There is a basic concept in our tax system—by the time a dollar of corporate income earned lands in a shareholder’s jeans, the same rate of tax has been paid no matter how that income is paid out from the company.
This concept is called ‘integration’ and it is great in theory. However, it is imperfect.
Currently there is a tax advantage, to pay a salary over a dividend. This was much different a few years ago before the 2016 Federal Liberal government and 2016 Alberta NDP government started raising corporate and personal taxes. A few years ago it was more tax efficient to pay a dividend. As you can see, ‘integration’ is a flawed concept.
For a detailed comparison of Salaries vs. Dividends, including tax calculations and a more in-depth look at the advantages and disadvantages of salaries vs. dividends, see below.
Advantages of Paying Salaries
- Taxes are withheld and paid to the CRA throughout the year, meaning that less tax and/or instalments are payable by the shareholder personally in April of the following year, generally making their tax burden easier to deal with.
- Salaries build RRSP room, allowing you to contribute to an RRSP. Dividends do not.
- Salaries require the payment of CPP by the company and employee, meaning that you will receive a government pension when you retire. Some may not view this as an advantage, but we generally do.
- It is currently more tax efficient to pay salaries than dividends.
- Payment by salary provides access to certain deductions, such as for childcare expenses.
Advantages of Dividends
- It’s an easier-to-manage process. You just take cash out of your company, call it a dividend, and there is no requirement for the company to withhold or remit tax on these payments.
- Dividends do not count as ‘earned income’ for certain programs, such as maternity leave. It is possible for a mother to receive dividend income without jeopardizing her access to these programs in many cases.
Talk to your accountant about what to do this year to help minimize taxes. Depending on the tax rate of the tax bracket you fall into, you may be better off choosing one or the other.
A more detailed look: Remuneration Planning for Small Business Owners
“Should I pay myself dividends or salaries from my private company?” This is an issue we help business owners with all the time at Achen Henderson, and in most cases, the arguments one way or another are the same. In this article, we hope to demystify the issue of Dividends vs. Salaries for the average owner/manager.
Note that this page focuses on the remuneration of shareholders who are actively involved in the day-to-day operations of their business, and not ‘silent’ shareholders / investors. It was last updated using 2021 corporate and personal tax rates.
Salaries vs. Dividends – Which Attracts Less Tax?
First, I’ll run some calculations at various income levels to compare the tax bill triggered by paying dividends vs salaries. Next, I’ll highlight some of the other advantages of paying salaries and some common misconceptions about why dividends are better than salaries. Then I’ll introduce you to the Dividend Trap (hopefully you’re not already acquainted), and I’ll give you some ideas on how to get out.
Joe owns and operates an Alberta based landscaping company and he is trying to decide if he should take Dividends or Salaries this year. Joe’s 2021 net income projections are all over the map – so we prepared a few scenarios for him.
Scenario #1: $29,600 corporate earnings fully distributed to Joe:
Joe read somewhere on the internet that he can receive some amount of dividends from his company without paying any tax, he thinks the amount he read was around $26,000. Luckily, Joe checked with his CPA, who told him that this flawed thinking is wrong.
In this scenario, Joe is further ahead from an ‘immediate cash’ perspective by $1,630 if he pays dividends instead of salaries; however, with the dividend scenario, he pays an additional $1,060 in total taxes and makes no contributions to the CPP. This means that Joe’s access to CPP benefits when he retires has been diminished. The pros and cons of paying into CPP are described in part 2 (below).
Scenario #2: $110,000 corporate earnings fully distributed to Joe:
- Short-term cash advantage of paying dividends: $4,382
- Additional taxes paid by paying dividends instead of salaries: $1,950
- Diminished (or no) CPP benefits at retirement by paying dividends.
Scenario #3: $150,000 corporate earnings fully distributed to Joe:
- Short-term cash advantage of paying dividends: $4,013
- Additional taxes paid by paying dividends instead of salaries: $2,320
- Diminished (or no) CPP benefits at retirement by paying dividends.
Scenario #4: $200,000 corporate earnings fully distributed to Joe:
- Short-term cash advantage of paying dividends: $3,575
- Additional taxes paid by paying dividends instead of salaries: $2,757
- Diminished (or no) CPP benefits at retirement by paying dividends.
Takeaway #1: From an income tax perspective, ignoring CPP contributions (see below), at all income levels presented here dividends are more expensive than salaries.
