Small business owners in Canada can choose to pay themselves a salary or earn a personal income through dividends.

While there’s no wrong answer, the option you choose will play a role when the time comes to file your income taxes and, ultimately, is dependent on what kind of Canada Pension Plan or retirement savings plan you have in mind for yourself.

This article will examine the differences between a salary and dividends, including the pros and cons.

Dividend vs. Salary: key differences

Both a salary and dividends provide a source of employment income.

The corporation pays out salaries and thus, is considered an expense by the business. Therefore, individuals paid a salary are responsible for claiming all taxable income on their tax return at the end of the year.

As a steady source of income, a salary can also act as a record of consistent financial revenue and make it easier to secure a bank loan for a mortgage or a car or even open a new credit line.

On the other hand, a dividend is the distribution of a set amount of its earnings to some of its shareholders. Dividends are considered investment income, and as such, they are not subject to the standard tax deductions that many employees on salary see on their pay stubs.

Salary vs. hourly wages

Pay yourself a salary (or a wage) is a necessary cost of doing business as an entrepreneur.

Every small business owner must decide between paying out a business salary and paying an hourly rate, and there are pros and cons of each.

Salaried employees receive a fixed rate of pay. This means that their personal income is the same each pay period per year (unless a salary increase is determined), and there are no surprises or calculations done in error.

On salary, one can work as many or as few hours as they would like in a day, and the pay will always be the same.

Salaried employees also receive a T4 for their income tax records.

How the transaction works

If you, a small business owner, are paying your employees an hourly wage or decide to pay yourself an hourly wage, you must register a payroll account with Canada Revenue Agency on behalf of the corporation. Your payment will be subject to source deductions from the corporation that must be submitted to the Canada Revenue Agency (CRA).

Hourly wages can pose a financial problem for business owners looking to eventually grow and expand their small businesses while keeping their overhead costs down. Unfortunately, paying yourself or your employees by the hour can become quite expensive, especially opening a business. Therefore, it’s usually typical for the owner to work long hours.

As an owner, if you need your employees to work past the legal eight-hour workday and they are on an hourly wage system, by law, you must pay them overtime, which equates to their hourly rate plus a half. Long-term, this can become quite expensive and may not be sustainable for small business owners who are just starting.

Why choose a salary?

As many who have been paid a salary know, your gross salary on paper is never equal to the amount you collect via a paycheck.

By law, anyone who earns a salary or a taxable benefit must subtract source deductions from the rate of pay for that particular period. Then, those deductions are submitted to the Canada Revenue Agency (CRA).

If you choose to pay yourself a salary, you will likely be responsible for paying into a Canada Pension Plan (CPP), a registered retirement savings plan (or RRSP contribution), an employment insurance plan, as well as your federal, provincial, or territorial income tax.

Due to these involuntary contributions deducted automatically from earned income, being paid a salary makes it much easier to save for retirement.

Salaried employees also receive paid time off (vacation, maternity/paternity leave, bereavement leave, and sick leave) dependent on provincial guidelines and additional employer-sponsored benefits, like healthcare packages and insurance plans.

Employees paid hourly generally are not entitled to paid vacation or a leave of absence and are usually responsible for their healthcare.

To summarize, deciding to pay yourself a salary can provide several

• RRSP contribution room: paying yourself via dividends does not allow for this;
• Make CPP contributions: you cannot contribute to a Canada Pension Plan if dividends are paid;
• Less surprise tax bills: when the time comes to file your personal taxes, you’ve already paid your income tax, so you’re less likely to see tax charges or tax consequences that don’t add up;
• Getting a mortgage: banks like to see a steady source of employment income, and a salary guarantees this, so you’re more likely to qualify for a loan.

Why would you choose dividends?

Many business owners pay themselves or their businesses via dividends because there is less personal tax liability than a wage (or salary). Plus, they come with a special dividend tax credit.

Investors who receive dividends also gain access to a special non-refundable tax credit, recognizing that the tax was already paid on the corporation’s income.

Furthermore, individuals can earn an enhanced dividend tax credit that provides compensation for the higher tax rate paid on general income earned and taxed in the corporation.

In short, dividends allow the corporation to withdraw funds with ease and provide the following key benefits:

• Cheaper for owners and employers: dividends don’t require CPP contributions, which brings the tax rate down.
• No mandatory payroll: if you own the corporation, you can withdraw or invest as much or as little money as you’d like without worrying about registering your business for payroll, or dealing with source deductions.
• Less room for penalties: when you own the business, you’re likely responsible for everything, and it’s easy to make a payroll mistake. Because dividends don’t require payroll, this is avoided.

How the transaction works

As dividend payments are not subjected to normal payroll deductions, CPP deductions, or RRSP contribution deductions, the income earned per pay period will be similar or on par with the money earned through the corporation.

Much like paying yourself a salary, paying yourself a dividend also means that you face tax deductions, though the tax rates are much different.

More often than not, provinces and territories have two income tax rates; one is lower, and one is higher. The lower rate is reserved for all income-eligible for the federal small business deduction, while the higher rate applies to all other income.

Paying dividends to shareholders of a corporation is quite simple.

First, dividends are declared. Next, the cash flows from the corporate account to a shareholder’s account (as a business owner, this could be your employee). Finally, much like how those on a business salary receive a T4 slip during tax season, any shareholders must receive a T5 slip on behalf of the corporation.

Reduce tax burdens with child and spouse dividends

Though dividend taxes are generally much lower than salaried taxes, tax savings can be further generated when business owners use dividends to split income between eligible children aged 18 and older.

Small business owners and entrepreneurs who set up salary dividends can set up a family trust, legally acting as a corporation shareholder.

As a shareholder, that family trust can thus earn dividends, and those dividends can be paid out as net income to your spouse or adult children.

Once it’s time to file tax returns, those supported by the family trust will pay little to no taxes (unlike a regular salaried employee in a family business) due to exemptions from CPP deductions and RRSP deductions, as well as tax credits.

Is one method better than the other?

Canadian corporations have two options to consider when it comes time to make money. They can pay themselves or their employees a business salary or use dividends.

There is no right or wrong answer when selecting a method to generate cash for the corporation; simply, it comes down to your unique personal obligations and financial goals.

A salary is a popular option for many. This is because a salary allows for CPP and RRSP contributions, which can help with various lifestyle factors, like planning for retirement or putting away savings.

On the other hand, dividends are also a good choice due to their flexibility and lower tax rates. Before you choose either, it’s always a good idea to go over your long-term business goals to ensure that whichever way you go, it’s a smart investment for you and your business.

Ready to access the best government funding options for your business? Major Developments Canada (MDC) has helped over 500 Canadian entrepreneurs and small businesses find the best options. If you have any questions about the available programs, please email us at info@majordevelopmentscanada.