When Daniel Cowan incorporated his holiday lighting business, FestiLight, he had a decision to make about how he wanted to pay himself – as an employee or a shareholder.
As an employee, Mr. Cowan would take a salary and have to contribute to the Canada Pension Plan (CPP) as both an employer and an employee, at a cost of up to about $5,000 a year. He would also develop room to contribute to a registered retirement savings plan (RRSP), which is tax deductible.
As a shareholder, Mr. Cowan would pay himself in dividends. That means not having to cough up the cash for CPP, providing more cash flow. However, he would receive fewer CPP benefits in retirement compared to someone who contributed during his or her entire working life. He would also lose the RRSP room.
Mr. Cowan decided to go with dividends since he has a second job in the summer, working as a seaplane pilot in Vancouver, where he collects CPP. Also, because his lighting company is busiest between October and February, he set Oct. 31 as his fiscal year end and pays himself afterward, based on how well the business did the previous year and how orders are stacking up in the current season. He likes the added flexibility.
“A dividend is almost a bit of a reward in a way,” Mr. Cowan says. “Maybe it’s totally psychological, but if we have a really great season, I’ll write myself a bigger cheque. That feels pretty good, as though the insane season was worth it.”
His wife is also involved in the company and can take a salary or dividend or both, which provides them with more options for their combined income.
The one drawback Mr. Cowan has experienced since incorporating in 2011 surfaced when he and his wife applied for a mortgage. They had to get a co-signer because the bank didn’t recognize the income in the corporation, which was still young at the time. The couple’s combined salary wasn’t considered adequate to get the loan.
Whether to draw a salary or a dividend is a conundrum for many small-business owners who are incorporated.
Debbi-Jo Matias, a Vancouver-based chartered professional accountant, says the tax system is designed so that there is no meaningful difference in the tax treatment of salary versus dividends, when drawn as income.
The decision often comes down to personal circumstances, including how well someone saves for retirement and whether they need to show a salary to buy a home or want to take advantage of writeoffs such as the child care expense deduction.
“Sometimes a salary is paid up to the CPP limit. Sometimes it is paid up to the RRSP limit,” she says, depending on the person’s lifestyle and retirement goals.
To get the maximum CPP benefit, owners would need to pay themselves up to $54,900 a year in salary in 2016, about $144,500 to maximize RRSPs, and about $12,000 (for children born after 2008) to qualify for the child tax credit.
Ms. Matias says a salary is often best for people who need forced retirement savings.
“Not all of my clients are disciplined enough to save the money that they don’t contribute to CPP,” she says.
Others are good at saving for retirement on their own and aren’t relying on the CPP, or believe they can get better returns investing on their own.
“If you are disciplined about a retirement plan and if you have a financial planner, taking a dividend gives you the most flexibility,” Ms. Matias says.
For many clients, she recommends a blended strategy of taking out both salary and dividends.
Small-business owners can also switch up the strategy, paying themselves one or the other, or both, in a given year, Ms. Matias says.
There’s also an advantage for small-business owners with spouses and children to reduce the overall tax burden, says Gabrielle Loren, a chartered professional accountant and partner at accounting firm Loren Nancke & Co., based in North Vancouver, B.C.
For example, people with children 18 and older can set up a family trust that becomes a shareholder of their corporation. The trust would then pay the child dividends that the trust received from the corporation. The child would pay little or no tax on the dividend income received because of personal exemptions and the dividend tax credit, Ms. Loren says, if it’s their only income for the year.
“What a great way to support your kids, without increasing your income,” Ms. Loren says.
It’s a particularly good strategy for small-business owners to use when putting their offspring through college or university, she says.
“There are different things like that which small-business owners can set up, they just have to know how,” Ms. Loren says. “It’s not for everyone, but there are lots of opportunities there.”