie tax") that apply if you're splitting income with family members under 18 or if certain conditions aren't met