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In the course of navigating the Canadian small business landscape, entrepreneurs often face a myriad of decisions, many of which can significantly impact their business and personal financial futures. A crucial decision involves determining the method of compensation for oneself as a business owner – salary or dividends? This decision, though seemingly simple, has far-reaching implications on tax planning, retirement savings, and even personal finance management.
Opting for a salary as a small business owner brings a certain level of predictability and stability. Salaries represent a fixed, regular payment, usually made on a monthly or bi-weekly basis. This consistency can be particularly advantageous when it comes to personal financial planning. It's easier to manage household budgets, plan for personal investments, or even qualify for loans when you have a regular income stream. A consistent salary can make the process of acquiring major assets, such as a home, significantly smoother due to the assurance of steady income.
From a tax standpoint, a salaried income is classified as employment income in Canada. This classification means that the income is subject to Canada Pension Plan (CPP) contributions and Employment Insurance (EI) premiums. Both these statutory deductions serve as contributions towards future benefits. CPP contributions go towards providing a monthly pension once you retire, while EI provides temporary financial assistance in case of job loss, sickness, or maternity/paternity leave.
Moreover, receiving a salary allows for contributions to a Registered Retirement Savings Plan (RRSP), a government-approved account for holding savings and investment assets. The RRSP is particularly advantageous due to its tax benefits; contributions to RRSPs are tax-deductible, and any income earned within the RRSP (such as interest, dividends, or capital gains) is usually exempt from tax as long as the funds remain in the plan.
On the other side of the compensation coin are dividends. As a business owner, dividends represent a portion of the company's profits that are distributed amongst its shareholders. Given that many small businesses are wholly or majority-owned by their founders, dividends can form a substantial part of the compensation structure.
One significant advantage of dividends over salaries is that dividends are not subject to CPP or EI contributions. This exemption can result in lower personal tax liability, particularly in years when the business achieves high profitability.
However, dividends are drawn from the after-tax profits of the corporation. This fact implies that corporate tax has already been paid on these earnings. Essentially, tax is levied twice on the same income – once at the corporate level and again at the individual level when the dividends are received. However, to counteract this double taxation, the Canadian tax system offers the Dividend Tax Credit, reducing the personal income tax payable on dividends received.
It's important to note that while dividends do not contribute towards your RRSP contribution limit, they are typically taxed at a lower rate than salary income, thanks to the Dividend Tax Credit. This reduced tax rate can prove particularly beneficial for business owners in higher tax brackets.
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The decision between receiving compensation as a salary or dividends is unique to each business owner, depending on their specific circumstances. Key considerations include current income needs, retirement plans, the profitability of the business, the corporate tax rate in your province, and your RRSP contribution room.
If your business is in the early stages and not yet consistently profitable, it may make more sense to draw a salary, providing a consistent income stream to meet your personal financial needs. On the other hand, in highly profitable years, it may be more tax-efficient to take dividends.
Remember, while dividends may seem more attractive due to their flexibility and lower tax rate, relying solely on dividends can impact your future CPP and EI benefits, and limit your RRSP contributions. A mix of both salary and dividends often proves the most efficient, balancing the need for current income, future security, and tax efficiency.
Navigating the salary vs. dividends debate is a complex process and one that requires careful consideration. Here are some top tips for 2023 to help guide you:
Be aware of the current corporate and personal tax rates in your province. They can influence whether it's more tax-efficient to take a salary or dividends.
The profitability of your business in a particular year can influence your decision. In highly profitable years, it may make sense to pay out more in dividends, while in leaner years, a regular salary might be more beneficial.
Consider your RRSP contributions. If you're planning on making significant RRSP contributions for your retirement, you'll need to pay yourself a sufficient salary to create the necessary contribution room.
Stay informed about any changes to tax laws or regulations. The federal government often announces changes in the federal budget, and provincial governments may also make changes that could affect your decision.
Always consult with a tax professional or financial advisor. This decision involves complex financial and tax implications that require professional expertise to fully understand.
Your compensation strategy should not be a "set it and forget it" decision. Regularly revisit this decision as your business changes and grows.
Consider your personal financial needs. You need to balance the needs of the business with your personal income needs, retirement plans, and tax planning strategies.
While dividends might be attractive now due to their lower tax rate and flexibility, remember that relying solely on dividends may limit your future CPP and EI benefits.
The decision between salary and dividends is not a one-size-fits-all scenario, and what worked in 2022 may not be the best strategy for 2023. Keep these tips in mind as you navigate your compensation decisions this year.
The decision of how to structure your compensation as a small business owner in Canada – whether as salary, dividends, or a combination of both – is a crucial one with both immediate and long-term implications. The complexity of the decision underscores the importance of seeking advice from a tax professional or financial advisor. These experts can help you understand the tax implications of each option, evaluate your personal and business financial goals, and determine the optimal compensation structure for your unique circumstances.
Remember, your compensation strategy isn't a static decision. As your business grows, your personal financial circumstances change, and tax laws evolve, you can – and should – adjust your approach. Regularly revisit this decision to ensure that your compensation strategy continues to align with your financial goals and provides the best advantages for you and your business.
If you are interested in learning more you can contact Mitch, here.
Salary is an employment income that is paid regularly, and it is subject to payroll taxes, CPP contributions, and EI premiums. Dividends are a distribution of profits from the corporation to the shareholder and are not subject to payroll taxes, CPP, or EI.
Yes, salaries are tax-deductible for your corporation, potentially lowering your corporate tax burden. Plus, a salary can increase your RRSP contribution room and is eligible for certain tax credits and social benefits like CPP and EI.
Yes, dividends are taxed at a lower rate than salary due to the Dividend Tax Credit, which recognizes that the corporation has already paid tax on its profits. This can result in overall lower personal tax if the business owner is in a high personal tax bracket.
Yes, many business owners choose a mix of salary and dividends to maximize their tax advantages. The ideal mix depends on your personal and business circumstances.
No, dividends are not considered earned income for CPP purposes, so you don't need to make CPP contributions on dividends. However, this also means you won't earn CPP benefits based on this income.
No, dividends are not insurable, so you don't need to pay EI premiums on them. Again, this means you're not eligible for EI benefits based on this income.
RRSP contribution room is based on your earned income, which includes salary but not dividends. If you plan to contribute to an RRSP, paying yourself a salary will increase your contribution room.
Yes, how you pay yourself can be adjusted as your circumstances change. You should review your compensation strategy regularly with a financial advisor or accountant to ensure it remains optimal.
Lenders often prefer salary income because it's regular and predictable. If you plan to apply for a personal loan or mortgage, having a salary can make the process smoother.
Not necessarily. While dividends might lower your immediate tax bill, there are other considerations, like RRSP contribution room and CPP benefits, which may make a salary more attractive in the long run. It's best to discuss your specific situation with a financial advisor or accountant.
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