Business owner compensation: Salaries vs dividends
By ATB Wealth 6 February 2020 3 min read
As an owner of an incorporated business, you have a choice as to the form of compensation you wish to receive. You can pay yourself a salary, receive payment in dividends, or use a mix of both. While there are advantages and disadvantages to both, it is important to have an in-depth review of your financial situation to determine which type of compensation sets you up for success both personally and professionally. As your business evolves and grows, it’s also crucial to revisit your compensation structure on a regular basis to ensure it is still serving your financial needs.
Basic considerations surrounding salaries and dividends
- Salaries paid to employees and bonuses paid within 179 days after the corporate year-end are deductible to the corporation.
- Salaries paid to family members must be reasonable or the deduction could be denied.
- A salary is included in earned income for the purposes of determining an individual’s RRSP contribution limit ($154,611 of earned income in 2020 is required to maximize 2021 RRSP contributions).
- Salaries above the basic $3,500 exemption and below the maximum annual pensionable earnings ($58,700) will result in a requirement to make CPP contributions.1
- Where salaries are paid, a payroll account will be required. Source deductions must be withheld and remitted to CRA. A T4 must be prepared for each employee.
- Dividends are paid to shareholders out of the after-tax earnings of a corporation.
- Prior to 2018, dividends could be paid to adult family members with no restrictions and, as such, were often an effective income splitting measure where family members would otherwise have been in different tax brackets.
- Dividends are not included in earned income for the purposes of RRSP contributions or CPP pensionable earnings.
- A T5 must be prepared for each taxable dividend recipient.
New tax on split income (“TOSI”) rules
Effective January 1, 2018, the federal government enacted the new TOSI rules. These rules may prevent taxpayers from obtaining tax benefits that were previously available by paying dividends from a private corporation to certain family members. Rather than being taxed at the individual’s marginal tax rate, any dividends that fall offside these new rules will be taxed at the highest marginal rate.
The TOSI rules include a number of exceptions. One notable exception is for an excluded business. A business will be considered an excluded business to an individual that was at least 17 years old at the beginning of the calendar year and was actively involved in the business on a regular, continuous and substantial basis in the current year or any previous five years. This threshold will be considered to be met if the individual worked an average of 20 hours per week in the business in the current year or any previous five years. The new TOSI rules depend on detailed facts in each case and should be discussed with your tax advisor prior to the payment of dividends.
Non-eligible, eligible and capital dividends
To complicate matters further, there are three types of dividends payments from a Canadian controlled private corporation (“CCPC”) to be considered within the dividend component of the compensation mix.
- Sometimes referred to as high-rate or small business dividends
- Paid from the after-tax earnings of the corporation that were taxed at the small business tax rate or investment tax rate
- 42.31% top marginal tax rate for Alberta residents in 2020
- Sometimes referred to as low-rate dividends
- Paid from the corporation’s general rate income pool, which consists of eligible dividends received from an investment portfolio or another corporation as well as the after-tax earnings of the corporation that were taxed at the general corporate tax rate
- 31.71% top marginal tax rate for Alberta residents in 2020
- Sometimes referred to as tax-free dividends
- Paid from the corporation’s capital dividend account, which consists of the tax-free portion of capital gains realized by the corporation among other items
It's a personal decision
As a business owner, there is no simple rule of thumb as to whether a salary, dividend or combination of the two will be optimal. How you wish to pay yourself is a personal decision that should be made based on your financial situation and the key tax considerations which will benefit you most. Engage a tax professional to help you determine which form of compensation works best for you and your business both in the short and long-term.
The combined employee and employer CPP contribution rate is 10.5% for 2020 (maximum self-employed contribution of $5,796).
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