(Originally posted on May 6, 2016)

 

Salary vs. Dividends, What is Best for You?

 

Before we can explore the benefits of receiving Salary or Dividends, it is important to first understand what exactly dividends are;

Generally speaking, Dividends are amounts paid to the Shareholders (owners) of a Corporation from the Retained Earnings of that Corporation.

Retained Earnings are simply the accumulated Profits a Corporation has earned over a period of time; therefore, a Corporation can only pay Dividends to the Shareholders if there are Retained Earnings (Profits less Income Taxes).

You may have heard that Dividends you receive are ‘tax-free’, but such is not the case. Dividends for the most part receive specialized treatment by CRA because the Corporation has already paid tax on the Profits it has earned and the Dividends are then being paid from After-Tax dollars. And, depending on your personal tax situation, tax bracket and other factors, a significant amount of dividends could be received before you notice an increase in your personal tax burden, making them seem to be ‘tax-free’.

When you receive Dividends, you also receive an amount called a ‘Dividend Tax Credit’ on your information slip (T3 or T5). This Credit is to recognize that the Corporation has already paid some tax on these amounts.

To make things a little more confusing though, there are 2 types of Dividends you could receive, “Eligible” and “In-Eligible”; simply put, Eligible Dividends receive a higher tax credit for recipients because the Corporation paying the Dividends has paid income tax on these amounts at the highest tax rate already. In-Eligible Dividends therefore, receive a lower tax credit.

Most small business owners will only ever receive the ‘in-eligible’ type of dividends.

So, if Dividends could be relatively tax-free, why would you want to receive a salary instead of dividends?


There are several things to consider:

Dividends are NOT Earned Income, therefore you could lose out on:

  • RRSP Contribution Room
  • CPP Contributions and Benefits (Retirement Pension, Disability etc.)
  • Many Personal Tax Credits and Government Benefits
  • Many Tax Deductions will be lost (Child Care, Medical Etc.)
  • Many Lending Institutions may not recognize Dividend Income in considering your credit requirements.
  • Loss of approximately $14,000 personal tax exemption


Dividends could cause your other income to move into a higher tax bracket.

If your income from other sources (employment, investments etc.) puts you close to a tax margin threshold, the Dividends received could possibly cause you to pay more tax on the other earnings.

Of course, there are some great advantages to Dividends as well;

Dividends could create a potential for Income Splitting, reducing your overall family tax burden

From your business perspective, Dividends are much easier as there is no need to deal with payroll and CRA for payroll taxes.

So, with these advantages and disadvantages, what is the best way to pay yourself?

The answer – it depends!

Everyone’s situation is very different and will require you to talk to accounting and tax professionals, however, there are several rules of thumb that many financial planners will recommend:

Pay yourself a salary high enough to maximize your CPP Pensionable Earnings (some may say high enough to maximize your RRSP contribution room).

You want to be able to have the security of a pension plan upon retirement as well as the other benefits of CPP.

Pay yourself enough salary to meet your personal financial obligations so you can meet your creditor requirements (mortgage, groceries etc.)

Pay your spouse / children reasonable amounts if they work in the business (these wages are 100% tax deductible to the business) and assist with income splitting reducing your overall tax burden

As mentioned, every situation is different and you should talk to accounting and financial planning professionals to determine what is best for your specific circumstances, additionally, remember to review your remuneration strategy each year.

Need more advice? email us and we will have a Ledgers Financial Planning Professional contact you.


See a couple of Examples of the Tax Impact of Dividends HERE.