Takeaway #2: No amount of dividends received are “tax-free”.
As you can see from the scenarios above, dividends generally attract more income taxes than salaries do, however they allow you to avoid paying into the CPP (which comes at the cost of CPP benefits at retirement) if the CPP is not a part of your retirement strategy. Check out Part 2 of this (below) for a discussion on the pros and cons of paying into the CPP.
NOTE that starting in 2019 CPP cost have started increasing and are expected to continue to increase until 2025. These increases are enough to sway some private company owners away from paying themselves salaries, and instead choosing how to invest for their retirement. Here’s our blog about the “enhanced” CPP rates (aka the increases).
Would you like us to run to help you determine if Salaries of Dividends are better for your small business?
Five advantages of paying salaries over dividends
1. Salaries encourage forced savings
Companies are legally required to withhold income tax and CPP from the owner’s paycheck when a salary strategy is deployed, there is no option to defer the payment of taxes until next year like you can in the first-year dividends are paid.
This has the effect of forcing a company to have enough funds to cover the owner’s draw plus the owner’s personal taxes prior to making a distribution to the owner. The personal taxes which the company withholds are remitted to the government on the owner’s behalf and are credited to the owner when they file their personal tax return.
Also, regular salaries encourage a business owner to get into a rhythm on their personal spending rather than attempting a very difficult balancing act of regulating personal spending based on company’s bank balance.
All of this means that there is no surprise next April when the owner files their personal taxes – the tax has already been paid! Oh what a feeling!
2. Salaries receive a (slightly) preferential tax rate (AB -2021)
Until only a few years ago, the combined tax rate on dividends was slightly lower than salaries. This is no longer the case. The above scenarios demonstrate that in all the cases listed here, salaries attract less income tax than dividends do.
3. Salaries allow for CPP contributions and benefits
Critics of the CPP would argue that the benefit levels from the CPP are subject to change, that your life expectancy is not certain, and that there are better investment vehicles for retirement savings. Additionally, as of January 1, 2019, the Liberal government announced increases to the CPP program which will see private companies and employees shelling out up to $1,350 each by 2025 over 2018 levels. See our 2021 blog on the “enhanced” CPP premiums (which is a fancy word for ‘increases’) here.
CPP has its benefits though. It is effectively a stable defined benefit (like) pension plan that pays you from retirement until you die. Private company owners who struggle with cash flow problems almost never set aside money for their retirement and could consider the CPP to put something away for retirement. I also like the fact that if I live to 102 years old, I am still entitled to my CPP benefits.
Contributions to the CPP are mandatory when salaries are used (up to a maximum); while contributions to the CPP are impossible when only dividends are used. If a business owner wants to receive CPP benefits on retirement, they will need to include salaries in their remuneration strategy in order to be eligible to pay into the CPP and receive benefits from the CPP.
4. Salaries build RRSP contribution room
In order to contribute to an RRSP, an individual must build up “contribution room” and can only contribute up to that allowed maximum in a given year. Broadly speaking, the current year’s RRSP contribution limit is calculated as 18% of “earned income” from the previous year to a maximum of $27,830/year (2021). This limit is added to any unused room from previous years.
Dividends are not considered “earned income” and so the payment of dividends does not build RRSP room. If RRSPs are a part of a business owner’s investment strategy, they must include salaries in their remuneration mix in order to build RRSP room.
5. Salaries are ‘safe’ from CRA claims on unpaid corporate income tax
If the company has unpaid corporate income taxes, GST, and or payroll remittances, the CRA can assess and collect the tax from a shareholder for dividends which were paid to the shareholder from the company. The CRA cannot, however, come after salaries under the same rules. This rule is in place to prevent shareholders from inappropriate transfers of property (cash or other property) from companies to shareholders, where that company has unpaid tax liabilities.
Do you have questions about Salaries vs. Dividends?
Two Myths About Paying Dividends
1.Dividends are a great form of cash flow management
Many business owners pay themselves dividends as a form of cash flow management, effectively treating the CRA as a creditor who will finance their annual tax bills in exchange for penalties and interest.
This is flawed thinking:
- By the time you factor in penalties and interest, the effective ‘lending’ rate at the CRA is quite high. The Q1 2023 interest rate on late tax payments is currently 8%, and installment interest is an additional 8%, and penalties can be charged on top of this.
- The CRA is one of the worst creditors. Period. They have legal power to make life difficult for delinquent taxpayers. In the worst-case scenario, they can seize and empty bank accounts and seize personal assets.
