Salary Vs Dividend
When a person is a shareholder of a corporation and operates a business through that corporation, there are a number of ways through which that person can get access to the income generated in that corporation. The two most common ways are the payment of a salary as employee of the corporation or the receipt of dividends as a shareholder of the corporation. This article provides a general overview of the two methods of remunerating owner/managers.
When a salary is paid to the employee-shareholder for work done in the business, that salary is deductible by the corporation when determining profits for tax purposes. The amount of the salary is then included in the employee-shareholder’s income (and he or she is issued a T4). The corporation, as employer, has an obligation to withhold CPP or QPP (and EI, though the employee-shareholder may be exempt), income tax, and other amounts. The employer corporation also has to pay its share of CPP or QPP, as well as other taxes (such as worker’s compensation and health taxes). This can make each dollar paid out to an employee-shareholder more expensive to the corporation. However, the employee-shareholder, when receiving a salary, will also build RRSP room and be able to defer the tax on some of the amounts received.
When a dividend is paid to the shareholder, the dividend must represent a portion of the retained earnings of the corporation. This makes it an after-tax amount. The dividend is not deductible from the corporation’s income for income tax purposes. The shareholder who receives the dividend must go through a gross-up and credit calculation in including the dividend in his or her income (the corporation will issue a T5 to the shareholder).
The gross-up amount is meant to represent the before-tax amount that the dividend represents, while the tax credit is meant to represent the corporate taxes paid on that amount. The factors for the gross-up and dividend tax credit depend on whether the dividend is an eligible or not an eligible dividend. This is part of the tax-integration mechanism of the Income Tax Act. Some dividends, capital dividends, are received tax free, while others, stock dividends, can be used to defer taxes or increase ownership stakes in the corporation.
There are benefits and drawbacks to each salary and dividend structure other than the tax payable by the shareholder/employee or the total tax payable as between the shareholder and the corporation. One non-tax considerations include protection from CRA action to recover payments (under section 160). The choices for determining the best mix of owner/manager remuneration depend on a number of factors that your tax accountant can help you work through.