How to Pay Yourself in a Small Business

As the owner-manager of a Canadian small business corporation, you have two options when it comes to paying yourself: a dividend or a salary. We discuss the pros and cons of each option in this post.

Dividend vs. Salary

As the owner-manager of a Canadian small business corporation, you have two options when it comes to paying yourself:

  • Dividend – an investment return paid out of the corporation’s retained earnings
  • Salary – an employment return paid out of the corporation’s net income

There is almost no short term difference between the total tax paid as a result of a dividend and the total tax paid as a result of a salary. Canadian small business and personal tax rates were designed with this outcome in mind.

The taxes on dividends are paid in two places: first, in the corporation (since dividends are derived from ownership, they aren’t deductible from corporate income) and second, in the owner-manager’s hands. The taxes on salaries, on the other hand, are only paid in the owner-manager’s hands (since salaries are derived from employment, they are deductible from corporate income). The key tax difference between salaries and dividends is that salaries are subject to the CPP and dividends are not.

In 2013, the combined employee/employer contribution to the CPP is calculated as 9.9% of the salary paid, to a maximum of $4,712.40 – half of which is paid by the employee, and half by the employer. As both employee and employer, the owner-manager must pay both halves.

While paying into the CPP is not necessarily a bad thing, the fact that it is paid twice by owner-managers makes it a less appealing savings vehicle for this group than it is for typical employees. What’s more, the two-sided CPP contribution is not a trivial outlay for an owner-manager; avoiding it can make dividends appealing from a cash flow standpoint.

Retirement Savings

If an owner-manager takes a salary from her company, she would be able to save for retirement as most Canadians do: via involuntary CPP and voluntary RRSP contributions. These retirement savings vehicles would not be available to her if she were to compensate herself through dividends. Dividends do not trigger CPP contributions or earn additional RRSP contribution space. It becomes incumbent on these owner-managers to invest both the CPP they save and the money they make in excess of their personal expenses in a corporate investment account (held in either the operating company itself or in a holding company).

In this scenario, the company itself can be viewed as an RRSP, but in reverse. Whereas an RRSP contribution is made from the amounts saved from an employee’s salary and then deducted from his taxable income, the contributions to retirement savings of a dividend receiving owner-manager are made from funds not withdrawn from the company in the first place, and, as such, never included in taxable income.

Assuming retirement funds are invested primarily in equities, there is a strong argument to be made for investing within the corporation rather than in an RRSP. While it’s true that funds invested in an RRSP — unlike funds invested in the corporation — grow tax free while invested, the growth is fully taxable when the funds are eventually pulled out.

On the other hand, the growth of funds invested in the corporation is taxed as it occurs but at the favourable effective rates applied to dividend and capital gains income rather than the taxpayer’s full marginal rate. (Read a more detailed discussion of this argument.)

Personal Service Businesses

While this article has been very much pro-dividend, there is a type of Canadian corporation that we believe should never pay them: the personal service business.

The Income Tax Act defines a personal service business as a business carried on by a corporation through which services are provided by an individual who would, but for the existence of the corporation, be thought of as an employee of the entity receiving the services. For practical purposes this means that nearly all single shareholder corporations contracting with, predominantly, a single client could be considered personal service businesses.

Unlike any other corporation, a personal service business is not allowed to deduct most non-salary business expenses and is ineligible for the general rate reduction.

This means that if the CRA were ever to deem a corporation, that reported as an active small business, a personal service business, the increase in corporate tax payable as a result of the reassessment would be dramatic and punitive.

This is particularly bad if the small business paid out dividends, because the corporate income subject to the punitive personal service business tax rate would be higher (as dividends are not expenses and do not reduce the corporate income).

What’s more, in order to reduce the punitive personal service business taxes that would be re-assessed on prior year corporate income, the company would have to declare additional salary for the owner in the current year (to be applied back as an expense against corporate income from previous years). Additional personal taxes would be triggered on this additional salary. The net result is that prior year income taken by an owner as dividends would be taxed once as dividends and again as salary.

Closing Thoughts

Generally speaking, we think that dividends are a great way for owner-managers of active small businesses to compensate themselves. But salaries are good too, especially if you don’t want to go to the trouble of setting up an investment account within your company or, ideally, through a holding company.

In our opinion, corporations consisting of a single person contracting with, predominantly, a single client are at real risk of being deemed a personal service business and should always pay out salaries rather than dividends.

Please feel welcome to contact the Origami Professional Accountant assigned to your account if you’d like to discuss dividends vs. salaries in greater detail.

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