- We have found that in the last few years the CRA has become increasingly aggressive on collection efforts, particularly with private company owners caught in the Dividend Trap (see below). In fact, we are now seeing collection notices go out on delinquent accounts as early as 30 days after the balance due date.
Lastly, business company owners who pay their installments on time see little or no advantage in the timing of cash flow management over the payment of salaries and accompanying remittances.
2. Dividends are easier than salaries
It is mechanically simple to take money out of the company and let your accountant figure out the consequences next year when they prepare your taxes – which almost always results in a dividend being calculated by the accountant and declared by the company. This is the root cause and essence of The Dividend Trap.
Calculating withholding taxes and CPP on salaries, and then remitting those withholding taxes is a cumbersome process for most business owners. If a remittance date is missed, even by a day, the penalties for late remitting are stiff (currently 10% of the remitted amount). Preparing T4 slips (for employment income) is more difficult than preparing T5 slips (for dividends).
This used to be a very real concern for private companies, but now there are a variety of very affordable software solutions that can take care of all aspects of payroll including:
- Withholding calculations
- Automatic transfers from the company’s bank account to the owner’s personal account and to the CRA (on time every time)
- Preparation and filing of year end T4 slips
Part 3: The Dividend Trap
What Is The ‘Dividend Trap’
Business owners regularly find themselves in what I like to call ‘The Dividend Trap’, a cycle where every personal tax bill is a surprise and/or they are constantly paying penalties and interest. When you’re in The Dividend Trap, it can be really hard to get out because you are always paying off last year’s taxes rather than paying the taxes that are due today. If you are already in The Dividend Trap, I’ll offer some ideas to help you get out.
So, what is The Dividend Trap? Many business owners see cash in their company’s bank account and mistakenly assume that it is available to be drawn personally, for non-income generating purposes, without tax consequences. It is, after all, “their money”, and it is often needed to cover personal expenses. Then, at year end time, accountants become “the bearer of bad news”, presenting the unsuspecting company owner with a large personal tax bill (due April 30th) along with an installment schedule to pay personal tax for the current year. Instalments are due anytime an individual owes greater than $3,000 at personal tax time (in either of the last two years), and the first installment is due March 15th. In other words, your first tax installment is generally due before you became aware that you had to make installments at all.
The problem is that when the tax bill hits there is no cash, it’s all been spent. So the owner spends the next year paying off last year’s tax bill and getting behind on this year’s tax bill, and the cycle continues. One way of avoiding The Dividend Trap is to pay yourself salaries and bonuses, which is what we recommend in most circumstances.
A great flaw in thinking private company ownership is the idea that “the corporation is mine, and so it’s cash is mine”. The proper way to think about this is “the corporation is mine, but I don’t get any cash from it until the government gets their cut”.
I’m in The Dividend Trap and I Want Out!
The only way out of the Dividend Trap is to start setting aside enough money to pay this year’s tax bill. This is easier said than done, particularly when you’re still paying off last year’s tax bill because that would mean paying two years’ worth of taxes in a single year! Here are some tips to help get out of the Dividend Trap once you are out:
- Analyze your personal spending / create a personal budget. This will allow you to visualize your personal spending needs and decide where you can cut back. This is a very uncomfortable exercise so be prepared to ask for help from your accountant or financial adviser.
- Pay yourself a fixed salary based on your personal budget. Sign up with a payroll provider to calculate, withhold taxes from your monthly paycheques and remit them to the CRA. Do not draw more than you need to live. When you are out of The Dividend Trap, re-evaluate your financial situation, and paycheque, with the help of your accountant.
- #2 may be easier said than done if you are paying off last year’s tax bill (i.e. if you are caught in The Dividend Trap) because you will end up paying two year’s taxes in a single year. If this is too much to handle, consider paying yourself a combination of salaries and dividends (say 40% salaries, 60% dividends) in year one, then adjust the ratio in year 2 (75% salaries, 25% dividends), and move to 100% salaries in year 3. This will help smooth out the transition from being behind to being caught up on your taxes.
- Increase sales or decreases expenses in your business in order to increase its net income… and freeze personal spending. This may free up the cash necessary to execute #2 or #3.
- Ask your accountant for help! They can help you create a plan to get out of The Dividend Trap.
Are you ready to automate your payroll and get out of The Dividend Trap? We can help!