Many small business owners are faced with deciding how to pay themselves from the money earned within their business. It’s only fair to take some money out for all the hard work, but what’s the most tax efficient way to do it? Note that this article only discusses the basics on businesses that are incorporated. For specific advice it is best to consult your tax professional.
Salary vs. Dividends
A salary paid to you by your business is deductible by your business and taxable income in your hands (employment income). Dividends are distributions of business profits from the business to you and are not deductible by your business.
RRSP Contribution Room
A salary allows for more RRSP contribution room since the amount you are allowed to contribute to an RRSP is based on your ‘earned’ income.
The downside of this is obviously that you will have to pay taxes on any salary paid out to you from your corporation.
Dividends aren’t taxed as employment income but also don’t increase your RRSP contribution room.
Canada Pension Plan
When you pay yourself a salary you are also paying into your Canada Pension Plan (CPP). This is good because the amount you receive from CPP when you retire will increase the more you pay into it, but also bad because decreases the net amount you receive in cash from the salary.
Dividends don’t count towards your CPP contributions but also don’t get any CPP deducted when they are paid.
Carrying Back Losses
One drawback to paying a salary is that it can’t be used to carry back a loss in a later year. Let’s say you pay yourself a salary of $50,000, which brings the business earnings down to $150,000. If the business has a loss the next year, you won’t be able to carry back the loss against your personal income.
On the other hand, if the $50,000 was paid out as dividends instead of a salary you would be able to carry back the loss to the prior year – and reduce business taxes for that year.
Business and Personal Income Levels
Another thing to consider is the income level of both yourself and your business. If you are at a very high income level personally, it wouldn’t make any sense to make that amount even higher by paying yourself a salary since it would probably be taxed at the highest marginal tax rate.
On the other hand, if you have a lower income level personally and high income within the business, it makes sense to even things out by paying a bonus and reducing the tax rate within the business.
Regardless of your situation, the key is to avoid a high income level (and tax rate) within your business or for yourself personally.
As you may know, the government has a maximum income you can earn before they start taxing the OAS (Old Age Security) payments heavily – called a clawback. There is a 15% tax on every dollar of income earned above the maximum (in 2013 the clawback starts at $70,954). The clawback continues on the excess income until the OAS payments have been recovered. This means that the marginal tax rate is increased heavily on the affected portion of income.
Related: The History of OAS
For salaries, the amount is taken into income and as long as your taxable income is lower than $70,954 you will likely not be subject to an OAS clawback.
Dividend payments are “grossed up” (usually by 25%). So if you were given $25,000 in dividends, this means you’d have to report $31,250 as income that year – increasing the chances of an OAS clawback.
Child Care Costs
Young families that pay child care costs should also consider whether to pay salaries or dividends from the business. If the lower income spouse is paid dividends only then he/she likely won’t be able to claim any child care costs because dividends do not count as earned
Bonus Accrual – Deferral of Taxes
If you will be paying yourself a salary, one way to reduce your taxes is to accrue a bonus at year end. The idea is to accrue a bonus at the year end of the business and therefore make it deductible and reduce the taxes owing within the business. The bonus is then paid to you after year end and is taxable in your hands when you receive it.
This strategy defers business income from one year to the next by accruing the bonus at year end (making it deductible), but not actually paying it until after year end. The bonus must actually be paid to you within 180 days of year end for this strategy to be allowed by CRA.
Final thoughts: as you can see there are lots of things to consider when deciding between salary or dividends from a business. Some people like taking a salary because they don’t want to miss out on their RRSP contributions, others have found dividends better for their situation while some find a mix of the two works best. Everyone is different so it’s best to consult a tax professional who can look at factors specific to your situation before making a decision.