As a Canadian business owner, you’ve likely heard in the Salary vs Dividends debate that paying yourself dividends instead of a salary can lead to significant tax savings. However, the reality is far more nuanced. While dividends can indeed offer advantages in certain situations, there are several widespread misconceptions about their benefits that need to be addressed.
Let’s debunk some of the most prevalent myths about the advantages of dividends in the salary vs dividends debate:
- Lower tax rate: While it’s true that dividends are taxed at a lower personal rate than salaries, this doesn’t tell the whole story. The lower personal tax rate on dividends is designed to account for the fact that the corporation has already paid tax on its earnings before distributing dividends. When you consider both corporate and personal taxes together, the overall tax burden may be similar to or even higher than salary income in some cases.
- Unexpected tax liability: Unlike salaries where taxes are typically withheld at source, dividends are paid out in full with no tax deducted. This can create a false sense of higher take-home pay throughout the year. However, come tax time, many business owners are caught off guard by a substantial tax bill they hadn’t budgeted for. This sudden expense can strain cash flow and potentially lead to late payment interest. It’s crucial to set aside funds throughout the year to cover these tax obligations or consider making installment payments to avoid this shock.
- Childcare expenses not deductible: Childcare expenses are generally only deductible against “earned income,” which includes employment income, self-employment income, and certain taxable benefits. Dividend income is not considered “earned income” for this purpose. This means that if a spouse’s income consists solely or primarily of dividends, they may not be able to claim childcare expenses, even if they are the lower-income spouse. This limitation can significantly impact the tax planning strategies of business owners who compensate themselves primarily through dividends.
- Retained earnings requirement: Dividends can only be declared and paid out if the corporation has sufficient after-tax profits (retained earnings) available. This means that new or struggling businesses, or those that have reinvested most of their profits, may not have the option to pay dividends even if they want to. In contrast, salaries can be paid regardless of the company’s profitability or retained earnings position.
- Simplicity: While dividend payments may involve less paperwork than managing a payroll, they still require proper tax reporting and can complicate personal tax planning. The perception of simplicity often doesn’t consider the complexity of optimizing the overall tax strategy.
- SR&ED credit eligibility: Salary compensation paid to employees or owner-managers directly involved in Research & Development activities is eligible for the SR&ED tax credit. This can significantly reduce the after-tax cost of R&D activities for the corporation. In contrast, dividend compensation is not eligible for SR&ED credits. For technology-focused or innovative companies engaged in qualifying R&D activities, this difference can be substantial.
- RRSP contributions: Dividends don’t create RRSP contribution room, which can be a significant disadvantage for retirement planning. This is often overlooked when comparing the benefits of dividends to salaries.
- CPP benefits: While avoiding CPP contributions with dividends can seem beneficial in the short term, it’s important to consider the future retirement benefits that CPP provides. This long-term perspective is often missing in the dividend vs. salary debate.
These misconceptions highlight the importance of considering all factors when comparing salary vs dividends for compensation. The optimal strategy often involves a nuanced approach tailored to your specific circumstances.
If you’d like to schedule a Salary vs Dividend tax calculation and analysis for your unique situation, get in touch with our Tax Team.