The first thing we recommend is to try to minimize the amount of money you draw out in the first place. If you are not accumulating money in your corporation or in a holding company, you aren’t getting the main advantage of incorporating.
Realistically though, everyone has living expenses and needs to pay themselves something so we need to figure out the most tax-friendly way to get those funds from the corporation to the owner. Many accountants will get to the end of the year, assign all of your draws as a dividend, and call it a day. They do that because it’s easy and requires little or no pre-planning.
It’s possible that this is the best strategy for you –
but wouldn’t you rather be certain?
What’s the difference?
- Dividends are a share of the after-tax profits of the company that are then paid to the owners.
- Wages paid to employees (including the owner) are deducted from the company’s taxable income and result in considerably less corporate tax payable.
In order to offset the tax that the corporation already paid, the owners receive a dividend tax credit along with their dividends. This means that the individual will pay much less tax on a dividend than on a wage – but the corporation will have paid more tax on those profits. CRA attempts to make it a neutral choice so between the corporation and the individual, the total tax bill is the same – no matter how the draws are paid out.
- But as we know, nothing is ever that clean . When you factor in credits, benefits, and endless other exceptions, there is always an optimal plan for each situation and in most cases just dumping on a dividend for the full amount of the draws is not that best option.
Paying yourself a dividend
When you pay yourself a dividend, there are a few key advantages:
- No remittances: Because there are no employee wages, you will not have to make payroll remittances each month.
- No CPP premiums: When you remove CPP premiums from the calculation, it is often slightly less expensive overall in terms of straight cashflow to pay out at least partially in dividends.
- Lower personal tax bill: Depending on the size of the dividend and your other sources of income, the magic of the dividend tax credit means that you might not have to pay any personal taxes at all.
- Income splitting: If you have a spouse or adult children who are shareholders of the corporation, dividends can be used to easily split income between members of the household. If each shareholder owns a separate class of shares, the dividends can be paid in any amount to each person.
- Note: Family members cannot be paid a large “wage” to “do bookkeeping” or “clean the office” or “file the paperwork”. If a wage is paid to an employee who is a family member, the compensation must be equal to what would be paid for the same tasks to a similarly qualified stranger. There is no such restriction on the size of a dividend paid to an owner. An owner doesn’t need to justify his/her dividend.
Paying yourself a salary
There are also a number of advantages to paying yourself a wage
- Lower corporate tax bill: Wages are a direct deduction against corporate profits. If your combined corporate tax rate is 13.5%, for every $1,000 in wages, the corporation will save $135 in taxes.
- Future CPP benefits: Since wages are subject to CPP contributions (up to $5,088.60 in 2016), by paying premiums now, you are directly increasing the CPP benefits you will receive when you retire.
- Deductible childcare: Because wages are considered “earned income” and dividends are investment income, you can deduct your childcare expenses from your salary, not your dividend.
- RRSP contribution room: By having earned income, you also build up contribution room in your RRSP, which can allow you to defer taxes until retirement.
- Lower net income: Dividends are reported on your T1 return at a “grossed-up” amount which is 18% higher than what you actually received. The dividend tax credit takes that into account on your final tax payable but it artificially inflates your Net Income line on your personal return. This line is used to calculate the GST Credit, Canada Child Benefit, Old Age Security, and many other benefits. So, by having a slightly smaller wage, you may also qualify for larger benefit cheques.
Conclusion
Like most business tax questions, there is no magic answer. And the good thing is we don’t have to just choose one or the other. We often split up the draws between wages and dividends in order to make sure that you (and your household) and your corporation pay the lowest amount of tax possible, while also considering the future in terms of CPP, RRSP, and benefits.