Small business owners in Canada can choose to pay themselves a salary or earn a personal income through dividends.\r\n\r\nWhile there's no wrong answer, the option you choose will play a role when the time comes to file your income taxes, and ultimately, is dependent on what kind of Canada Pension Plan or retirement savings plan you have in mind for yourself.\r\n\r\nThis article will examine the differences between a salary and dividends, including the pros and cons associated with each.\r\nDividend vs. Salary: key differences\r\nBoth a salary and dividends provide a source of employment income.\r\n\r\nSalaries are paid out by the corporation and thus, are considered an expense by the business. Individuals paid a salary are responsible for claiming all taxable income on their personal tax return at the end of the year.\r\n\r\nAs a steady source of income, a salary can also act as a record of consistent financial revenue and make it easier to secure a bank loan for a mortgage or a car or even open a new credit line.\r\n\r\nOn the other hand, a dividend is the distribution of a set amount of the company's earnings to some of its shareholders. Dividends are considered investment income, and as such, they are not subject to the standard tax deductions that many employees on salary see on their pay stubs.\r\nSalary vs. hourly wages\r\nTo pay yourself a salary (or a wage) is a necessary cost of doing business as an entreprenuer.\r\n\r\nDeciding between paying out a business salary and paying an hourly rate is something every small business owner must decide, and there are pros and cons of each.\r\n\r\nSalaried employees receive a fixed rate of pay. This means that their personal income is the same each pay period per year (unless a salary increase is determined), and there are no surprises or calculations done in error.\r\n\r\nOn salary, one can work as many or as few hours as they would like in a day, and the pay will always be the same.\r\n\r\nSalaried employees also receive a T4 for their personal income tax records.\r\nHow the transaction works\r\nIf you, a small business owner, are paying your employees an hourly wage or decide to pay yourself an hourly wage, you must register a payroll account with Canada Revenue Agency on behalf of the corporation. From there, your payment will be subject to source deductions from the corporation that must be submitted to the Canada Revenue Agency (CRA).\r\n\r\nHourly wages can pose a financial problem for business owners who are looking to eventually grow and expand their small business while looking to keep their overhead costs down. Paying yourself or your employees by the hour can become quite expensive, especially in the early stages of opening the business. It’s usually normal for the owner to work long hours.\r\n\r\nAs an owner, if you need your employees to work past the legal eight-hour workday and they are on an hourly wage system, by law, you must pay them overtime, which equates to their hourly rate plus half. Long-term, this can become quite expensive and may not be sustainable for small business owners who are just starting out.\r\nWhy choose a salary?\r\nAs many who have been paid a salary know, your gross salary on paper is never equal to the amount you actually collect via a paycheck.\r\n\r\nBy law, anyone who earns a salary or a taxable benefit is required to subtract source deductions from the rate of pay for that particular period. Then, those deductions are submitted to the Canada Revenue Agency (CRA).\r\n\r\nIf you choose to pay yourself a salary, you will likely be responsible for paying into a Canada Pension Plan (CPP), a registered retirement savings plan (or RRSP contribution), an employment insurance plan, as well as your federal, provincial, or territorial income tax.\r\n\r\nDue to these involuntary contributions that are deducted automatically from earned income, being paid a salary makes it much easier to save for retirement.\r\n\r\nSalaried employees also receive paid time off (vacation, maternity/paternity leave, bereavement leave, and sick leave) dependent on provincial guidelines, as well as additional employer-sponsored benefits, like healthcare packages and insurance plans.\r\n\r\nEmployees paid hourly generally are not entitled to paid vacation or a leave of absence and are generally responsible for their own healthcare.\r\n\r\nTo summarize, deciding to pay yourself a salary can provide several advantages, including:\r\n\r\n \tRRSP contribution room: paying yourself via dividends does not allow for this;\r\n \tMake CPP contributions: you cannot contribute to a Canada Pension Plan if dividends are paid;\r\n \tLess surprise tax bills: when the time comes to file your personal taxes, you've already paid your income tax, so you're less likely to see tax charges or tax consequences that don't add up;\r\n \tGetting a mortgage: banks like to see a steady source of employment income, and a salary guarantees this, so you're more likely to qualify for a loan.\r\n\r\nWhy would you choose dividends?\r\nMany business owners pay themselves or their businesses via dividends because there is less personal tax liability than a wage (or salary). Plus, they come with a special dividend tax credit.\r\n\r\nInvestors who receive dividends also gain access to a special non-refundable tax credit, in recognition that the tax was already paid on the corporation's income.\r\n\r\nFurthermore, individuals can earn an enhanced dividend tax credit that provides compensation for the higher tax rate that is paid on general income that is earned and taxed in the corporation.\r\n\r\nIn short, dividends allow the corporation to withdraw funds with ease and provide the following key benefits:\r\n\r\n \tCheaper for owners and employers: dividends don't require CPP contributions, which brings the tax rate down.\r\n \tNo mandatory payroll: if you own the corporation, you can withdraw or invest as much or as little money as you'd like without worrying about registering your business for payroll, or dealing with source deductions.\r\n \tLess room for penalties: when you own the business, you're likely responsible for everything, and it's easy to make a payroll mistake. Because dividends don't require payroll, this is avoided.\r\n\r\nHow the transaction works\r\nAs dividend payments are not subjected to normal payroll deductions, CPP deductions, or RRSP contribution deductions, the income earned per pay period will be quite similar or on par with the money earned through the corporation.\r\n\r\nMuch like paying yourself a salary, paying yourself a dividend also means that you face tax deductions, though the tax rates are much different.\r\n\r\nMore often than not, provinces and territories have two income tax rates; one is lower, and one is higher. The lower rate is reserved for all income eligible for the federal small business deduction, while the higher rate applies to all other income.\r\n\r\nPaying dividends to shareholders of a corporation is quite simple.\r\n\r\nFirst, dividends are declared. Next, the cash flows from the corporate account to a shareholder's personal account (as a business owner, this could be your employee). Finally, much like how those on a business salary receive a T4 slip during tax season, any shareholders must receive a T5 slip on behalf of the corporation.\r\nReduce tax burdens with child and spouse dividends\r\nThough dividend taxes are already generally much lower than salaried taxes, tax savings can be further generated when business owners use dividends to split income between eligible children aged 18 and older.\r\n\r\nSmall business owners and entrepreneurs who set up salary dividends can set up a family trust, legally acting as a shareholder of the corporation.\r\n\r\nAs a shareholder, that family trust can thus earn dividends, and those dividends can be paid out as net income to your spouse or adult children.\r\n\r\nOnce it's time to file tax returns, those supported by the family trust will pay little to no taxes (unlike a regular salaried employee in a family business) due to exemptions from CPP deductions and RRSP deductions, as well as tax credits.\r\nIs one method better than the other?\r\nCanadian corporations have two options to consider when it comes time to make money. They can pay themselves or their employees a business salary, or they can use dividends.\r\n\r\nThere is no right or wrong answer when selecting a method to generate cash for the corporation; simply put, it comes down to your unique personal obligations and financial goals.\r\n\r\nA salary is a popular option for many. It allows for CPP and RRSP contributions, which can help out with various lifestyle factors, like planning for retirement or putting away savings.\r\n\r\nOn the other hand, dividends are also a good choice due to their flexibility and lower tax rates. Before you choose either, it's always a good idea to go over your long-term business goals to ensure that whichever way you go, it's a smart investment for you and your business.