So you’ve taken a giant leap and incorporated your business...congrats! This is a significant milestone for many business owners. It signals that your business generates healthy profits and you can ‘leave’ money in the business after you pay yourself. As we covered in our recent blog post, operating a business as a sole proprietor is quite different from running a business as a corporation. One of the main differences is how you pay yourself. When you are operating as a sole proprietor, all of the net profit your business generates is taxed at your marginal personal tax rate. Whereas, if your business operates as a corporation, you have the option of drawing a salary or paying out a dividend (or a combination of the two). The profit you draw out to pay yourself is still subject to personal income tax outside of your corporation. However, the profit you are able to leave in your corporation may benefit from lower corporate tax rates. Along with this, there are more tax planning strategies available to you once you are incorporated. Sound interesting? Read on to find out more and best practices on when to pay yourself a salary vs. dividend.
When you incorporate and continue to work in your business, you essentially become an employee of your corporation. The corporation is a separate legal entity from you, even if you are the sole shareholder. That means that the corporation can pay you a salary. To do this, you will need to register for a payroll account with the CRA and remit deductions for Canada Pension Plan (CPP) and income tax along with any other specific provincial source obligations each time you pay yourself. Then a T4 will be issued to you from the corporation, which you would then use to file your personal income taxes.
One of the main benefits of paying yourself a salary is maintaining a steady income regardless of revenue fluctuations in your business. Once your business has sufficient cashflow to allow for it, having a consistent salary will allow you to build your lifestyle and plan for the future. The salary you take is considered an expense in your business and reduces the profit that corporate tax is paid on (a.k.a it’s a write-off).
Paying yourself a salary also allows you to build RRSP contribution room, which opens up the door for more tax planning strategies (re: reducing your personal income tax bill). In addition, because you are also contributing to CPP, you will get to collect those benefits in your retirement.
Hate surprise tax bills? (who doesn’t)! Paying yourself a salary from your corporation is a great way to make sure you know what’s coming during tax season. Because you are already deducting and remitting tax, you don’t have to worry about a surprise tax bill at the end of the year. This is a breath of fresh air for sole proprietors who are used to sweating it out over their bill.
Taking a salary from a corporation can also help you when it comes to securing bank financing. Banks like to see a history of predictable and consistent income for those seeking financing. They prefer to see a steady salary when approving large purchases like home mortgages or business loans. The fewer fluctuations you have in your income, the better.
When deciding on how you pay yourself, you should consider whether you will need a mortgage in the future or a loan injection into your business.
At-a-glace: the benefits of paying yourself a salary out of a corporation:
To summarize - the decision on how to pay yourself goes beyond only thinking about tax savings.
The second way to pay yourself out of your corporation is by issuing a dividend. This method is the more straightforward way to move money out of your corporation. Dividends don’t require you to contribute to CPP or participate in other provincial payroll programs. They also don’t require you to set up payroll, which can be an administrative pain. You have to declare a dividend payment and transfer the funds into your personal bank account to pay yourself a dividend. The corporation must file a T5 to account for each year's dividend payments. Dividend payments also need to be documented in your corporate minute book.
From a personal income tax perspective, dividends can lead to a more favourable personal income tax situation, as they may be eligible for the dividend tax credit, hence reducing the amount of personal income tax that is payable. Therefore, often there is an opportunity to save on your personal income tax bill. However, it’s important to note that dividends are paid out of the corporation after tax. So while you may save tax at the personal level, there is tax paid at the corporate level to consider.
A note for business owners who are not sole shareholders in their corporation: Dividends are issued based on shareholder ownership. This is effected by quantity of shares and also share class. So if you are not the sole shareholder in your corporation, you may have to pay dividends to the other shareholders based on the percentage of ownership and class of shares.
To summarize, the main benefits of paying yourself a dividend out of a corporation are:
The CRA aims to apply the integration mechanism. This means that, when both personal and corporate tax are considered, your income from salary is taxed roughly at the same rate as the money you receive as a dividend. This isn’t always the case in practice, and many business owners opt for a combination of salary and dividend.
So which option is right for you? It depends! Deciding which way to pay yourself goes beyond saving the most in tax. It's a cost-benefit analysis that includes your personal goals. Maybe paying more in tax now will set you up for a more comfortable retirement. Perhaps you need all the cash you can get at this moment to grow your business and sustain yourself? Your situation is unique and it’s important to take a holistic view of your personal circumstances when considering which option is right for you. Just as you do in your business, map out your personal goals over the next 5, 10, 15 years and beyond, and ensure your plan for drawing income from your corporation aligns with those goals. Having a solid relationship with a personal finance expert, as well as an accountant goes a long way to ensuring your strategy sets you up for success.
And be sure to be mindful and take care with your cashflow planning both within your business, and with your personal budgeting. It’s a balance, but worth taking the time to give it careful consideration to set yourself up for long term success.
Are you reading this as someone who is a sole proprietor, but who is considering a move to becoming incorporated? And if so, are you feeling lost in knowing if this is the right decision for you? We've got you covered. LEARN MORE FROM GROW CPA'S ASHLI - CPA, CA, IN OUR GROW MINI SERIES - SHOULD I INCORPORATE? TAKE THE GUESSWORK OUT OF THIS DECISION AND GET THE ANSWER YOU NEED TODAY.
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Wishing you success in your business,
- Martina + Ashli