If you own an incorporated business, there are two primary ways to pay yourself:
- Salary and/or
If you pay yourself a salary, the amount is a deductible expense to your corporation and is taxable in your hands. You will be required to deduct and remit income tax and CPP to CRA (this assumes you own> 40% of the issued shares of your corporation, thereby exempting you from deducting and remitting EI). As a corporate shareholder, the amount of salary does not have to be reasonable and is typically unchallengeable by CRA.
Alternatively, you can have the income taxed in your corporation and then pay the after-tax earnings to yourself, as dividends, which is not deductible to the corporation. Dividends are payments made to shareholders from retained earnings of the corporation. If the corporation does not have retained earnings, then it cannot technically pay a dividend. You’ll face tax on the dividends paid to you, but at a lower tax rate than salary, given that the corporation pays the dividend out of after-tax earnings and hence, when dividends are received, the amount is “grossed up” and the individual is entitled to a dividend tax credit (to provide a tax credit for the approximate tax that was paid by the corporation).
Pros and Cons when considering Salary or Dividends:
- Salary is considered 'earned income' for RRSP purposes and pension contributions, while dividends are not.
- If you are planning on applying for a line of credit or a mortgage, then paying yourself a salary will help you qualify.
- Salary is deducted as an expense in the corporation, reducing net earnings and ultimately, corporate taxes payable.
- Salary can be used only to pay employees of the corporation.
- The burden to do payroll; source deductions (income tax and CPP) have to be calculated and remitted to CRA, typically on a monthly basis; preparation and filing of T4 slips by February 28th of the following year.
- Salary attracts a higher personal tax rate than dividends.
- Dividends can be paid to shareholders of a corporation.
- Dividends are tax efficient, as they are taxed at a lower rate than salary.
- Dividends are administratively simple, although you will need to file a T5 with CRA by February 28th of the following year.
- Dividends require a resolution by the Directors of the corporation.
- Dividends directly reduce the equity of the corporation. (For example, when a dividend of $100,000 is declared and paid, the corporation's cash and retained earnings are both reduced by $100,000).
- Dividends are not an expense of the corporation and therefore, dividends do not reduce the corporation’s net earnings or taxable income.
- If you pay dividends in excess of retained earnings and should the corporation become insolvent, you may be liable to repay the dividends taken.
There are benefits and drawbacks to each option, so choose what's right for your business.