If you’re an owner of a corporation, chances are you’ve received or will be receiving income from your business in the form of a salary, dividends or a combination of both. In this month’s blog, we compare the advantages and disadvantages of each compensation method to help you reach both your personal and business financial goals.
For a personalized recommendation, or if you have any questions on what’s presented, the friendly staff at McNabb Lucuk LLP are just a phone call or email away.
The Salary Method
One of the most significant benefits of choosing the salary compensation method is that wages paid are reported as an expense of the corporation and therefore directly reduce the business’s taxable income and corporate taxes owed.
To use this method, the corporation must register for a payroll account with the Canada Revenue Agency (CRA) then withhold, report and pay source deductions regularly on all salaries and benefits paid to employees. At the end of the calendar year, the corporation must also file T4s for all wage earners.
One disadvantage to this compensation method is that it can carry additional administration costs and functions to ensure accurate payroll calculation, reporting and payments.
Wages received from the corporation are taxed to the recipient at their marginal tax rate and reported annually on their personal income tax return. Income tax is withheld and submitted by the corporation, reducing the risk of a large, unexpected personal tax bill at year-end. As personal tax rates vary, the individual receiving the income should consider their income tax bracket to determine if the rate is higher or lower than receiving the same income as a dividend.
Receiving a regular salary offers significant advantages in personal financial planning. From building the recipient’s RRSP contribution room and demonstrating a steady income source, earning a salary from the corporation can help with long-term financial goals like saving for retirement or applying for a mortgage.
Other potential advantages to the salary method include making contributions to Employment Insurance which can enable employees to collect maternity or parental benefits and the Canada Pension Plan (CPP) which reduces the take home income of earners now in exchange for a government benefit in retirement. Depending on the level of income received, a low earning worker may also qualify for the Canada Workers Benefit.
The Dividend Method
Dividends are paid from the Corporation’s after tax earnings, therefore they are not a business expense and thus do not reduce corporate taxes. To receive compensation using the dividend method, the Corporation simply declares a dividend then transfers or issues payments from their business account(s) to its shareholder(s). This method can also offer significant cost savings to the business as there are no requirements to register for a payroll account or submit source deductions to the CRA. All dividends issued must be reported in the Return on Investment Form (T5) and sent to the CRA before the last day of February following the calendar year to which the T5 information return applies.
One potential drawback to this method is that dividends are issued equally to all shareholders in each shareholder class, meaning more active shareholders would be compensated the same as another if they hold the same share class.
A common pitfall we see with the Dividend Method is poor personal tax planning. Although dividends are issued from after-tax earnings by the Corporation, they are taxed after they are received and reported by the recipient on their personal income tax return using the information listed on the T5 form. To avoid penalties for taxes owed on income received, we recommend setting up a separate bank account or making regular submissions to the CRA on your personal tax account when dividends are received.
If the shareholder receiving dividends qualifies for the dividend tax credit, the dividend method of compensation may result in a lower personal tax rate when compared to the salary method.
Making an informed decision on compensation is not only a financial choice but it can directly impact short and long-term goals of income earners. Speak with your accountant or contact McNabb Lucuk LLP today for a personalized estimation on costs and benefits of both methods.