Maximizing Profits: Salary vs. Dividends for Business Owners

As a business owner, one of the critical decisions you face is how to structure your compensation. While there are various methods to pay yourself, two primary options stand out: salary/bonus and dividends. Each comes with its own set of advantages and considerations, and choosing the right approach can significantly impact your personal finances and the overall success of your business.

Understanding Salary and Bonus

Paying yourself a salary involves taking a regular, fixed amount of money from your business on a periodic basis. Another alternative is a one-time, or less frequent, bonus payment. These methods are similar to how employees are compensated in traditional employment settings.

Here are some key points to consider when opting for a salary:

1. Predictability: A salary provides stability and predictability in your personal income. You know exactly how much money you'll receive each pay period, making it easier to budget and plan for your expenses.
2. Tax Deductions: Salary and bonus payments are considered a business expense, which means they are tax-deductible for your company. This can help lower your business's taxable income and potentially reduce your overall tax liability, especially if your company’s taxable income is higher than the Small Business Deduction (SBD) limit (currently $500,000)
3. Contributions to Government Programs: By paying yourself a salary or bonus, you may become eligible for certain government programs and benefits that are based on earned income, such as the Canada Pension Plan (CPP) and potentially Employment Insurance (EI).
4. Generating RRSP Contribution Room: Salary and bonus is considered employment income, which can generate RRSP contribution room for the recipient, allowing access to a potentially powerful tax deferral opportunity.

However, it's essential to note that paying yourself a salary or a bonus also comes with its drawbacks. For instance, salaries and bonuses are subject to payroll taxes, including CPP, potentially EI, and income tax withholding. Additionally, setting a salary too high can strain your company's cash flow, especially during periods of financial uncertainty.

Exploring Dividends

Dividends represent a distribution of after-tax profits (aka retained earnings) to the shareholders (which may include you as the business owner) of a corporation. Here's why dividends might be an attractive option for business owners:

1. Tax Efficiency: Unlike salaries, dividends are taxed at a lower rate in many jurisdictions, including Canada. This may result in significant tax savings, especially when the company has paid refundable taxes.
2. Flexibility: Dividends offer flexibility in how and when you distribute profits to yourself and other shareholders. You can adjust dividend payments based on the company's performance and cash flow needs.
3. Retained Earnings: By paying dividends, you can leave a portion of your company's profits as retained earnings, which can be reinvested back into the business for growth opportunities, providing a major tax deferral opportunity by avoiding the personal taxes until the money is paid to you.

Despite these benefits, it is essential to approach dividends with caution. Unlike salaries, dividend payments are not tax-deductible for the company and must be paid out of after-tax profits. Moreover, relying solely on dividends may limit your ability to contribute to government programs like CPP; furthermore, dividend income does not generate RRSP contribution room to the recipient. Both of which may impacting your personal retirement benefits.

Avoiding Traps

Shareholder loans/Advances: Advances or loans to individual and trust shareholders (or related parties) throughout the year needs to be monitored closely. If a loan is outstanding for too long, it can become fully taxable to the recipient. Careful planning needs to be performed to properly account for any shareholder loans or advances to ensure they do not result in unnecessary deemed income or benefits to the recipient.

Salaries to family members: Salaries and bonuses paid to related parties are subject to a reasonableness test. If a salary or bonus paid to a family member is determined to be unreasonable (given the work performed compared to the market value for the services) then the salary or bonus expense in the company could be denied, resulting in a potential double-tax scenario.

Tax on Split Income (TOSI): Careful consideration needs to be given when allocating dividends to family members. There is a complex set of rules which outline how and when a private company may pay dividends to a shareholder who may not be actively involved in the businesses, without being subject to the TOSI rules. If offside, the resulting dividend may be taxed at the highest marginal tax rate for the recipient.

Finding the Right Balance

Ultimately, the best approach to compensation for business owners is fact dependent. What is ideal in one year may not be ideal in another year due to differing needs of the shareholder and the situation of the corporation. By striking the right balance, you can optimize your personal and corporate income, minimize tax liabilities, and ensure the financial health of your business.

Before making any decisions, it is crucial to consult with a tax professional who can provide personalized guidance based on your unique circumstances and business goals. By carefully weighing the advantages and considerations of each option, you can make informed choices that benefit both you and your business in the long run.

Remember, the key is to prioritize sustainability, profitability, and compliance with tax regulations while maximizing the rewards of your hard work as a business owner. With the right strategy in place, you can navigate the complexities of compensation and position your business for continued success.

Contact TAAG in Ottawa to find the right strategy for you and your business

Our team of tax advisors and professional accountants at TAAG can assist you with finding the right strategy for you and your business. Contact us today either online or by calling our office at: 613-234-6006