GUEST COLUMN: Salary vs dividends

Pros and cons of using salary and dividend pay schemes.

Our personal and corporate income tax structure is as fair as it has ever been.

It is what accountants refer to as being fully integrated. This means that at the end of the day, whether you pay yourself a salary or a dividend or a combination of the two, when you take the income taxes paid at the corporate level and those paid personally, the combined taxes should be the same.

That said, nothing in life is perfect. In almost all cases, there is a discrepancy of one or two percentage points that can work for you, or against you, and potentially influence your decision on how you compensate yourself.

What’s the difference – Salaries are an expense to the company, so all tax is borne by the individual on the personal tax return. Dividends are paid out of retained corporate income that has already been subject to corporate tax.

When shareholders receive dividends and include them on their personal income tax returns, they will receive a dividend tax credit essentially equal to the taxes already paid at the corporate level to prevent any double-dipping by the tax man.

Dividends are investment income – They are a return on your shares. As such, they are not subject to normal payroll deductions and charges such as CPP and EI premiums, provincial payroll/health taxes or workers’ compensation premiums. They are also not subject to a withholding tax at source, although if you continually take all dividends, you will likely be subject to quarterly income tax installments as you can’t wait until you file your tax return each year to give the government its cut. Dividends are a very clean source of compensation in this regard.

Dividend benefits – In many provinces, taking dividends from income taxed at the lowest corporate tax rate results in an all-out tax savings of a couple percentage points. When combined with the avoidance of CPP premiums, the savings can quickly add up, significantly influencing many people’s compensation decision.

Another benefit to dividends is that unlike salary, they are an effective means of income splitting with family members who may own shares in the corporation directly, or indirectly through a family trust.

Dividends are not subject to the same reasonability test as salaries are; salaries limit the amount you can pay family members to an amount similar to that you would pay an arm’s length person for performing the same duties. Basically, dividends are a much more flexible and defendable vehicle for income splitting within the family.

However, dividends should not be paid to children under the age of 18 to avoid the punitive kiddie tax.

Salary summary – Salary is subject to all of the deductions/charges mentioned above, but does offer some benefits in terms of providing pensionable earnings for CPP purposes (if you are interested in participating in the plan), generating RRSP/IPP deduction room (which dividends do not since they are investment income and not earned income) and qualifying for the basic non-refundable employment tax credit on your annual personal income tax return.

Some form of salary also helps to justify non-taxable benefits provided to the owner-manager such as health and dental insurance coverage.

Salary benefits – With salary comes the ability to contribute to an RRSP/IPP, and with those investment vehicles comes creditor protection, which may be more important to professionals and certain other business owners who have limited means of creditor-proofing their assets.

A word of caution – Regardless of which compensation method or combination you choose, you need to ensure your disability insurance coverage is not inadvertently impacted as a result of any change.

Blair Gronlund is a business advisor with MNP LLP in Vernon. This article is provided for information purposes only. Please consult with a professional advisor before implementing a strategy.