How should I pay myself as a small business owner? This is a question that many small business owners ask themselves, as they try to minimize the amount of tax that they need to pay.
When you own a small business, you need to not only think of how to deal with your personal income and tax you may owe, but you need to think about income and tax as they relate back to your business.
There are a few options of how you can draw an income from your business, including salary, dividends, or a combination of these three. Below we will look at these different income streams and some of the pros and cons of each.
When you pay yourself a salary, you are considered to be an employee of your company. The salary that you receive does need to be reasonable in relationship to the role you take in the company, so as to not raise questions at tax time.
Wages that are paid out are considered to be a tax deduction to the business. This means that the company.
will not be taxed on the wages paid out. These wages will be taxed at a personal level though, at both the provincial and the federal rate.
More specifically, in BC an individual is looking at the following tax rates in 2021.
At the federal level, one is looking at the following tax rates for 2021
This salary that you are now receiving is considered personal income. Besides the benefit of having a personal cash flow, having a personal income can also help you when you are looking for a personal loan or a mortgage. Some financial institutions look specifically for this personal, steady income that is separate from the business.
Since these wages are considered to be an earned income, they are taken into consideration for your Registered Retirement Savings Program (RRSP) contribution limit. These RRSP contributions can then help the following year as the CRA will reduce the income earned by your contribution from the previous year.
For example, hypothetically assume that RRSP contributions are limited to $27,230 – the 2020 Canadian Limit.
The benefit of paying into an RRSP is that these contributions are deductible against any type of income. So, you can deduct $27,230 from any income you earn, which can help lower your tax rate.
Since you are now earning a salary, your company will be doing payroll. This is where necessary deductions are taken off, including tax and CPP. As a shareholder who owns more than 40% of the company shares, you will not need to take off a deduction for Employment Insurance (EI).
Being an employee, you may find payroll to be beneficial in that you will likely not have to pay additional tax at tax time because it has already been paid by the source, your company. On the other hand, you may find setting up payroll, making these source deductions and remitting them to the CRA cumbersome.
In addition to your salary now being 100% taxed, your company is now responsible for paying for CPP.
The Canada Pension Plan (CPP) can be considered both a pro and a con. As a con, the 2020 CPP rate for an income of $58,700 is 5.25% at both the employee and employer rate, which means for you as the business owner, a total of 10.5%. More simply stated, half of your CPP contribution is paid by your corporation and half is taken off of your, the employee’s, pay cheque.
As a benefit, this amount that you are contributing to CPP now will be available to you in your retirement. If you decide that it is more important to keep this money inside of your business and invest it, you would be wanting to set up your own retirement account.
It is always best to speak with a tax professional to see what will work best for you.
A dividend is the distribution of some of the company’s earnings. In order to get paid dividends, you must be a shareholder of the company.
Since these dividends are considered to be a distribution of profits to the shareholders, this means that the corporation has a taxable income. The dividends are not a tax deduction for the business like a salary is, and the corporation will have to pay tax, since the dividends are paid as ‘after tax’ earnings of the company.
Dividends are taxed at a lower rate than a salary at the personal level, because the corporation has already paid a portion of these taxes. It is important to consult a tax professional to compare taking dividends and paying tax at both the personal and corporate level compared to wages, where tax is taken only at the personal level.
If you choose to take out dividends, you will need to remember that this money will be taxed at the personal level (unless you take less than the federal or provincial personal amounts). Depending on the value of your dividends, you may be required to make quarterly tax installments, or you may need to set aside some of the money being paid out to you as dividends for tax time.
If you don’t need much personal income, you may choose to keep your funds in the corporation so it can continue to work for you. When you choose to take out dividends, this can be at a time that works best for both you and your corporation. You may also find that paying yourself or any other shareholders dividends is simpler than having to set up payroll.
Another benefit of dividends is that you don’t need to take any deductions for Employment Insurance (EI) or Canada Pension Plan (CPP) which saves your business money now. You do need to remember at retirement though, that since contributions were not made, there will be nothing on the other end.
Another point to remember is that dividends are not considered to be earned income. This means that they do not create RRSP contribution room for you, so you will not have this benefit when filing your personal income tax return. If you do have another source of income that is classified as earned income though, this is taken into consideration for your RRSP contribution, and benefit can be used to benefit your dividend income at tax time.
As a business owner, you can take a bonus based on income needed and how the company is doing.
A small business may choose to use a combination of salary, dividends and a year-end bonus, depending on how the company is doing.
As we discussed in our blog Taxation of Investment Income, a Canadian controlled private corporation (CCPC) has a considerably lower tax rate when they do not surpass the small business limit of $500,000. A business may decide to pay a year-end bonus to keep under this limit of $500,000.
This bonus will count as a tax deduction, even if it is not paid out right away. When the bonus is paid out, you will need to pay personal tax on it, and the tax rate will depend on your annual income.
Again, you will need to evaluate your business and your personal income to determine the specific tax rates that you are looking at, depending on which province you live in. You may find that it is more beneficial to leave the money inside of your business and be taxed at a higher rate while investing this money. In the meantime, you would be keeping your personal income low and when you do decide to take dividends in the future, this money will be taxed at your personal marginal tax rate.
One final note to remember when looking at taking a bonus. A bonus is considered to be earned income, which means that you will need to deduct Canada Pension Plan contributions and income tax at the source, your business. On the positive side though, because the bonus is considered to be earned income, it can be used towards your RRSP contribution room.
There are several pros and cons to taking a salary, dividends, a year-end bonus- or a combination of all three. It is important that you sit down with your tax professional so that you can evaluate which method is best for you and your company.
Need help from an expert?
If you need clarification on salary and payroll, dividends and bonuses and which is best for you and your company, let one of our experts at Valley Business Centre help. For over 30 years, Valley Business Centre has been providing comprehensive bookkeeping, payroll and tax services to our clients in Whistler, Squamish, the Sea to Sky Corridor and metro Vancouver BC areas. Valley Business Centre provides reliable and effective services to all clients.
This article is written for informational purposes only. It is current at the date of posting and changes to laws and regulation may result in the information becoming outdated. It is not intended to provide legal, tax, or financial advice. It is recommended that readers get advice from a tax professional before making any final decisions.