Salaries are an expense to the company and thus all tax is borne by the individual on their personal tax return. Dividends are paid out of retained corporate income that has already been subject to corporate tax. When dividends are received by the shareholders and included on their personal income tax returns, they will receive a dividend tax credit essentially equal to the taxes already paid at the corporate level to prevent any “double-dipping” by the tax man.
Dividends are investment income – a return on your shares. As such, they are not subject to normal payroll deductions and charges such as CPP and EI premiums, provincial payroll/health taxes, workers’ compensation premiums, etc. They are also not subject to a withholding tax at source (although if you continually take all dividends, you will likely be subject to quarterly income tax installments as you can’t wait until you file your tax return each year to give the government their cut). Dividends are a very clean source of compensation in this regard.
As an added benefit, in many provinces dividends from income taxed at the lowest corporate tax rate results in an all out tax savings of a couple percentage points. When combined with the avoidance of the CPP premiums, the savings can quickly add up, significantly influencing many people’s compensation decision.
Another benefit to dividends is that unlike salary, they are an effective means of income splitting with family members who may own shares in the corporation directly, or indirectly through a family trust. Dividends are not subject to the same reasonability test as salaries are, which limits the amount you can pay family members to an amount similar to that which you would pay an arm’s length person for performing the same duties. Basically, dividends are a much more flexible and defendable vehicle for income splitting within the family. Caution that dividends should not be paid to children under the age of 18 to avoid the punitive “kiddie tax”.
Salary, on the other hand,
is subject to all of the deductions/charges mentioned above but does offer some benefits in terms of providing pensionable earnings for CPP purposes (if you interested in participating in the plan), generating RRSP/IPP deduction room (which dividends do not since they are investment income and not earned income) and qualifying for the basic non-refundable employment tax credit on your annual personal income tax return. Some form of salary also helps to justify non-taxable benefits provided to the owner-manager such as health and dental insurance coverage.
With salary comes the ability to contribute to an RRSP/IPP, and with those investment vehicles comes creditor protection, which may be more important to professionals and certain other business owners who have limited means of creditors proofing their assets.
A Word of Caution
One word of caution is that regardless of which compensation method or combination you choose, ensure your disability insurance coverage is not inadvertently impacted as a result of any change.
Some common compensation strategies we tend to see are:
- Only dividends to inactive family members
- Only dividends to owners who aren’t keen on paying into the CPP and are fine with using their operating company (or better yet, a holding company) to accumulate their retirement savings on a tax-deferred basis. In this case, I often recommend a nominal salary of at least $5,000 per year to qualify for the non-refundable employment tax credit on their annual personal income tax return as well as to provide a base level of disability insurance coverage through the nominal CPP premiums that will be triggered as a result.
- Salary of at least $130,000 to the owner (often professionals) to maximize RRSP/IPP deduction room with any excess compensation requirements coming out in the form of dividends, often to an inactive spouse as well as to the professional.
Clearly, there is no one right answer in the salary vs. dividends debate, but speaking with your MNP Tax advisor will help confirm which strategy is right for you.
Digging Deeper on Salary vs Dividends