When it comes time to take money out of your business, what’s the most beneficial way? Some business owners choose to set up a set salary while others take a dividend. Both of these methods come with tax advantages and disadvantages that need to be considered to make the best choice for your situation.
What is a Salary?
A salary results in you getting paid like any other employee on a set schedule and for a fixed amount. The salary amount is a qualifying business expense, reducing the business’s taxable income. However, in order to be deductible, the compensation needs to be reasonable for the position and job duties performed. Any amount that is unreasonable does not qualify for a deduction. For owners and managers, reasonableness is generally not an issue since you control a majority of the daily operations.
The major drawback of a salary is that the amount you pay is subject to payroll taxes. In addition, the company will need to match employees’ contributions to the Canada Pension Plan or the Quebec Pension Plan. Other expenses, such as provincial worker’s compensation and health insurance taxes may occur, but these expenses are also deductible. You will be required to pick salary payments up as income on your individual tax return and pay taxes at your marginal rate, but you may have expanded tax credit opportunities, such as a credit for CPP contributions.
What is a Dividend?
A dividend payment is money withdrawn directly from the company, such as going to the ATM and pulling out money. These amounts are a non-deductible expense and can go against your Capital Dividend Account in the company. Dividends are not subject to the reasonableness test and have already been taxed once at the corporate level. This payment method can be favorable since individuals have the opportunity for a dividend tax credit.
Although dividends remain a simpler method compared to taking a salary, dividend payments don’t allow you to contribute to the Canada Pension Plan. In addition, if you withdraw more from the company than you have in your Capital Dividend Account, your dividends will be subject to additional taxation.
Which One is More Beneficial?
Both salaries and dividends come with their own sets of advantages and disadvantages for tax purposes. Salary payments can be more beneficial if you are looking to purchase a house through a mortgage because lenders look for earned income. Additionally, you will be more likely to receive fewer surprises when you file your annual tax return and wages allow for CPP contributions. However, wages do come with a higher tax burden compared to dividends.
Dividends on the other hand can result in a lower tax bill and a simpler process compared to wages. Despite the lower tax bill, this method can be unfavorable if you plan on financing something in the future. Due to the benefits of each method, many Canadian business owners implement a combination of both salary and dividend. This includes taking a set salary amount and supplementing any additional income needed with a dividend.
Salaries and dividends retain pros and cons, making one potentially more valuable compared to the other. To talk through the benefits of each one based on your specific situation, reach out to the team at NRK Accounting. We have helped numerous business owners find the most beneficial way of pulling their hard-earned money out of the business. Reach out today to set up a consultation.