Salary or dividends, which is better for entrepreneurs?
After investing time, energy and money, your company starts to become profitable. Undeniably, the question that all entrepreneurs ask themselves is: how should I pay myself? Business owners have two options. They can choose to pay themselves income in two ways: employment income (salary) or dividends. Faced with this choice, it’s important to know the advantages and disadvantages of each of these options.
Dividends more advantageous?
A dividend is the portion of profit allocated to each shareholder of a company. This benefit, which would be known as a cash distribution, can be collected by the entrepreneur.
Remember there are two types of dividends: eligible dividends and ordinary dividends. Eligible dividends are dividends when the business has earned income for which it does not benefit from a small business deduction (SBD). In this case, the entrepreneur’s income will be taxed at a lower rate because the company pays a higher tax. Ordinary dividends are simply income recorded by a company that is entitled to the SBD. As a result, the entrepreneur’s income will be taxed at a higher rate because the company pays less tax.
Note that dividends are not a deductible expense for the company. This is also why individuals’ tax rate is lower than the rate applicable to income in the form of a salary.
The other side of the coin: allocating a dividend as compensation may be poorly perceived by financial institutions. In fact, they see the dividend payment as a capital withdrawal from the company. It would be appropriate for you to inform and explain to your financial institution that this is a salary in the form of dividends and not a capital withdrawal from the company.
On paper and because of their favourable taxation, dividends appear to be an interesting choice. In reality, it is not always the case.
What about salaries?
On the other hand, the payment of employment income (salary) generates additional costs for the employee and employer attributable to social contributions: the Quebec Pension Plan (QPP), Quebec Parental Insurance Plan (QPIP) or Health Services Fund (HSF)). Despite these costs, entrepreneurs will be able to benefit from the advantages of these plans, which is not the case with dividends. The company is also a winner since it will be able to deduct the amount paid for salaries from its taxes.
Last but not least, if business owners want to pay themselves a salary, they can also contribute to a Registered Retirement Savings Plan (RRSP), which will generate tax savings in the year of contribution in addition to yielding a tax-sheltered return until the RRSP is withdrawn. Payment of a dividend does not allow you to contribute to an RRSP.
In the event that a business owner planned to start a family, he or she may opt for salary compensation to benefit from the QPIP in the coming years. In addition, it should not be overlooked that the QPP contribution allows an employee to generate retirement income, which is not the case by paying a dividend. Depending on the entrepreneur’s situation, the salary option may therefore be more attractive than the dividend option.
A choice with many variables
To answer the question “Should I pay myself a salary or a dividend?”, in the long run, each owner must carefully consider all the parameters (monetary and non-monetary) in order to decide what is best for him/her. As needs change and situations evolve, you can always alternate between salary and dividend. The ideal situation might also be to pay part of the compensation as salary and part as a dividend to optimize the entrepreneur’s overall compensation. All of this must be analyzed according to each entrepreneur’s financial objectives.
Also to be read: What happens when you undergo a tax audit?