As an owner-manager of a corporation, there are two methods of shareholder compensation:
- Salary – an employment compensation that is paid from net income.
- Dividends – an investment compensation that is paid from retained earnings in a company.
Salary is deducted when arriving at taxable income in the company and is subject to personal tax based on the bracket you fall into. Dividends, on the other hand, are not deducted in arriving at taxable income in the company meaning you would pay corporate and personal tax on the dividends. Because of this, dividends are eligible for a dividend tax credit so that, at the end of the day, the total income tax you are paying in either scenario ends up to be nearly the same. The Canadian tax system was designed with this goal, and is known as tax integration.
That said, there are some key considerations that do differentiate the options. Salary is subject to CPP (Canada Pension Plan), while dividends are not. Because an owner-manager is paying both the employer and employee portion, this could mean up to a 9.9% payment into CPP. You are generally eligible to receive CPP payments after the age of 65 years, with an option to receive payments earlier or later. Based on the historic rate of return in which the government pays for CPP, many owner-managers would rather save the 9.9% and invest it within their company.
Salary also creates room for RRSP contribution, beneficial in the sense that an owner-manager can then invest in their RRSP plan and claim a deduction on their own personal tax return. RRSP plans grow tax free, but the funds are fully taxed on your personal return when withdrawn. In comparison, to save for retirement, those who take dividends often elect to save and invest their money in a corporate investment account by retaining a portion of their earnings in the corporation. There is often an investment advantage by doing this because the funds will only be subject to the investment income corporate tax rates rather than the personal tax rate, which typically are lower. Amounts invested in a corporation have the strong advantage of being eligible for favourable corporate tax rates and deferral advantages on any investment earnings. Therefore, a strong argument can be made for electing to invest in a corporation.
When investing in a corporation, it is often desirable to pay out dividends and claim back “refundable tax”. This is a tax on the investment income earned in a corporation which is refunded on the payment of dividends out of that corporation. This is another reason dividends may be preferred.
Dividends also present the option of sprinkling income to other shareholders who are family members, which could result in significant tax savings. See our December 14, 2017 article on the income sprinkling rule changes for more information on eligibility. Salaries paid to family members must be reasonable for the work performed, equivalent to what a third party would be paid.
A final consideration is the administration associated with paying a salary. Salary payments require tax withholdings and remittances made to the CRA (payroll taxes). This requires some up-front planning and organization to ensure that you do not miss payments, which would result in penalties down the line. Dividends do not have withholding tax requirements when paid to owner-managers in Canada, which often can result in less administrative burden.
At Kapasi, we often employ a combination of salary and dividends, depending on both the corporate tax picture and the personal tax picture of the owner-manager and his or her family. Feel free to reach out to us to learn more about how this applies to your tax situation.