When your business finally starts making a profit, how do you pull money out? Despite what you may believe, you can't simply pull money out whenever with no record keeping. Instead, you should meticulously plan withdrawals from your company to maximize financial and tax savings, calling on the need to understand the difference between a salary and a dividend and how to choose the right method for your situation.
What is a Salary?
A salary is a regular payment from company funds. Salaries are run through payroll and paid out like other regular employees with payroll taxes withheld. This ensures you are receiving compensation from your company, but does subject you to additional taxes at the employer and employee level. The CRA requires employers to remit Canada Pension Plan contributions for all eligible employees in addition to employment insurance (Government of Canada). These taxes do not exclude owner pay.
What is a Dividend?
A dividend is money withdrawn from the company not run through payroll. Think of a dividend as going to the ATM and taking out money from the company account or writing yourself a check. These payments are tax-free when you take the money out, but are not deductible to the corporation like salary payments are. Corporations generally pay these out after-tax, resulting in the money already being taxed once.
How Do I Choose the Right One?
The first step in choosing the right one for your needs is to understand the tax consequences. Salaries are a qualifying business expense while dividends are not; however, you must report salary payments on your individual tax return and pay any corresponding taxes. On the contrary, a dividend is a tax-exempt transaction unless you exceed your basis, which is the contributions and income currently attributable to you in the business. In these cases, dividends may be taxable.
Another aspect to consider is retirement. Since employers and employees contribute to the Canada Pension Plan with salary payments, you will see more favorable benefits when you retire. Moreover, contributions to other retirement accounts with employer matches are common with salary payments, boosting your income at retirement. Contrastingly, dividend payments don't have requirements for CPP contributions, but you can contribute the money to outside retirement accounts.
The amount of money you are looking to pull out will also impact your decision. Salary payments are subject to the reasonableness test while dividends are not. The reasonableness test requires that salary payments are reasonable based on the resources contributed to the company. This deters many owners from overpaying themselves in compensation. If you are looking to take high amounts of money out of your company, but provide few hours of service, a dividend might be a better option.
Finding the right payment method for your needs takes careful consideration of financial and tax factors. Due to the benefits of both, many business owners choose to implement a combination of a salary and dividend. To uncover the right solution for your needs, contact Online Accountant. The team of experts at Online Accountant can work alongside you to find the right solution for your business. Reach out to a team member today for more information.
Government of Canada. "Employers' Guide – Payroll Deductions and Remittances." Government of Canada, 1 June 2022, https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/t4001/employers-guide-payroll-deductions-remittances.html. Accessed 12 June 2022.