For Canadian small business owners, particularly those operating a Canadian-Controlled Private Corporation (CCPC) that qualifies for the Small Business Deduction, deciding between compensating themselves through dividends vs salary is a pivotal financial and tax planning decision.
This comprehensive analysis aims to delve into the intricacies of both options, examining their tax implications, benefits, and drawbacks at both corporate and personal levels, their impact on retirement planning, and the Canada Pension Plan (CPP). Furthermore, a detailed sample calculation for an Ontario business owner will provide practical insights into these considerations.
Understanding the Taxation Landscape
Salary: A Dual-edged Sword
At the Corporate Level:
When a CCPC pays out a salary, it’s treated as a business expense, thus reducing the corporation’s taxable income. This immediate tax relief is attractive but comes with obligatory contributions to the CPP for both the employer and the employee, increasing overhead costs.
At the Personal Level:
Salaries are taxed at the recipient’s marginal tax rate. For high-income earners, this can be substantial. However, salaries contribute to CPP and RRSP contribution room, offering long-term benefits like retirement savings growth and pension entitlements. The requirement for both employer and employee CPP contributions, though increasing costs, also bolsters future CPP benefits.
Dividends: Elegantly Efficient but Complex
At the Corporate Level:
Dividends are paid from after-tax profits, meaning the corporation pays its taxes first, and the remaining profits can then be distributed. This lack of tax deductibility at the corporate level could lead to a perception of inefficiency; however, the lower personal tax rates on dividends due to the dividend tax credit can offset this.
At the Personal Level:
Dividends attract personal taxation at a lower effective rate thanks to the dividend tax credit, designed to mitigate the issue of double taxation. Unlike salary, dividends do not entail CPP contributions, nor do they affect RRSP contribution room, presenting both an advantage in reduced immediate financial outlay and a drawback in terms of retirement savings potential.
Dividends vs Salary: Weighing Pros and Cons
The choice between dividends and salary impacts tax liability, retirement planning, and financial flexibility.
The Case for Salary
Pros:
- Enhances RRSP contribution room, fostering tax-deferred retirement savings.
- Boosts CPP contribution history, potentially increasing retirement pension amounts.
- Facilitates loan approvals and credit ratings through verifiable earned income.
Cons:
- Higher personal tax rates can diminish take-home pay.
- Dual CPP contributions increase costs.
The Case for Dividends
Pros:
- Lower effective personal tax rates due to the dividend tax credit.
- Greater flexibility in distribution amounts and timing.
- Absence of CPP obligations conserves cash flow.
Cons:
- Does not create RRSP contribution room.
- Lacks CPP contributions, possibly affecting future pension benefits.
- No corporate tax deduction, which could lead to a higher total tax burden without careful planning.
Dividends vs Salary: Retirement Planning
Retirement account contributions, namely into RRSPs or TFSAs, offer tax planning opportunities regardless of compensation type. Salaries increase RRSP contribution room, providing a shelter for income growth from tax until withdrawal. Dividends, though not affecting RRSP contribution room, leave room for strategic TFSA contributions, offering a tax-free growth avenue.
CPP Considerations
The decision between salary and dividends also affects CPP contributions. Salaries necessitate CPP contributions, securing future pension benefits but also increasing current expenses. Dividends offer a way to bypass these contributions, preserving cash flow but at the expense of future CPP benefits.
Dividends vs Salary – Sample Calculation
Let’s consider an Ontario-based CCPC owner contemplating between taking a $100,000 salary or equivalent dividends.
Salary Scenario:
- Corporate Benefit: Salary reduces corporate taxable income, potentially saving the corporation up to 12.2% (Ontario small business rate) in taxes, equating to $12,200.
- Personal Tax Implications: Assuming no other sources of income,
- CPP Contribution:
- RRSP Contribution Room: Increases by 18% of earned income up to a maximum limit, enhancing retirement savings potential.
- Total Tax Impact:
Dividend Scenario:
- Corporate Tax Prepaid: The corporation pays corporate tax first, at a rate of 12.2% on its profits, leaving less for distribution.
- Personal Tax Implications: Eligible dividends attract a lower effective tax rate, potentially under 30% after the dividend tax credit, offering significant savings over a salary.
- No CPP Contributions: This scenario avoids approximately $5,000 in CPP contributions (employer and employee combined), improving current cash flow.
- Total Tax Impact:
Detailed Financial Impact:
To quantify, if the corporation earns $120,000 in profit:
- Salary: After a $100,000 salary, the corporation saves $12,200 in taxes but has $20,000 left, taxed at the small business rate. The individual then pays up to $43,410 in personal taxes (excluding CPP contributions).
- Dividends: If the entire profit after corporate tax (approximately $105,440) is distributed as dividends, the personal tax owed would be significantly less, due to the lower effective tax rate on dividends, potentially saving thousands in personal taxes.
This simplified example underscores the need for precise calculations based on current tax rates and personal circumstances.
Our Recommendation
…for predictable, consistent pay, do salary
…for ad hoc pay, where cash flow is not consistent..or true profit distributions to owners … do dividends
Conclusion: Crafting the Optimal Compensation Strategy
Deciding between dividends vs salary requires a nuanced understanding of tax implications, personal financial goals, and the strategic use of retirement savings accounts. While dividends offer tax efficiency and flexibility, salaries provide tangible benefits for retirement planning and financial credibility.
A hybrid approach, carefully calibrated to individual circumstances and business performance, often represents the most balanced and advantageous strategy.
FAQ
Q: Can business owners change their compensation strategy year-to-year?
A: Yes, depending on business performance and personal financial needs, switching between dividends and salary or using a combination of both can be advantageous.
Q: How does the dividend tax credit actually work?
A: The dividend tax credit is a non-refundable tax credit that applies to individuals who receive dividends from Canadian corporations. It’s intended to offset the corporate tax already paid on the income distributed as dividends, effectively reducing double taxation.
Q: What is the impact of salary vs dividends on loan qualification?
A: Lenders often prefer consistent, verifiable income when assessing loan applications. Salaries are typically viewed more favorably in this regard compared to dividends, which may be perceived as less stable.
Q: How should business owners approach retirement planning when taking dividends?
A: Business owners should consider maximizing their TFSA contributions and strategically investing their after-tax dividends. Additionally, exploring other investment vehicles that do not rely on earned income, such as non-registered investment accounts, can complement their retirement planning strategy.
The choice between dividends and salary is not one-size-fits-all. It requires a tailored approach that considers the long-term financial health of both the business and the individual. This comprehensive exploration provides a foundation, but personal consultation with tax experts is crucial to navigate the complexities of Canadian tax law and optimize financial outcomes.
More Tips and Help
Need help for your specific circumstances? Reach out to our tax team here.
Subscribe to our free newsletter where we regularly share tips like these with our readers!
