Once you are established in your business, or if you plan to launch an entity that is more than a side-hustle right from the start, it is important to consider the entity structure you will use to operate under.
Many Canadian small business owners choose to incorporate their businesses rather than begin (or continue) operating as a sole proprietor. this is when incorporation comes into play. Incorporation means that your business becomes a distinct legal entity separate from its owners (also known as shareholders).
When you form a corporation, each owner receives shares in the company proportional to the percentage of their ownership. In addition, you will receive compensation from the company either as a salary, through dividends, or through a combination of these methods. Let’s look at the pros and cons of these payment strategies in more detail.
Pros and Cons of Payment Methods for Owners of Canadian Incorporated Businesses
First, off no matter what, be prepared to pay taxes no matter what type of payroll arrangement you have.
Our firm can set you up with Quickbooks Payroll to make paying yourself and any other shareholders in your small business corporation easier and streamlined for accounting and tax purposes.
The main benefits of paying yourself a salary from the corporation is that you will not need to pay estimated taxes to the Canadian Revenue Agency (CRA) until the end of the year (instead of on a quarterly basis). In addition, the 2022 tax rate for corporations in Canada is 11.5% this is much lower than the lowest personal tax rate of 20%.
As you can see, this much lower tax rate is a key benefit of being paid from a corporation as a small business owner. By keeping the revenue of the company inside the company, it makes tax planning and income spreading much easier.
Additional benefits of having your Canadian corporation pay you a salary include:
- You will contribute to the Canada Pension Plan (CPP) which benefits you during retirement.
- You can also take advantage of other retirement investment accounts by contributing to a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA).
- The payment will be a tax deduction for the corporation, reducing the total taxable revenue and potentially your overall tax burden.
- You can pay salary to any related employees such as a spouse or children.
Some cons of being paid a salary as a small business owner from your Canadian corporation include:
- Payroll must be done and you must set up an account to manage it or outsource your payroll to our firm.
- When you invest in a retirement account, you pay as both the employer and the employee.
- Your salary is 100% taxable, which, depending on your total household income, could increase your tax burden.
Should you pay yourself dividends from your Canadian small business corporation instead of a salary?
There are some advantages to paying yourself dividends instead of a salary as a small business owner in Canada. The main ones include:
- The dividends you receive are taxed at a lower rate than salary which may reduce your personal tax burden.
- You have flexibility as to when you declare dividends. This allows you to optimize your tax situation.
- When you elect to pay dividends, you do not have to pay into the CPP, which can save you money.
- You do not have to administer payroll. At the end of the year you must report the dividends paid as part of a director’s resolution.
There are also some significant disadvantages to paying dividends, especially when it comes to retirement savings. For example:
- Not paying into CPP will reduce the amount of CPP benefits you are entitled to when you retire.
- Receiving dividends doesn’t allow you to contribute to an RRSP, because you don’t have any income.
- When you receive dividends instead of a salary, this prevents you from claiming other personal income tax deductions, such as childcare costs.
Combined salary and dividends for small business corporation compensation
The maximum allowable business limit for the standard tax rate of 11.5% as a Canadian business is $500,000. Over this amount, the tax rate is much higher, almost 16%. To ensure that a business does not exceed this lower tax threshold, many small business owners elect to receive a salary and bonus (or dividend).
While this tax limit plays a part in the decision to receive compensation in the form of salary or dividends, there are other factors to consider including your income level, cash flow needs, your projected annual earnings, how much cash you need for investments and tax deductions, and where you are in your career.
It is advisable to solicit professional advice from an accountant prior to making this election. Our team of Canadian small business accountants can help you determine which compensation structure is right for you.
Not sure which method is ideal for your business?
Looking to analyze your potential tax savings? We have developed a Sole Proprietor vs. Corporation calculator tool, which has been designed to help you calculate the potential tax savings you could access by incorporating your business. Simply click here to utilize our calculator and review your potential tax savings.
Still unsure about which method is right for your business? Don’t worry! Our team of experts can help you in making the right decision. Click here to book a FREE consultation with our experts to discuss this in detail.